Fiscal

Highlights U.S. growth will remain firm over the next 12 months, but then will begin to slow from its above-trend pace as the economy runs out of spare capacity. Fiscal stimulus, by the time it is enacted, may simply end up pushing up wages, interest rates, and the dollar, rather than boosting corporate profits. While the U.S. is not at an imminent risk of a recession, the historic record suggests that recessions are more likely to occur when an economy has achieved full employment. Equity investors should favor Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are reasonably favorable. Feature The Rusty Lining The U.S. economy is approaching full employment. The headline unemployment rate has fallen to 4.7%, close to most estimates of NAIRU. Broader measures of labor market slack, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 1). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are near 2007 levels (Chart 2). Chart 1U.S. Labor Market: Not Much Slack Left Chart 2Most Labor Market Survey Measures ##br## Now Consistent With Full Employment It is obviously good news that most people in the U.S. who want to work are able to find jobs. However, at the risk of sounding like spoilsports, we see three risks associated with this development. First, and most obviously, the fact that the U.S. economy is close to full employment means that it will not be able to grow at an above-trend pace for much longer. Second, efforts by the Trump administration to lift aggregate demand with fiscal stimulus may prove to be counterproductive: Rather than boosting GDP growth, the stimulus may simply lead to higher wage inflation and a stronger dollar. This could hurt corporate profits. Third, there is compelling evidence that the risks of a recession rise as an economy approaches full employment and begins to overheat. We discuss all three issues in turn. Weak Supply Will Limit Growth One of the more striking aspects of the U.S. economic recovery is that the output gap - the difference between what an economy is capable of producing and what it actually is producing - has nearly disappeared even though GDP growth has been rather lackluster. This has occurred for one simple reason: Potential GDP growth has been extremely weak. Chart 3 shows that the slowdown in potential GDP growth has been a global phenomenon. In every major economy, the output gap would be larger today than in 2008 if potential GDP had grown at the rate that the IMF forecasted back then. Chart 3AWeak Supply Growth Has Narrowed Output Gaps Chart 3BWeak Supply Growth Has Narrowed Output Gaps Many commentators are hopeful that the combination of sizeable tax cuts and President Trump's pledge to reduce red tape will lead to a marked acceleration in potential U.S. GDP growth. There is some validity to this view. Statutory corporate tax rates in the U.S. are among the highest in the OECD, while the Code of Federal Regulations is 178,000 pages long, eight times the size that it was in 1960 (Chart 4). Still, we are skeptical that the economic benefits of slashing corporate taxes and cutting red tape would be as great as some pundits are touting. If one includes the various loopholes and deductions that companies can avail themselves of, effective corporate tax rates in the U.S. are not particularly high compared with those of other countries.1 Cutting corporate taxes may also do precious little to lift investment spending, given that U.S. companies are already flush with cash and have access to plenty of cheap financing. While the regulatory burden on U.S. businesses has increased somewhat over the past seven years, it is still quite low compared to other major economies according to the World Bank's Doing Business report (Chart 5). And many of the regulations that businesses routinely complain about serve a useful purpose, particularly in the areas of health, clean air and water, and financial stability. Consistent with the analysis above, there is little evidence that Reagan's tax cuts and deregulation initiatives had much effect on productivity growth in the 1980s (Chart 6). Meanwhile, Trump's efforts to crack down on illegal immigration will reduce labor force growth, curbing potential GDP growth in the process. Trade protectionism will also dent productivity in some sectors of the economy. The bottom line is that potential growth is unlikely to rise much above 2% for the foreseeable future. Chart 4There Are Prolific Writers In The U.S. Administration Chart 5Regulatory Burden In The U.S. Is Relatively Low Chart 6The Reagan Years Were No Boon For U.S. Productivity Flagging Fiscal Multipliers As we discussed last week, market participants may be overestimating the extent to which fiscal policy will be eased over the next two years.2 Suppose, however, that the optimists are right; suppose Donald Trump is able to fully deliver on his campaign pledge to raise infrastructure spending and slash taxes. Let us also suppose that, contrary to our expectations, lower personal and corporate tax rates do prompt households to significantly boost spending, while incentivizing firms to increase capital expenditures. What then? The answer is that this still may not translate into significantly faster economic growth. The reason is straightforward: When the output gap is small, an increase in aggregate demand will largely translate into higher inflation rather than increased output. An overheated economy, in turn, will drive up real interest rates, leading to less spending on rate-sensitive goods such as consumer durables, housing, and business equipment. In addition, higher interest rates will cause the dollar to strengthen, swelling imports and reducing exports. This "crowding out" effect will reduce the net effect of fiscal stimulus on growth. The empirical evidence bears this out. Table 1 shows the fiscal multipliers are much smaller when an economy is close to full employment. Table 1The Effect Of A $1 Increase In Fiscal Spending On Aggregate Demand The implication is that Trump's fiscal stimulus plan, by the time it is enacted, may simply end up lifting interest rates, the dollar, and wages, without delivering much acceleration in real business sales. Again, this is not just a theoretical possibility. Chart 7 shows that the ratio of corporate profits-to-GDP has tended to decline when the unemployment rate has fallen below its full employment level. This suggests that the re-acceleration in earnings growth that began last summer could run out of steam later this year. Chart 7The Effects Of Full Employment Recession Risks Are Slowly Rising Business cycle recoveries may not die of old age. However, as anyone who's been around long enough knows, old age isn't exactly conducive to good health either. Chart 8 shows that there is a positive correlation between the degree of labor market slack and the length of time until the next recession. This implies that recessions are more likely to occur when an economy approaches full employment. In fact, outside of the 1982 recession, which in many respects was just a continuation of the 1980 recession, there has never been a case in the post-war era where a recession began at a time when the unemployment rate was above its full employment level. Formal econometric analysis bears this out: According to our calculations, the U.S. has had nearly a 31% chance of falling into recession over the subsequent 12-month period when the economy was at or above full employment, compared with only an 8% chance at all other times.3 Part of the relationship between economic slack and recession risk can be explained by the fact that the unemployment rate is mean reverting. Thus, when the unemployment rate is very low, it is more likely to go up than down. And history suggests that even a slight rise in the unemployment rate is a powerful harbinger of recession. In fact, Chart 9 shows that there has never been a case where the unemployment rate has risen more than one third of a percentage point without the U.S. falling into a recession. Chart 8U.S.: A Tighter Labor Market Means We Are Getting Closer To The Next Recession Chart 9Even A Small Increase In The Unemployment Rate Warns Of A Recession When Animal Spirits Bite Back Mean reversion, however, is only part of the story. As Hyman Minsky famously noted, stability begets instability. By this, he meant that good economic times tend to encourage excessive risk taking, and this sows the seeds of a future crisis. The good news is that the U.S. does not currently suffer from any major economic imbalances. Perhaps it was the severity of the crisis; perhaps it was the lackluster recovery; but whatever the reason, animal spirits have been slow to return this time around. Sure, stocks have soared thanks to ultra-low interest rates, but both business and residential investment remain subdued (Chart 10). Nevertheless, signs of excess are starting to appear in places. Corporations may have been restrained in their capital spending plans, but that did not stop them from piling on new debt to finance share buybacks, and mergers and acquisitions (Chart 11). As a result, our Corporate Health Monitor has been in deteriorating territory since the second half of 2013 (Chart 12). Chart 10Business And Residential Investment Remain Subdued Chart 11Companies Have Been Piling On New Debt Chart 12U.S. Corporate Health Keeps Deteriorating Policy risks have also increased. These include the possibility of a global trade war, rising support for anti-establishment parties in Europe, and a pronounced slowdown in China that precipitates mass capital flight and a sharp depreciation of the RMB. Complicating matters is the fact that policy rates remain quite low across all major economies, which limits the ability of central banks to respond to another economic downturn. Investment Conclusions Chart 13More Optimism About The ##br##Longevity Of The Business Cycle Fears of secular stagnation, which were all the rage just 12 months ago, have given way to unbridled confidence about the future. Investors now dismiss the exact same things they once feared from Donald Trump, even though Trump the President has proven to be little different from Trump the Candidate. Among participants in the New York Fed's Survey of Primary Dealers who assign a non-zero probability that rates will fall back to zero at some point over the next three years, the median respondent expects that it would take 27 months to reach this sorry state of affairs, up from 11 months in April 2016 (Chart 13).4 If one uses this as proxy for when investors believe the next recession will roll around, it implies that market participants now believe that the recovery will last more than twice as long as they thought last summer. We agree that U.S. growth is likely to remain firm over the next 12 months. As we argued last October in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the U.S. economy has a lot of momentum behind it.5 As such, we continue to expect Treasury yields to rise and the dollar to appreciate over the next 12 months. Nevertheless, we are cognizant that much can go wrong with this assessment. Chart 14 shows that most of the recent better-than-expected data has been confined to survey measures of economic activity - what economists call "soft data." The so-called "hard data" has been mediocre. This is not a major red flag, as the hard data often lags the survey results, but it does underscore the fragile nature of the recovery. Chart 14Survey Measures Have Improved More Than The Hard Data All this puts U.S. stocks in a difficult position. If growth does end up disappointing, equities will suffer. However, if growth remains strong, bond yields are likely to rise further, taking the dollar up with them. Meanwhile, a tight labor market will increasingly put upward pressure on real wages, hurting corporate profit margins in the process. With that in mind, investors should overweight equity markets in Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are more favorable. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 According to a report by the Congressional Research Service, the U.S. statutory corporate tax rate was 39.2% while the GDP-weighted average rate in the OECD excluding the U.S. was 29.6% (based on 2010 data). Meanwhile, the U.S. effective tax stood at 27.1% versus the 27.7% average of its OECD peers (based on 2008 data). Studies conducted before the Great Recession also show that the U.S. effective rate is about the same as the GDP-weighted average rate of other major countries. For further details, please see Jane G. Gravelle, "International Corporate Tax Rate Comparisons and Policy Implications," Congressional Research Service (January 6, 2014). 2 Please see Global Investment Strategy Weekly Report, "Two Speed Bumps For The Global Reflation Trade," dated January 27, 2017, available at gis.bcaresearch.com. 3 The probability of a U.S. recession occurring within the next 12 months is calculated by employing a simple logistic model using data from 1960 to the present. The dependent variable (Y) is assigned the value "1" during months when a recession occurs over the subsequent 12-month period, or "0" otherwise. An independent variable (X) is assigned the value "1" when the economy is at full employment, or "0" otherwise. Assuming full employment is reached when the unemployment rate is at least 25 bps lower than the non-accelerating inflation rate of unemployment, the resulting probabilities for a recession within the next year are as follows: P(Y=1 given that X=1) = 31%; P(Y=1 given that X=0) = 8%; P(Y=1 given that X=1 or given that X=0) = 17%. In a nutshell, the probability of a recession occurring increases by 23 percentage points (from 8% to 31%) once full employment is reached. 4 In both the April 2016 and December 2016 surveys, all but one respondent indicated that there was a non-zero chance that rates will fall to zero over the relevant forecast horizon. 5 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Feature For the first time since the beginning of the recovery in 2009, the U.S. economy has the potential - and is showing signs - of entering a self-reinforcing phase. After years of expecting that the next recession is just around the corner, economic agents are now optimistic about the strength and longevity of the business cycle. The likelihood of a period of above-trend growth would be a bullish development for risk assets (Chart 1). Our view is that the surge in business confidence is exaggerated due to federal politics, and Trump's election "honeymoon" effect will partially unwind at some point. However, the U.S. consumer is finally well-placed to shake some of the long-term angst that has been in a fixture for almost a decade. This chart-driven Special Report looks at the U.S. economy from several angles and highlights key themes (Chart 2): Chart 1Self-Reinforcing Recovery Finally At Work Chart 2U.S. Consumer Is The Bright Light Consumption will be the brightest spot in the recovery: The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. Most important is that the main driver of consumption trends, income, is on track to accelerate. Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that the labor market has reached full employment and wages are rising. Residential real estate will be resilient despite the threat of higher rates: Residential construction will continue to make a positive contribution to growth, given that the supply of homes is low, especially relative to our expectations for a pick-up in demand. Capex will continue to lag: Non-residential business investment is likely to remain a sore spot for the economy for some time. Capex spending historically follows consumption with a lag; businesses first wait to see a pick-up in demand for their products and services before undertaking capital expansion. Various measures of capital utilization also suggest that there is still ample capacity, especially in the manufacturing sector, although capital spending growth has historically been driven by the direction of capacity utilization, not its level. Fiscal thrust could be positive but only late in the year: Federal, state and local government spending were only a very modest positive contribution to growth in 2016 and that is likely to be the case at least for the first half of 2017. Thereafter, federal spending may have a much larger impact, although there remain many unknowns. Thus, the coming cyclical improvement in growth will be mainly driven by the consumer sector, at least at first. Although our global leading economic indicators are heading higher, we are wary to extrapolate an overly positive view. There are a number of unresolved headwinds in China, Trump's anti-trade rhetoric is a risk, as is U.S. dollar strength for U.S. exporters. Meanwhile, financial markets are in the midst of a "euphoria rally," based on the expectation that a new U.S. federal government will unleash a powerful combination of pro-business reforms and fiscal ease. Thus, although the U.S. economic recovery rests on improving fundamentals, the stretched level of optimism suggests that investors should be prepared for a reality check. Consumer Spending Rising expectations for real household income growth over the next one to two years and improving job security are a result of a tightening labor market. Since income trends are the main driver of consumption growth, an improved labor market should help boost consumer spending growth to over 3% in 2017 (Chart 3). The cost of essential items as a share of income has declined throughout the recovery. In particular, food and energy costs as a share of income are very low and it is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. This leaves plenty of room for spending on discretionary items. The combined wealth effect from real estate and financial markets has been positive for some time. Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out - i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits - then a positive wealth effect will continue to support consumption in 2017. Wages And The Labor Market U.S. wage growth is in a sustainable uptrend now that the bulk of our indicators suggest that the labor market is at full employment (Chart 4). According to the Atlanta Fed's wage tracker, overall median wages are growing at their fastest pace since the 2008. The gains are broad-based: wage gains have occurred for both "job switchers" and "job stayers." Other measures of wage inflation are also turning higher. The Employment Cost Index (ECI) is the most decisive measure for tracking broad developments for employee wages and benefits among geographic divisions, sectors (services vs goods-producing) and industries. The gains in this index are not as robust, but are nonetheless still rising and, according to business surveys, labor compensation is likely to continue to rise. The Fed views wage growth in the range of 3-4% per year as an important signal that consumer price inflation is moving toward the Fed's 2% target. Although the ECI is still below this range, if the current trend pace continues, 3% inflation in the wages and salaries component is reachable later this year. Chart 3Tailwinds For Robust Consumer ##br##Spending Are Firmly In Place Chart 4Tight Labor Market Will Boost ##br##Further Wage Growth Residential Investment Residential investment as a percent of GDP normally averages about 5% of GDP; it currently stands at 3.7%. However, it should continue to recover, making a significant positive contribution to GDP growth through 2017. Robust long-term fundamentals suggest that residential construction should continue to follow the recovery path experienced by other developed countries when boom/bust cycles occurred (Chart 5). Household formation is a critical measure of new housing demand over the long-term. The number of households formed continues to build towards pre-recession rates. Demographics may help the housing market over the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.1 Finally, housing supply is no longer a headwind. This suggests that if final demand continues to improve, the lack of inventory overhang implies that the incentive for builders to take on new projects is high. Non-Residential Investment The corporate sector has been loath to undertake capital investment throughout the recovery. Despite rock-bottom interest rates, the lack of confidence in the outlook for final demand has kept businesses from investing (Chart 6). Business confidence has surged in recent months, although the sustainability of this trend is questionable. Survey respondents' optimism has been buoyed by great expectations about pro-business reform in Washington. This excessive optimism is vulnerable to pullbacks should Trump's leadership and policies disappoint. Only once businesses see a clear upswing in demand for their products and services will a new capex cycle emerge. The BCA Model for business investment tracks broad capex swings and has been trending down for several months now and remaining in contractionary territory. Investment in equipment, the largest portion of business investment, has been falling sharply for the past year. Much of the weakness is concentrated in the energy sector following the collapse in oil prices in late-2014. The U.S. dollar has also been a headwind for the manufacturing sector. Chart 5Housing Market Is ##br##Recovering Gradually Chart 6Corporate Sector Has Yet ##br##To Unleash Capex Spending Exports Net exports were a slight positive to GDP growth at the end of 2016, after being a drag for the past three years. However, the Q3 2016 improvement is due chiefly to one sector - a surge in soybean exports (Chart 7). Indeed, exports to all regions except Asia remain weak. Exports to the rest of North America, Europe, and Central & South America all peaked in 2014. As mentioned above, the exception to this trend is Asia, which now accounts for about 28% of total U.S. exports. Surging soybean exports to China were the major driver of the Q4 trend change. Government Federal spending was a drag on GDP growth from 2011 to 2015. In 2016, federal spending was a modest positive. Looking ahead, hopes are high that a new government in Washington will significantly boost fiscal spending. Our base case is that the Federal fiscal thrust will rise by about 0.5% of GDP, although the timing is uncertain and may not boost GDP growth until 2018 (Chart 8). Tax cuts could provide an earlier lift, but it would show up as increased consumer and capital spending. State and local spending lost momentum in 2016 after finally recovering the previous year. The 2016 decline in state tax revenues was not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year. Chart 7Nominal Exports Led Mainly By Asia Chart 8Government Spending Will Expand Modestly Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see "The State Of The Nation's Housing 2016," Joint Center for Housing Studies of Harvard University.

Highlights Undue pessimism about global growth is giving way to unbridled optimism. Chinese growth has accelerated. However, there is a risk that the economy hits a speed bump later in 2017, as fiscal policy becomes less accommodative, monetary policy is tightened in an effort to curb capital outflows, and recent steps by the authorities to crack down on rampant speculation in the property sector begin to bite. The threat of a trade war will also loom large. U.S. fiscal policy will remain stimulative, but may fail to live up to expectations: There is little appetite among Republicans for increasing infrastructure spending; the multiplier effects from the proposed tax changes are likely to be small; and many GOP leaders are already chomping at the bit to take an ax to government spending. Fortunately, the U.S. economy has enough momentum to continue growing solidly above trend, even if fiscal policy disappoints. This will allow the Fed to raise rates three times this year, one more hike than the market is currently pricing in. Developed market equities are overbought and vulnerable to a correction, but will be higher 12 months from now. Favor Europe and Japan over the U.S. in local-currency terms. Stay underweight EM. Feature Global Growth Is Accelerating, But Headwinds Persist The global economy is on the mend. Measures of current activity are rebounding, as are a variety of leading economic indicators (Charts 1 and 2). Chart 1Global Economy ##br##Springing Back To Life Chart 2Global Leading Economic ##br##Indicators Are Improving Investors have taken notice: Market-based inflation expectations have risen, as have growth-sensitive commodity prices. Earnings growth expectations have surged, rising in the U.S. to nearly the highest level in a decade. Cyclical stocks have also bounced back, after having lagged the overall market for five years (Chart 3). We agree with the market's positive re-rating of global growth prospects, but worry that undue pessimism is starting to give way to excessive optimism. Two potential developments in particular could end up giving investors pause: A slowing of China's economy later this year. The possibility that U.S. fiscal policy will end up being less stimulative than expected. China: Living On Borrowed Time? Chinese growth has been surprising to the upside of late (Chart 4). Timely indicators such as excavator sales and railway freight traffic, which are well correlated with industrial activity, have been rising at a fast clip. Manufacturing inventory levels have come down, corporate profitability has improved, and producer price inflation has turned positive. The labor market has also picked up steam, as evidenced by the expansion in the employment subcomponents of the PMI indices. Chart 3Market's Positive Re-Rating Of Growth Prospects Chart 4Chinese Growth Has Been Surprising To The Upside Looking out, however, there are reasons to worry that the economy will weaken anew. Growth in government spending slowed from a high of 25% in November 2015 to nearly zero in December (Chart 5). Recent efforts by policymakers to clamp down on rampant property speculation could also cause the economy to cool. Meanwhile, capital continues to flee the country (Chart 6). This has put the government in a no-win situation: Raising domestic interest rates could entice more people to keep their money at home, but such a step could increase debt-servicing costs and undermine the country's creaky financial system. Chart 5China: Fiscal Stimulus Is Running Off Chart 6China: Ongoing Capital Outflows A Problem Of Inadequate Demand There is no shortage of commentary discussing the problems that ail China. Much of the analysis, however, has focused on the country's inefficient allocation of resources and other supply-side considerations. While these are obviously important issues, they overlook what has actually been the most significant binding constraint to growth: a persistent lack of aggregate demand. It has been this deficiency of demand - the flipside of a chronic excess of savings - that has kept the economy teetering on the edge of deflation. If a country suffers from excess savings, there are only three things that it can do. First, it can try to reduce savings by increasing consumption. The Chinese government has been striving to do that by strengthening the social safety net in the hopes that this will discourage precautionary savings. However, this is a slow process which will take many years to complete. Second, it can export those excess savings abroad by running a current account surplus. This would allow the country to save more than it invests domestically through the famous S-I=CA identity. The problem here is that no one wants to have a large current account deficit with China. Certainly not Donald Trump. Third, it can channel those excess savings into domestic investment. This is what China has done by pressing its banks to extend credit to state-owned companies and local governments. Remember that debt is the conduit through which savings is transformed into investment. From this perspective, China's high debt stock is just the mirror image of its high savings rate. The problem is that China already invests too much. Chart 7 shows that capacity utilization has been trending lower over the past six years and is back down to where it was during the Great Recession. The good news is that as long as there is plenty of savings around, Chinese banks will have enough liquid deposits on hand to extend fresh credit. The bad news is that there is no guarantee that borrowers taking on this debt will be able to repay it. This has made the Chinese economy increasingly sensitive to changes in financial conditions. And that sensitivity has, in turn, made global financial markets more fragile. Chart 8 shows that global equities have sold off whenever China stresses have flared up. The risk of another such incident remains high. Chart 7China: Capacity Utilization Back ##br##To Pre-Recession Levels Chart 8When China Has a Cold, ##br##Global Equities Sneeze China Trade War: The U.S. Holds The Trump Card Chart 9China Would Suffer More ##br##From A Trade War With The U.S. Adding to the pressure on China is the prospect of a trade war with the United States. Donald Trump has flip-flopped on almost every issue over the years, but he's been perfectly consistent on one: trade. Trump has always been a mercantilist at heart, and nothing that has happened since the election suggests otherwise. It is sometimes argued that the damage to the U.S. economy from a trade war with China would be so grave that Trump would not dare initiate one. This is wishful thinking. Chinese exports to the U.S. account for 3.5% of Chinese GDP, while U.S. exports to China account for only 0.6% of U.S. GDP (Chart 9). And much of America's exports to China are intermediate goods that are processed in China and then re-exported elsewhere. Blocking these exports would only hurt Chinese companies. Yes, China could threaten to dump its huge holdings of U.S. Treasurys. However, this is a hollow threat. The yield on Treasurys is largely determined by the expected path of short-term interest rates, which is controlled by the Federal Reserve. To be sure, the dollar would weaken if China started selling Treasurys. But why exactly is that a problem for the U.S.? Donald Trump wants a weaker dollar! In short, the U.S. would not lose much by provoking a trade war with China. Where does this leave us? The most likely outcome is that China blinks first and takes more concerted steps to open up its market to U.S. goods. This would hand Donald Trump a major political victory. However, the path from here to there is likely to be a very rocky one, which means that the reflation trade could suffer a temporary setback. A Trumptastic Fiscal Policy? Getting tough with China was one of Trump's key campaign promises; increasing infrastructure spending and cutting taxes was another. Unfortunately, investors may end up being disappointed both by how much fiscal stimulus is delivered and by the bang for the buck that it generates. For starters, much of Trump's proposed infrastructure program may never see the light of day. The $1 trillion ten-year program that he touted during the campaign was scaled back to $550 billion on his transition website. And even that may be too optimistic. Most Republicans in Congress have little interest in expanding public infrastructure spending. They opposed a big public works bill in 2009 when millions of construction workers were out of a job, and they will oppose one now. The public-private partnership structure that Trump's plan envisions will also limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Granted, the definition for what counts as public infrastructure could be expanded to include such things as hotels and casinos, to cite two completely random examples. But even if one ignores the obvious governance problems that this would raise, such a step could simply crowd out private investment that would otherwise have taken place. The reason that governments invest in infrastructure to begin with is because there are certain categories of public goods that do not lend themselves well to private ownership. To purposely exclude such goods from consideration, while devoting public funds to projects that the private sector is already perfectly capable of doing, is the height of folly. Trump And Taxes House Republicans are pursuing a sweeping tax reform agenda. There is much to like about their proposal. In particular, the shift to a cash flow destination-based tax system could encourage new investment over time, while making it more difficult for firms to carry out a variety of tax-dodging strategies. However, as with many major policy initiatives, the Republican tax proposal could generate significant near-term economic dislocations. Most notably, as we discussed in detail last week, the inclusion of a border adjustment tax could lead to a sharp appreciation in the dollar.1 This would benefit foreign holders of U.S. assets, but hurt debtors with dollar-denominated loans. Such an outcome could put stress on emerging markets, potentially undermining the global reflation trade. Trump's proposed cuts to personal income taxes may not boost spending by as much as some might hope. The Tax Policy Center estimates that the top one percent of income earners will see their after-tax incomes increase by 13.5%, while those in the middle quintile of the distribution will receive an increase of only 1.8% (Table 1). Since the very rich tend to save much of their income (Chart 10), measures which boost their disposable income may not translate into a substantial increase in spending. In fact, cutting the estate tax, as Trump has proposed, could actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Table 1Trump's Proposed Tax Cuts Would Largely Favor The Rich Chart 10Savings Heavily Skewed Towards Top Earners Spending Cuts On The Horizon? Then there is the question of whether Congressional Republicans will try to take an ax to government spending. The Hill reported last week that several senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years.2 The plan contains many of the same elements as the Republican Study Committee's Blueprint for a Balanced Budget, which called for $8.6 trillion in cuts over the next decade. Separately, Representative Sam Johnson of Texas, the chairman of the House Ways and Means subcommittee on Social Security, has introduced legislation seeking large cuts to pension benefits. Under his plan, workers in their mid-thirties earning $50,000 per year would see a one-third reduction in lifetime Social Security payments.3 Paul Ryan and other Congressional Republicans have also begun to argue that the goal of health care reform should be to guarantee "universal access" to high-quality medical care, rather than "universal coverage." This is a bit like arguing that the goal of transportation policy should be to ensure that everyone has access to a Bentley, provided that they can pony up $200,000 to buy one. It remains to be seen whether President Trump will acquiesce to these changes. He has repeatedly insisted that no one will lose medical coverage under his administration. However, one of his first actions in office was to loosen the mandate that requires healthy individuals to purchase insurance under the Affordable Care Act. Such a measure, however well intentioned, could greatly undermine the Act. If healthy people can wait until they are sick to sign up for insurance, only sick people will sign up. In order to cover their costs, insurance providers would have to raise premiums, ensuring that even fewer healthy people sign up. Such a vicious "adverse selection cycle," as economists call it, could lead to the collapse of health insurance exchanges, which currently provide coverage for 12.7 million Americans. Our guess is that Trump will ultimately put the kibosh on any plan to radically cut government spending or curtail Medicare and Social Security benefits. Say what you will of Trump, he has proven to be a skilled political operator for someone who has never been elected to public office. He knows that people were chanting "build the wall" at his rallies, not "cut my Medicare." Indeed, it is possible that Trumpcare will ultimately look a lot like Obamacare but with more generous subsidies for health care providers. Nevertheless, the path to this more benign investment outcome will be a bumpy one, suggesting that market volatility could rise in the months ahead. Investment Conclusions Chart 11DM Stocks Are Overbought Markets tend to swing from one extreme to another. This time last year, investors were fixated on secular stagnation. Now they are convinced that we are on the edge of a new global economic boom. Neither position is justified. Global growth has picked up, and this should provide a tailwind to risk assets over the next 12 months. However, as this week's discussion makes clear, there are still plenty of headwinds around. This suggests that the recovery will be a halting affair, with plenty of setbacks along the way. The surge in developed market equities since the U.S. presidential election has pushed stocks deep into overbought territory (Chart 11). A correction is likely over the next few weeks. We expect global equities to fall by 5%-to-10%, paving the way for higher returns over the remainder of the year. Once that recovery begins, European and Japanese stocks will outperform their U.S. counterparts in local-currency terms. We continue to expect EM equities to lag DM. In contrast to stocks, bond yields have already moved off their highs. As we discussed in our Strategy Outlook in early January, the transition from deflation to inflation will be a protracted one.4 Nevertheless, the path of least resistance for yields is to the upside. The Fed is likely to raise rates three times this year, one more hike than the market is currently pricing in. This should be enough to keep the dollar bull market intact. We expect the trade-weighted dollar to rise another 5% by year-end, with the risk tilted to the upside if Congress ends up approving a border adjustment tax. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 2 Please see Alexander Bolton, "Trump Team Prepares Dramatic Cuts," The Hill, dated January 19, 2017. 3 Please see Stephen C. Goss memorandum to Sam Johnson, "Estimates Of The Financial Effects On Social Security Of H.R. 6489, The 'Social Security Reform Act Of 2016,' Introduced On December 8, 2016 By Representative Sam Johnson," Social Security Administration, Office Of The Chief Actuary (December 8, 2016). 4 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. Some of the cyclical tailwinds that have aligned for consumers are: very low essential spending burdens, rising incomes, a positive wealth effect, and improved credit scores. Several areas of the U.S. equity market are set to outperform on the back of this improved consumer profile. Feature Financial markets continue to be optimistic about a more fertile business backdrop under a Trump presidency. At current valuations, equities are likely to undergo a testing phase. Indeed, the equity market's reaction to President-elect's press conference last week - the first in months - may be an omen of what is in store should Trump disappoint relative to what appears like very high expectations for the early days of his Presidency. At first blush, it appears that the surge in sentiment among a broad range of economic agents was precipitated by just one factor: Donald Trump's victory in the presidential election. Measures of both business and consumer confidence all rose sharply after November 8th (Chart 1). An important question is how sustainable and how far-reaching is this new-found optimism? After all, a major missing ingredient in the recovery to date has been faith that the economic future would get better. Last year, over half of respondents to a Nielsen global confidence survey still believed the world was in recession. Our take is that the uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. In contrast, the rise in business optimism is thus far built on shakier fundamentals, and therefore vulnerable to disappointment - at least until corporate executives see signs of a pickup in consumer demand. This view runs counter to the current popular narrative, where businesses - and therefore their stock prices - perform better once a new era of pro-business policies are ushered in. We have noted in past weekly reports that we believe the equity market has overshot and that policy is likely to under-deliver; it is a high bar to assume that the new American government will succeed in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending and a lighter regulatory burden, while simultaneously avoiding any negative shocks from trade reform and foreign policy blunders.1 Thus, we interpret the surge in business confidence, as reported in various surveys, to be exaggerated and prone to a pullback. On the flipside, a number of cyclical tailwinds have aligned for consumers. Although consumer sentiment surveys also spiked higher since November, this merely extends an already rising trend. Below, we outline the fundamental factors that support stronger consumption growth in the coming quarters. Cost Of Essentials Is Ultra-Low First, the cost of many essential items have declined throughout the recovery, particularly energy prices (Chart 2). The decline in energy prices since 2014 means that spending on energy as a percent of disposable income is near thirty year lows. Likewise, spending on food and interest payments as a share of income is also as low as it has been in thirty years. It is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. Chart 1Confidence Surge: Some Trump, ##br##Some Fundamentals Chart 2Essential Spending Burden##br## Is Very Low Incomes Are Rising And Jobs Are Secure Much more importantly, the main driver of consumption trends, income, is on track to accelerate (Chart 3). Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that wage growth is rising. Indeed, as we highlighted in a Special Report in November, the labor market has reached full employment, which is the necessary threshold for a broad-based acceleration in wages (Chart 4). Although there are structural factors that will mitigate rapid wage hikes, it is likely that mild upward pressure on wages will continue throughout 2017 (Chart 5). This is obviously good news because higher wages means that consumers will have the wherewithal to spend more. In addition to this, a tighter job market has boosted job security. Various measures of consumer confidence highlight that over the past year, consumers now have much greater confidence in long-term job prospects. This is important because when job security is high, the propensity to spend instead of save is much higher (Chart 3, bottom panel). Chart 3Income Properties Drives Spending##br## More Than Any Other Factor Chart 4(Part I) Full Employment Calls##br## For Gradually Higher Wages Chart 5Part (II) Full Employment Calls##br## For Gradually Higher Wages Although income is the primary driver of consumption, the trend can be enhanced by several factors, including consumer wealth, the ability of consumer to finance purchases and fiscal handouts. The Wealth Effect Will Remain A Tailwind The wealth effect is the change in spending that accompanies a change, or perceived change, in wealth. The combined wealth effect from real estate and financial markets has been positive for some time (Chart 6). Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out, i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits, then a positive wealth effect will continue to support consumption in 2017. Debt/Deleveraging Cycle Is Advanced One of the major headwinds to consumer spending since 2008 has been the long, dark shadow of deleveraging. But that process is now well-advanced for the consumer sector. Consumer debt levels as a percent of disposable income peaked in 2008 at over 120%, but are now back under 100%, i.e. at the level that existed prior to the housing bubble and bust. Indeed, the financial obligation ratio for households (both renters and homeowners) is lower today than at any time in the past thirty-five years (Chart 7). Of course, part of this is due to very low interest rates, but our Bank Credit Analyst will show in their February publication that even a 100 basis point rise in borrowing rates from current levels would not lift the interest payment burden to elevated levels by historical standards. Chart 6Wealth Effect Will Remain Positive Chart 7Credit Conditions Are Not Problematic Finally, access to credit remains favorable. In late 2016, lending standards for consumer loans tightened slightly in late 2016, but access to credit generally is not a constraint on spending. A second important point is the ability of those scarred from the housing bust to re-enter the credit market. By law, information about any credit payment delinquencies, including mortgage payment delinquencies, must be removed from an individual's credit record after seven years. Therefore, if no other delinquencies occurred, individuals who experienced a foreclosure see their credit scores recover in seven years and can once again become candidates for mortgage purchases and therefore homeownership. According to research by the Chicago Federal Reserve, since the peak of foreclosures occurred prior to 2011, the bulk of borrowers that foreclosed during the housing bubble and bust are now seeing their credit scores improve. By 2016, both prime and sub-prime borrowers who entered foreclosure between six and nine years earlier (in 2007-10) appear to have recovery rates that are converging with the historical rates of recovery among their predecessor cohorts: nearly 100% of sub-prime borrowers from 2007-2010 who foreclosed have re-attained their previous credit scores, while over 60% of prime borrowers from 2007-2010 re-attained theirs (Chart 8). This means that in large part, the massive drag on housing demand due to poor credit scores from the previous housing bust have been alleviated. Chart 8Share Of Home Mortgage Borrowers Who Recovered ##br##Pre-Delinquency Credit Score After Foreclosure Fiscal Help? President-elect Donald Trump has promised fiscal stimulus in the form of infrastructure spending, corporate tax cuts and personal income tax cuts. The latter could have a positive impact on consumption, although it would likely be small. According to the Tax Policy Centre, if enacted, the highest income taxpayers (0.1 percent of the population, or those with incomes over $3.7 million in 2016 dollars) would experience an average tax cut of nearly $1.1 million, over 14 percent of after tax income. Households in the middle fifth of the income distribution would receive an average tax cut of $ 1,010, or 1.8 percent of after -tax income, while the poorest fifth of households would see their taxes go down an average of $110 or 0.8 percent of their after-tax income.2 The bottom line is that fiscal policy, if Trump's plan is enacted, could be a small positive tailwind for consumption in 2017. Overall, there are increasing signs that the scar tissue from the Great Recession is finally fading and that the improvement in consumer confidence is sustainable. This, combined with better income prospects will give households the wherewithal to spend more freely and will push real GDP growth up to 2.5% or perhaps slightly stronger. Our past research shows that sustainable capital spending cycles only get underway once businesses see clear evidence that consumer final demand is on the upswing. Thus, perhaps a healthier capex cycle will get underway, and businesses will have a fundamental reason to be more upbeat about their prospects. But for now, it seems more likely that businesses are at risk of being disappointed with the speed and efficacy of federal policy changes. On this basis, favoring equity sectors geared to the consumer rather than capex still makes sense. Favor Consumer-Geared Equity Sectors An acceleration in consumer spending will benefit consumer-sensitive equity sectors and would also support our domestic-over-global equity tilt. In our December 5th report, we outlined the bullish prospects and compelling value on offer in the consumer discretionary sector. In addition, our sister publication, U.S. Equity Strategy service just published their annual high conviction equity list. Home improvement retail, and consumer finance stocks were top of the list of high conviction overweights: Home Improvement Retail (Chart 9): Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. And as highlighted above, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. In addition, remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Consumer Finance (Chart 10): This group offers early-cyclical exposure and is levered to the rising interest rate environment and debt-financed consumer spending. Chart 9Home Improvement Retail Stocks Chart 10Consumer Finance Stocks Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led. This group is well-placed to take advantage of the improving consumer trends discussed above. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten", dated November 21, 2016, available at usis.bcaresearch.com 2 http://www.taxpolicycenter.org/publications/analysis-donald-trumps-revised-tax-plan/full Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral. The technical component retained its "buy" signal, with slightly more advancement in the breadth & trend indicators relative to the momentum indicator. The monetary component, which measures overall liquidity conditions, is still favorable for equities, albeit is moving into less bullish territory. However, on the cyclical front, the earnings-driven component still warrants caution. Even as real operating earnings have marginally improved, they remain at a significant distance from positive economic expectations. Earnings momentum is also sluggish, based on our earnings diffusion index. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model, unchanged from last month. Although the valuation and technical components of the bond model are still constructive, the cyclical component is significantly less bullish this month. Chart 11Portfolio Total Returns Chart 12Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

Highlights China's monetary and fiscal policy in 2017 will likely remain accommodative, in order to achieve the goal of an average 6.5% GDP growth over the next five years. China's policies related to its property market will be much more restrictive than the previous two years. Chinese metal demand will grow at a slower pace than last year, as reflationary policies are throttled back. Feature Base metals and bulk markets had a fantastic year in 2016, a complete reversal of their miserable performance in 2015 (Chart 1, panels 1 and 2). Last year, the LMEX base metal index, steel prices and iron ore prices were up 30%, 75%, and 91%, respectively (using average prices in January and December). In comparison, during the same period of 2015, the LMEX index, steel and iron ore were down 22%, 30%, and 41%, respectively. Massive supply reductions, and recovering demand caused by China's reflationary fiscal and monetary policies, were the driving forces behind these sharp rallies in bulks and base metals prices last year. Both the official manufacturing PMI and Keqiang index, which are broadly used as key measures of Chinese economic conditions, reached a three-year high in late 2016 (Chart 1, panels 3 and 4). Clearly, metal prices had already discounted a positive outlook vis-a-vis Chinese economic growth, which was boosted by a series of reflationary policy initiatives in the past two years. The question now is: will reflationary monetary and fiscal policies continue into 2017? If so, on how large a scale will it be? What factors could limit or even prevent reflationary policies in China? A look back China's reflationary policies actually started in late 2014, when the property market and overall economy showed signs of weakness. The country accelerated its reflationary policies throughout 2015 and maintained a moderate reflationary stance in 2016, in order to spur domestic economic growth. Monetary policy: China cut its central-bank directed policy rate five times in 2015 from 5.6% to 4.35%, the lowest level since the data started in 1980 (Chart 2, panel 1). The People's Bank of China (PBoC), the country's central bank, also lowered the reserve requirement ratio at banks - the amount of reserves banks must keep on hand - four times in 2015 and once in 2016 from 18% to 15%, the lowest level since May 2010 (Chart 2, panel 2). Chart 1China Reflationary Policy Drove ##br##Metal Price Rallies In 2016 Chart 2Both Monetary and Fiscal Policies ##br##Were Reflationary Last Year Fiscal policy: China halved its 10% sales tax on passenger cars with engines up to 1.6 liters in October 2015, which boosted auto sales and production significantly last year (Chart 2, panel 3). The country also maintained its high-growth infrastructure investment last year (Chart 2, panel 4). Real estate-related policy: China loosened its housing-related policies extensively since September 2014, by among other things, reducing down-payment requirements for first-time home buyers, and reducing down payments needed to finance second homes. The goal of the policies was to reduce elevated housing inventories. Indeed, those policies, along with the combination of falling mortgage rates, revived the Chinese property market in 2016, and sparked a massive rally in steel-making commodities - metallurgical coal and iron ore - and in base metals. For the first 11 months of last year, the average selling prices of 70 cities and the total floor-space-sold area rose 13.6% and 24.3% yoy, respectively, which considerably improved from the 2015 same period's 6% and 7.4% yoy growth. The floor-space-started area had an even more significant improvement - a growth of 7.6% for the first 11 months of last year versus a deep contraction of 14.7% yoy for the same period of 2015 (Chart 3). What now? This year, we continue to expect accommodative monetary and fiscal policy in China. "Stability" was the key word during the three-day Central Economic Work Conference (December 14-16, 2016), an annual meeting that set out economic targets and policy priorities for next year. "Stability" means the country's leaders will try to implement policies designed to keep the country's GDP growth around 6.5% this year, the average GDP growth target for the five years between 2016 and 2020, under China's five-year plan. China's economic growth is on a downtrend, coming in at 6.9% in 2015, and a predicted 6.7% in 2016 (for the first three quarters of 2016, China's GDP growth was all 6.7%) (Chart 4, panel 1). Chart 3Property Market Policy: ##br##Greatly Loosened In 2015 And 2016 Chart 4We Expect Chinese Monetary And Fiscal Policies ##br##To Stay Accommodative This Year The market's expectation for China's 2017 GDP growth currently is 6.5%. Even though President Xi has stated he is open to growth in China falling below 6.5%, too far below this level - for example, below 6% - could cause widespread disappointment in the country and trigger the "instability" leaders are trying to avoid. Hence, monetary accommodation likely will persist in 2017. As both headline inflation and core inflation in China still are not elevated, we do not expect any rate hikes or increases in the reserve requirement ratio to be announced by the PBoC this year (Chart 4, panel 2). In addition, the RMB depreciated considerably last year, which helps the country's exports and, to some extent, stimulates domestic economic growth (Chart 4, panel 3). In mid-December last year, Chinese policymakers raised the tax on small-engine autos slightly - from 5% last year to 7.5% this year - but this is still below its normal 10% level. This also indicates the country wants to maintain a moderate, but not too expansionary, level of fiscal stimulus In 2017. In 2016, most of Chinese automobile production growth came from small-engine passenger cars, which clearly benefited from this policy (Chart 4, panel 4). This year, we still expect positive growth in Chinese vehicle production but at a much slower rate than last year. Curbing Property Market Exuberance Regarding the Chinese property market, our take-away from the Central Economic Work Conference was that "curbing the speculative home purchases, containing asset bubbles and financial risks" will be among the country's top 2017 priorities. In comparison, back in 2016, reducing housing inventories was the focus. Indeed, with property sales recovering, inventory has fallen from its 2015 peak. Inventories still are elevated, but most of the overhang is in third- and fourth-tier cities, with some of it in even smaller cities (Chart 4, panel 5). A continuation of stricter housing policies deployed since last September to cool the over-heated domestic property market is expected. For example, Beijing raised the down payment for first-time homebuyers from 30% to 35%. Down payments for second homes rose from 30% to a minimum of 50%. For a second home larger than 140 square meters, the down payment is now 70%. So far, more than 20 cities have declared similarly strict policies to control speculative buying in property markets. Currently, a record high 20% of people surveyed plan to buy a new house in the next three months, which indicates further cooling measures are needed for the property market (Chart 5, panel 1). In the meantime, new mortgage loans as a share of home sales in value also reached a record high of 49%, and real estate-related loans as a share of total new bank loans now stand at a 6-year high, signaling financial risk in these markets is rising (Chart 5, panels 2 and 3). All of these factors signal that the Chinese authorities will maintain their restrictive property market policies in 2017. This will be negative for the country's bulk and base metals demand, as the property market accounts for some 35% of demand for these commodities. In conclusion, China's monetary and fiscal policies are likely to stay accommodative in 2017, while the country's housing market is facing restrictive policies. Shifting Economic Drivers For Bulk and Base Metal Demand We would like to remind our clients that China's economic structure is shifting: Services (also known as the "tertiary sector") account for a rising share of GDP, and are not big users of bulks or metals, while manufacturing (i.e., the "secondary sector) demand for these commodities is slowing. Services now account for 51.4% of GDP, while manufacturing now accounts for 39.8% (Chart 6). The GDP weight of services is up from 42% ten years ago, while the GDP weight of manufacturing is down 8 percentage points over the same period. Chart 5Property Market Policy Will Remain ##br##Restrictive in 2017 Chart 6China's Economic Structure Shift Is ##br##Negative To Metals Demand This shift is negative for metal demand growth, as the related manufacturing activity growth slows faster than the overall GDP growth. Overall, we believe Chinese bulk and base metal demand growth in 2017 will slow as a result of less expansionary policies than prevailed last year, and a more restrictive domestic housing market. Next week The Chinese Central Economic Work Conference also emphasized that 2017 will be a year to deepen supply-side structural reforms, which we will discuss in our next week's pub. We also will address the impact of Chinese environmental policy on Chinese metal output. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com ENERGY Chart 7Evidence Of Production Cuts Will Lift Oil Prices Oil Production Expected To Fall Reports of production cuts and reduced volumes being made available to U.S. and Asian refiners have been trickling out since the start of the year, lending underlying support to prices globally (Chart 7). The Kingdom of Saudi Arabia (KSA) is reducing exports of heavy-sour crudes favored by U.S. Gulf refiners, and boosting light-sweet sales, which will compete with North Sea volumes and U.S. shale production. This should tighten the spread between the light-sweet benchmarks Brent and WTI vs. Dubai (medium/heavy-sour). Reduced volumes being shipped by KSA to Asian refiners - particularly to Chinese refiners - will support Brent prices. We continue to expect the production cuts negotiated under the leadership of KSA and Russia to become apparent next month, and for inventories to draw in response. Continued high output by Iraq likely will be reduced in the near future. U.S. shale-oil output most likely will increase in 2H17 by ~ 200k to 300k b/d on average, given higher prices supporting drilling economics. Our expectation for global demand growth remains ~ 1.4mm b/d this year, roughly in line with 2016 growth. Given these underlying fundamentals, we expect inventories will begin showing sharp draws, causing backwardation in crude-oil markets to re-emerge in 2H17. As such, we are re-establishing our Dec/17 vs. Dec/18 WTI front-to-back spread - i.e., buying Dec/17 WTI and selling Dec/18 WTI against it. This spread was in contango going to press, making it particularly compelling. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

Highlights Barring major external disruption, Chinese GDP growth will likely continue to accelerate into the first half of 2017. The overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. Trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. The dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. Shorting the CNH/USD is not much different from a direct bet on the dollar index. Aggressive directional bet on Chinese shares is not warranted in the near term. Strategically favor Chinese equities over their global peers. Feature China has rung into 2017 with strengthening growth momentum that has been building in recent months, but the New Year clearly brings new challenges. China is on the receiving end of two major external uncertainties - namely, the anti-globalization backlash from the U.S. under President-elect Donald Trump and the outlook for the U.S. dollar, both of which are completely beyond its control. 2017 will also be a highly charged year in Chinese politics, as the ruling Communist Party prepares for a generational leadership reshuffle. This means the Chinese leadership will be more sensitive to perceived "provocations" from abroad, making political risk between the U.S. and China even less predictable. The Chinese authorities will remain highly vigilant about economic and financial stability. Meanwhile, the government will continue to mobilize the public sector and fiscal resources to support the economy, as external uncertainties mount. Domestic Demand Should Remain Buoyant Most of the recent data releases coming out of China have surprised to the upside, and the regained strength appears rather broad-based (Chart 1). Some indicators that are highly sensitive to industrial activity such as transportation freight, electricity generation and construction machine sales have rebounded sharply, partly due to last year's low base. Meanwhile, the consumer sector has remained buoyant, with strong expansion in durable goods sales such as cars and air conditioners. Looking forward, we expect the economy to continue to improve, at least in the next two quarters. Leading indicators are still strengthening. The latest PMI figures, both manufacturing and non-manufacturing, have continued to climb, and remain above the boom-bust threshold. The labor market is on the mend. The employment component of the PMIs has been rising in recent months, indicating increased hiring as the economy picks up (Chart 2). This could lead to a self-feeding virtuous cycle where an improving labor market leads to rising income growth and strengthening aggregate demand, which further boosts overall business activity and the labor market. Chart 1Broad-Based Recovery Chart 2Labor Market On The Mend The corporate sector is recovering. Inventories are exceptionally low, setting the stage for inventory restocking, which could further boost production (Chart 3). Profit growth among both private and state-owned enterprises has continued to accelerate. Rising profits are easing financial stress, particularly for debt-laden, asset-heavy sectors. This is also reflected in banks' asset quality; banks' non-performing loan accumulation has slowed sharply of late (Chart 4). In addition, recovery in the corporate sector should also bode well for investment, which is still subdued. The housing crackdown since early October has once again set the stage for negative surprises. Home sales have already begun to slow, and the government appears determined to check housing demand. A key difference between now and previous rounds of housing crackdowns is that developers have been quite cautious throughout the current cycle1: confidence has been downbeat, and housing starts have remained quite weak. Consequently, housing inventories have been quickly depleted nationwide. The demand crackdown has dashed hopes for a housing-led growth recovery, but low inventories and sluggish housing construction has also reduced the risk of another housing-led investment bust, which has typically followed previous housing tightening campaigns. Chart 3Inventory Restocking Will ##br##Further Boost Production Chart 4Corporate Sector Recovery ##br## Also Helps Banks Our model shows that Chinese GDP growth likely accelerated notably in the final quarter of the year, and the momentum will probably carry forward into the first half of 2017, assuming no major external disruption (Chart 5). The inauguration of Donald Trump next week marks the biggest uncertainty for China's growth outlook in recent history due to his well-publicized anti-globalization stance, especially his proposed harsh anti-China trade policies. Chart 5Growth Should Continue To Improve The Trump Wildcard Speculation on President-elect Trump's forthcoming China policies run amok, ranging from pragmatic deal-making, simmering frictions and tit-for-tat retaliation, to the inevitability of a full-fledged trade war and even to a geo-strategic alliance with Russia against China. It is impossible to tell at the moment where reality will eventually end up, but what is clear is that trade tensions between the world's two largest economies will inevitably increase, the degree of which matters greatly for how the Chinese economy as well as the global economy perform in the medium to long term. Low-profile trade tensions and punitive barriers will prove damaging to specific sectors and industries, but should not have a major macro impact. Chinese products that are likely to be subject to American punitive tariffs are some heavy industries such as metals. The usual suspects that may fall victim to Chinese retaliation are American transportation equipment and agricultural products - two main American export items to China. At the macro level, however, China's export sector performance should improve on a cyclical basis, especially if "Trumponomics" successfully lifts U.S. economic growth this year (Chart 6). As one of the major beneficiaries of globalization, China stands to suffer if the broad globalization trend reverses. The saving grace is that exports as a share of the Chinese economy have already almost halved to below 20%, a level comparable to the early 2000s before China joined the World Trade Organization (Chart 7). In other words, China's "globalization dividends" have already diminished to some extent. Moreover, Chinese exports depend more on the U.S. market than the other way around. Therefore, it is in China's best interests to avoid an escalation of trade frictions with the U.S., simply because it has more to lose.2 Nonetheless, it goes without saying that no country gains in a trade war, and the world risks a deep economic recession if the two largest economies engage in an all-out trade battle. Geo-strategic containment of some kind further darkens the outlook for both China and the world. A "cold war" between China and the U.S. would mark a drastic break from the global environment of the past four decades that allowed China to focus solely on economic development. One can only hope that a "clash of the titans" will not drag the world into a self-destructive downward spiral. Chart 6Trumponomics Should Also ##br##Help Chinese Exports Chart 7Globalization Dividends ##br## Have Already Diminished In short, it is too early to evaluate the impact of America's new trade policy on China's growth outlook. We suspect the near-term impact should be limited, as it is unlikely that trade tensions will immediately erupt once Trump takes office. Nonetheless, the situation needs to be monitored closely going forward. Policy: Fiscal Takes The Helm We expect the Chinese authorities will further downplay the significance of the annual GDP growth target as a binding policy constraint. Growth recovery and improvement in labor market conditions reduce the need for further pump-priming, but the overall policy stance will stay accommodative to safeguard against potentially negative shocks from abroad. On the monetary policy front, the case for further interest rate cuts has diminished (Chart 8). The People's Bank of China (PBoC) recently reiterated that its monetary stance will stay decisively "neutral." In our view, this means the PBoC will continue to fine-tune interbank liquidity, but any symbolic policy move in either direction can be ruled out, unless the economic situation takes a sudden turn. In contrast, fiscal policy will be more stimulative. The annual budget deficit will likely be further increased in the March session of the People's Congress. Moreover, some high-profile investment plans have been released in recent weeks, meaning policy-led investment spending will remain elevated going forward. The country aims to invest RMB 2 trillion, or US$290 billion, in tourism between 2016 and 2020. This would translate into annual growth of more than 14% in direct investment in the industry. China's National Energy Administration (NEA) plans to invest RMB 2.5 trillion (US$360 billion) to develop the nation's energy sector over the next five years, with a focus on renewable resources. Installed renewable power capacity including wind, hydro, solar and nuclear is expected to contribute to about half of new electricity generation in five years, which will boost growth and reduce pollution. The government continues to promote private-public partnerships (PPPs) to build infrastructure. The published PPP proposals so far amount to a whopping RMB 12.5 trillion, with a heavy concentration on the transportation network and urban development (Chart 9). Chart 8Expect No Change In Policy Interest Rate Chart 9Fiscal Takes The Helm It is worth noting that recent growth improvement has been accompanied by a notable slowdown in fiscal spending, leaving room for reacceleration going forward (Chart 10). In short, fiscal spending and policy-led investment will remain the key tools for the Chinese government to stabilize the economy. Chart 10Fiscal Spending Is Set To Reaccelerate Chart 11Weak RMB Or Strong Dollar? The RMB: Which Way Will The Wind Blow? Since the New Year, offshore RMB (CNH) liquidity has tightened dramatically, which has led to a massive surge in the Hong Kong Interbank Offered Rate (HIBOR) of the RMB and a sharp rebound in the CNH/USD cross rate. This is widely viewed as a successful short squeeze engineered by the PBoC to punish speculators. It is certainly true that the authorities "allowed" offshore RMB liquidity to dry up, but the sharp spike in the HIBOR rate also closely resembles a classic emerging market currency crisis: speculative attacks on the exchange rate forces the monetary authorities to dramatically jack up interest rates to maintain exchange rate stability - a textbook example of the "Impossible Trinity" thesis at work. In China's case, however, the offshore HIBOR rate bears no relevance on the funding cost of the Chinese corporate sector. As such, the PBoC couldn't care less about periodic tightening in CNH liquidity, as it has no consequence on the domestic economy. This bodes poorly for the internationalization of the RMB, but is a low-cost tool for the PBoC to maintain control over the exchange rate. Two observations can be made from this episode: It is unlikely that the PBoC will completely give up control over the RMB exchange rate, especially in this politically charged year. Sharp depreciation in the RMB/USD may be viewed as a sign of systemic financial risk and economic weakness, a taboo ahead of the Party Congress later this year. Since the New Year, the Chinese authorities have further tightened capital account controls to restrict capital outflows - a reflection of the PBoC's determination to maintain exchange rate stability. There is now an almost universal consensus that the U.S. dollar will strengthen further this year, and that the RMB will decline. It is of course foolish to blindly bet against consensus, but it also means shorting the CNH/USD has already become a very crowded trade. The sharp rebound of the CNH/USD a few days ago is a classic example of a market stampede where investors rush to a narrow exit when conditions change. All this has made the risk-return profile of shorting the RMB against the dollar unfavorable, as the PBoC, with its formidable resources, could unexpectedly hit back at any time. Indeed, the performance of the CNH/USD cross rate has closely tracked the broad U.S. dollar index over the past two years, a situation unlikely to change going forward (Chart 11). The bottom line is that the dollar trend will continue to dictate the USD/RMB cross rate in the near term. The PBoC will continue to intervene heavily to prevent excessive currency weakness. For investors, shorting the CNH/USD is not much different from a direct bet on the dollar index. What To Do With Chinese Stocks? Chart 12Chinese Shares Valuation Perspective Chinese stocks will likely range-bound in the near term. The downside is limited by accommodative policy, stable/improving growth and depressed valuation, especially for H shares (Chart 12). The upside is capped by the ongoing macro concerns and brewing tension with the incoming U.S. administration. Chinese shares may also be vulnerable if the more frothy global bourses correct. Therefore, aggressive directional bet is not warranted in the near term. From a big picture point of view, however, we remain convinced that market concerns on China's macro conditions are overdone, and Chinese equities have been unduly punished. Investors with longer-term horizons should hold H shares. Strategically we favor Chinese equities over their global peers. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture," dated November 17, 2016, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The economy is near full employment, but betting on significant inflation is premature. Market-based inflation expectations have risen substantially in recent weeks but these moves are not corroborated by survey measures of inflation expectations. Consumer inflation expectations are very well anchored due to ongoing deflation in many frequently purchased goods and services. We are on high alert for a near-term equity pullback, with Chinese liquidity tightening as a potential catalyst. Feature Chart 1Market-Based Inflation ##br##Expectations Breaking Out After years of focusing on deflation, the possibility of inflation has made a comeback on investors' radars. The shift makes sense, given that the labor market is now operating near full employment. The December payroll report showed that payrolls increased by 156,000, slightly lower than the 3-month average of 165,000. But, average hourly earnings increased by 0.4%, suggesting that slightly weaker employment growth is not due to sluggish demand, and reflects a smaller available pool of workers. However, as we explain below, the potential for a major inflation surge is low in 2017 and is premature as an investment theme. We are on high alert for a near-term pullback to the equity bull market, given that valuation and sentiment are stretched. But as we outline, the threat to the equity market is less likely to be domestic inflation than an external event, such as the fallout from tightening liquidity in China (similar to what occurred in mid-2015 and early 2016). In the past few weeks, one-year inflation expectations have moved to their highest level since mid-2014, when oil prices were above $110/bbl. Long-run inflation expectations have also spiked since the U.S. election (Chart 1). The extent to which this trend is judged sustainable, and provides an accurate forecast for general inflation, has important investment implications. Our view is that, although TIPS could move a bit higher, the market move should not be interpreted as a harbinger for a broad-based inflation acceleration. Policymakers consider a range of inflation expectations measures, but in recent years, market-based measures have garnered a lot of attention. The 5-year/5-year forward TIPS breakeven rate in particular is often viewed as the market's assessment of whether the Fed can successfully achieve its inflation target. According to the Minutes of the December FOMC meeting, the recent rise in market-based inflation expectations was discussed at length. On this basis, the rise in TIPS is important as it could have a significant role in setting monetary policy. Beyond that, we have argued for some time that a major challenge for firms this cycle will be to raise selling prices, i.e. a lack of pricing power will restrain profit margins and, ultimately, earnings growth. If the recent pick-up in market-based inflation expectations heralds a more robust rise in actual inflation, then profits could positively surprise this year. The Rise In TIPS Is Partially Energy-Driven... Since 2010, there has been a strong correlation between oil prices and TIPS (Chart 2). The correlation has somewhat confounded policymakers.1 In theory, any oil price shock, even if it is considered to be permanent, should not exert any lasting impact on long-dated forward measures of inflation expectations. The reason is that as long as the Fed is committed to its 2% inflation target, then the market should expect that monetary policy will prevent a one-time shock to oil prices from having any permanent effect on the overall inflation rate. This is why, in theory, the 5-year/5-year forward TIPS breakeven rate is a good indicator for policymakers. Chart 2Oil Prices And Breakevens As our fixed income team explained in a report last year,2 the main reason for the tight correlation between TIPS and oil prices stems from the market perception that monetary policy has been constrained. Prior to the financial crisis, oil prices rose from below $40 in 2003 to $140 in 2008. During that time, long-dated breakevens remained stable. One possible explanation for this lack of correlation is that the Fed tightened policy during this period, offsetting the inflationary impact from higher oil prices. But in 2015-2016, when oil prices fell from above $100 to below $40, breakevens plunged alongside. If the market perceives monetary policy to be constrained by the zero lower bound, then it could be the case that the cost of inflation compensation is highly sensitive to falling oil prices because the market perceives that the Fed has no ability to offset the deflationary shock. In other words, the 5-year/5-year TIPS breakeven rate has fallen because the zero lower bound is challenging the credibility of the Fed's inflation target. Our U.S. fixed income team forecasted that breakevens will head higher once oil prices move up and that the correlation between oil prices and breakevens will eventually weaken as the fed funds rate moves further away from the zero lower bound. The bottom line is that TIPS are most likely being unduly affected by energy price movements. ..And Only Thinly Corroborated By Alternative Inflation Indicators Despite our bias that the recent moves in market-based inflation expectations are exaggerated, TIPS are not the only gauge sending a more inflationary signal. This week's ISM manufacturing and non-manufacturing surveys both reported an uptick in prices paid (Chart 3). According to the manufacturing survey, 18 out of 21 recorded inputs were up in price over the past month. However, the bulk of these are commodities that have gone up in price alongside other financial market prices, and it is not clear the extent that the price rise is physical demand-driven, or financial demand-driven. In the non-manufacturing survey, the price rise was not quite as broad-based, but is nonetheless suggestive of upward price pressure. The NFIB small business survey also hinted at higher prices, although much more modestly than the ISM surveys (Chart 3). The Atlanta Fed's Business Inflation Expectations Survey has not broken out of the range that has held since 2011. There was no change in inflation expectations from the most recent survey of professional forecasters. Meanwhile, as we noted last week, consumers are not at all worried about inflation. In fact, according to the Conference Board survey, consumer inflation expectations are at a new cyclical low! At least part of the reason that consumers do not expect more inflation is likely due to their experience with frequently-purchased items. Table 1 shows inflation rates for selected high-frequency spending items, which account for about 30% of the total CPI basket. The table makes it easy to understand why perceptions about inflation are low: almost half of the items in the table are in deflation and only two are above the Fed's target of 2%. It may not matter that a good or service accounts for a small share of spending: if its price is going up/down at a steady pace, then there will be an impact on perceptions about inflation. Currently, very low or negative rates of inflation among frequently purchased items are likely pulling down consumers' perceptions of broad-based inflation. In this sense, one could argue that inflation expectations are very well-anchored. Chart 3Survey-Based Inflation ##br##Expectations More Mixed Table 1Inflation Rates For Selected ##br## High-Frequency Spending Items Actual Inflation Will Stay Subdued In 2017... Chart 4Only Mild Uptrend Likely In 2017 For many years, we have deconstructed core CPI and core PCE into their three major components to better understand and forecast the trend in consumer price inflation (Chart 4). Performing this exercise today continues to give a fairly benign forecast for inflation. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017. Core goods inflation (25% of core CPI) will also remain very low and possibly stay in deflationary territory. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 4, panel 3), and so will stay depressed as long as the bull market in the dollar remains intact. Wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 4, bottom panel). This component, which accounts for 25% of core CPI, is the most likely source of inflation pressure now that wages are beginning to rise. But as we wrote in a Special Report on November 28, 2016, any wage inflation and pass-through is likely to be very gradual based on several structural headwinds at play this cycle. All in all, core PCE may converge on the Fed's target of 2% in the second half of 2017, but an inflation overshoot should not be a major driver of investment decision-making over the next six - twelve months. ...And Don't Blame Government Spending For Higher Inflation When It Does Come One missing ingredient from the above analysis is the likelihood that the political environment will become inflationary. This subject has been thoroughly covered by the financial press. Our own view has been that upcoming policies may not turn out to be particularly inflationary, at least not this year. For example, Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions in 2017. As for proposed personal tax cuts, the impact is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that many companies are already flush with cash and effective tax rates are well below statutory levels. Our benign view about the impact of government spending on inflation is shared by researchers at the St Louis Federal Reserve. In a recent paper,3 researchers looked at periods when the central bank was not working to offset the potentially inflationary effects of fiscal policy, e.g. between 1959 and 1979, when the Fed followed a policy in which it accommodated increases in inflation. They found almost no effect of government spending on inflation. For example, a 10 percent increase in government spending during that period led to an 8 basis point decline in inflation. Note that this period covers years of when the economy was operating at full employment and below. As the researchers point out, this does not imply that countercyclical government spending is ineffective at boosting output, but it simply demonstrates that empirical evidence of inflation related to government spending is thin. The bottom line is that we view the likelihood of significant inflation pressure as low in 2017. The implication is that under this scenario, the Fed can afford to adjust their "dots" gradually, diminishing the risk for stocks and bonds of an aggressive adjustment to the policy backdrop. Equity Correction: Will China Be A Contributing Factor? Chart 5Is China Liquidity Tightening##br## A Repeat Threat To U.S. Equities? Over the past few weeks, we have argued that the odds of a meaningful equity correction are running high, given the aggressive rise in bond yields and exaggerated move in sentiment relative to only minor upside surprises in economic and earnings growth. We are still on high alert for this outcome and believe that one possible trigger is tighter liquidity conditions in China, which are aimed at supporting the renminbi. Indeed, just like the start of 2016, the Chinese renminbi is kicking off 2017 on a weak note. Chinese policymakers are again tightening rules to limit capital outflows: earlier this week, they adjusted the FX basket used to set the CNY's official daily fix. The new FX basket will include 24 currencies (up from 13). Consequently, the weight of the U.S. dollar drops from 26.4% to 22.4%. This will make it easier for the authorities to target a relatively stable renminbi versus the basket even as USD/CNY pushes higher. These attempts to support the renminbi is leading to tighter liquidity conditions and higher interbank interest rates. In Hong Kong, 3-month CNH Hibor has spiked to 10%. In the past, a combination of a weaker renminbi and rising interbank rates has spelled trouble for U.S. and global equities (Chart 5). There is no guarantee that history will repeat itself and one big difference with the sharp market sell-offs in mid-2015 and early 2016 is that the Chinese economy is not as weak as it was then. The PMIs released this week were generally firm. Overall, we are positive on equities and negative on bonds on a 12-month horizon but still see the risk of a correction to the Trump trade as elevated. Thus, investors should continue to stick close to benchmark tactically, looking to implement positions after a pullback in stock prices. Like in 2015 and early 2016, China could provide the trigger to that pullback if the authorities give up on capital controls and allow a sharp depreciation of the RMB. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.stlouisfed.org/~/media/Files/PDFs/Bullard/remarks/Bullard-N… 2 Please see U.S. Bond Strategy Weekly Report "A Tale Of Two Rallies", dated March 29, 2016, available at usbs.bcaresearch.com 3 https://www.stlouisfed.org/on-the-economy/2016/may/how-does-government-…

Dear Client, This is our last report of the year. We will be back the first week of January with our 2017 Strategy Outlook. On behalf of BCA's Global Investment Strategy team, I would like to take this moment to wish you and your loved ones a Merry Christmas, Happy Holidays, and all the best for the coming year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The global economy has entered a reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. Emerging markets should also gain from a more reflationary environment. However, a rising dollar and elevated debt levels will take the bloom off the rose. Chronically low productivity and labor force growth will make it difficult for central banks to contain inflation once it does begin to accelerate. Global bond yields will rise only modestly next year, but could begin to surge as the decade wears on. Feature Stagflation Is Coming, But Not Yet Bill Gates once noted that "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." This observation applies just as well to the risk of stagflation as it does to technology. For the next few years, the likelihood of a disorderly rise in inflation is extremely low. Beyond then, however, the risk is that inflation surprises to the upside, perhaps significantly so. Three factors will prevent global inflation from rising too rapidly over the next two-to-three years: The global economy still suffers from a fair amount of spare capacity; While spare capacity is likely to decline further, it will do so only gradually; Even when all remaining spare capacity is exhausted, the knock-on effect to inflation will initially be quite small. Spare Capacity Lingers Chart 1 shows that the global output gap has declined from its high in 2009, but is still larger than it has been at any time since the early 1990s. This can be seen in low industrial capacity utilization rates in some countries (Chart 2), as well as in the high levels of joblessness and involuntary part-time employment (Charts 3 and 4). Chart 1Mind The (Output) Gap Chart 2Global Capacity Utilization Remains Low Chart 3AJoblessness Still Elevated In Europe Chart 3BJoblessness Still Elevated In Europe Chart 4AHigher Incidence Of Involuntary ##br##Part-Time Employment Chart 4BHigher Incidence Of Involuntary ##br##Part-Time Employment Granted, the U.S. is much closer to full employment than most other economies. However, high levels of spare capacity abroad will still exert downward pressure on U.S. inflation. The reason for this was first laid out by Robert Mundell and Marcus Fleming in the early 1970s. The Mundell-Fleming model, as it is now called, posits that a country's interest rate will rise in response to stronger growth, thereby pushing up the value of its currency. Indeed, Mundell and Fleming showed that easier fiscal policy would not benefit a small open economy at all in a world of perfect capital mobility and flexible exchange rates because any gains from the stimulus would be entirely offset by a deterioration in the trade balance. Chart 5Real Rate Differentials ##br##Are Driving Up The Dollar While the Mundell-Fleming model is a gross oversimplification of how the global economy actually functions, it is still highly relevant for understanding today's macro environment. The real broad trade-weighted dollar has appreciated by 21% since mid-2014, largely due to the widening of interest rate differentials between the U.S. and its trading partners (Chart 5). We estimate that the stronger dollar has reduced the level of U.S. real GDP by 1% so far, and will reduce it by another 0.5% stemming from the lagged effects from the recent dollar rally. The buoyant greenback will keep a lid on U.S. inflation both directly, in the form of lower import prices and indirectly, in the form of slower employment growth. The analysis above leads to three important investment implications. First, it implies that the dollar will remain well bid as long as the Fed remains the only major central bank in hiking mode. We have been long the DXY since October 2014 - a trade that has gained 18.6%. We think there is another 5% of upside from current levels. Second, a stronger dollar will help redistribute growth to Europe and Japan, two economies that desperately need it. We are bullish on European and Japanese stocks and bearish on the euro and the yen. Third, Treasury yields will be hard-pressed to rise substantially from current levels until spare capacity outside the U.S. is extinguished. Only once other central banks start raising rates will the Fed be able to hike rates in a sustainable manner. Until then, any Fed tightening beyond what the market is currently expecting will put upward pressure on the dollar, reducing the need for further hikes. A Gradual Recovery Table 1Global Growth Will Improve Next Year Global growth should pick up next year in line with the IMF's most recent projections (Table 1). Alongside stronger growth in Japan and continued above-trend growth in Europe, the U.S. economy will benefit from robust consumer spending on the back of rising real wages. In addition, residential investment should rise, as foreshadowed by the jump in homebuilder confidence in December. Tighter credit spreads, deregulation, and a modest recovery in energy sector investment should also boost business capex. Despite this welcome reflationary backdrop, a number of factors will hold back growth. Most prominently, debt levels are still high around the world (Chart 6). In fact, emerging market debt continues to rise more quickly than GDP. Even in the optimistic scenario where the ratio of EM debt-to-GDP merely stabilizes, this would still entail a negative credit impulse (Chart 7). Chart 6Global Debt Levels Are Still High Chart 7Negative EM Credit Impulse Looming Meanwhile, monetary policy continues to be constrained by the zero bound in a number of developed economies. Many EM central banks will also be reluctant to cut interest rates due to fears that this could precipitate a disorderly plunge in their currencies. And while fiscal policy around the world will no longer be restrictive, a major burst of government stimulus is not in the cards. Donald Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. As we have noted before, most of America's infrastructure needs consist of basic maintenance. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions. There is also a significant risk that Congressional Republicans will try to sneak through cuts to Social Security and Medicare, much to the annoyance of many of Trump's voters. As for Trump's proposed personal tax cuts, while they are hefty in size, their bang for the buck is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Indeed, it is possible that cutting the estate tax would actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that companies are already flush with cash and effective tax rates are well below statutory levels. The bottom line is that global growth is likely to rise in 2017, but not by enough to cause inflation to surge. A Flat Phillips Curve ... For Now Chart 8The Phillips Curve Has Flattened It might take a few more years for most of the developed world to claw its way back to something approximating full employment, but with any luck, it will get there. What happens to inflation then? The answer is probably not much. The relationship between economic slack and inflation is encapsulated by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 8). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Economists have proposed a variety of reasons for why the Phillips curve may have flattened out over time. Globalization is often cited as one factor, but the empirical evidence for this view is rather shaky.1 True, free trade and capital mobility have helped keep inflation in check by diverting excess domestic demand into higher net imports via the Mundell-Fleming channel discussed above. However, this only implies that globalization may prevent economies from sliding too far along the Phillips curve. It says nothing about the slope of the curve itself. A fall in unionization rates and a decline in the use of inflation-indexed wage contracts are also often cited as reasons for why the correlation between inflation and economic slack has diminished. Here again, the evidence is rather mixed. While the U.S. has experienced a pronounced decline in unionization rates, Canada has not (Chart 9). Nevertheless, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-index contracts in the 1970s appears mainly to have been a response to rising inflation, rather than a cause of it (Chart 10). The one point on which most economists agree is that long-term inflation expectations are much more stable now than they used to be, which has reduced the volatility of actual inflation. Central banks deserve some of the credit for this. The adoption of inflation targeting, coupled with more transparent communication policies, has helped anchor inflation expectations. A more sober assessment of economic conditions has also been a plus. Back in the 1970s, the Fed continuously overstated the degree of economic slack (Chart 11). This led it to keep interest rates too low for too long, thereby sowing the seeds for much higher inflation later on. Chart 9Inflation Fell In Canada, ##br##Despite A High Unionization Rate Chart 10When High Inflation ##br##Entailed Inflation-Indexed Contracts Chart 11The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack Shifting Sands For Inflation The Fed has vowed not to make the same mistake again, but the temptation to exploit the flatness of the Phillips curve may be too great to resist. A flattish Phillips curve implies a low "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that it is at least willing to entertain the idea. The 25-year period of falling inflation that began in the early 1980s had a dark side. As Hyman Minsky first noted, economic stability can beget instability: The so-called "Great Moderation" that policymakers were patting themselves on the back for before the financial crisis created a fertile milieu for rising debt levels. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. The challenges posed by the zero-bound constraint could also justify efforts to raise inflation targets. After all, if inflation were higher, this would give central banks the ability to push down real rates further into negative territory in the event of an economic downturn. Such a step is unlikely to be taken anytime soon. That said, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF, San Francisco Fed President John Williams, and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. In any event, as we discussed in great detail last week, underlying economic trends - ranging from the retreat from globalization to the slowdown in potential GDP growth - are all pushing the global economy in a more inflationary direction.2 This suggests that inflation could move appreciably higher towards the end of this decade. Investment Conclusions Chart 12Near-Term Inflation Risk Is Low Inflation is unlikely to rise significantly over the next few years. Indeed, the sharp appreciation in the dollar since the election will put downward pressure on U.S. inflation in the coming months. This view is supported by the Federal Reserve Bank of St. Louis Price Pressure gauge, which shows that there is less than an 8% chance that inflation will rise above 2.5% over the next 12 months (Chart 12). And even when the economy has reached full employment and the effects of a stronger dollar have washed through the system, inflation will be slow to increase. Consider how inflation evolved during the 1960s. As my colleague Mathieu Savary has pointed out, U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 on the back of rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 13).3 The lesson is that it often takes a number of years for an overheated economy to generate meaningful inflation. This suggests that the global economy is entering a "goldilocks" reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. This is obviously good news for global risk assets, and underpins our cyclically constructive view on global equities. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. In fact, both economies have seen a decline in real yields since the U.S. elections, as rising inflation expectations have outpaced the increase in nominal yields (Chart 14). Emerging markets should also gain from a more reflationary environment, but a rising dollar and elevated debt levels will take the bloom off the rose. Chart 13It Can Take A While For Inflation ##br##To Rise In Response To An Overheated Economy Chart 14Europe And Japan: Rising Inflation ##br##Expectations Suppressing Real Yields While we have a positive cyclical (3-to-24 month) view on risk assets, we have significant concerns about both the near-term and longer-term outlooks. From a short-term tactical perspective, developed market equities - especially U.S. equities - are highly vulnerable to a correction. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 15). It can also be seen in the weak historic performance of global stocks following sharp spikes in bond yields (Table 2). Chart 15U.S. Equity Sentiment Is Stretched Table 2Stocks Tend To Suffer When Bond Yields Spike Over a longer-term horizon, the risks to global equities are also to the downside. Once inflation is on a firm upward trajectory, central banks may find it more difficult to arrest the trend. Against the backdrop of weak productivity and labor force growth, memories of stagflation may reappear. As Chart 16 shows, stagflation in the 1970s was devastating for equities, and this time may not be any different. The bottom line is that investors should lease the bull market in stocks, rather than own it. Chart 16Stagflation Was Devastating For Stocks From The Vault: Two "Big Picture" Holiday Reports Lastly, for those who would like to take their minds off the nitty-gritty of the financial world for the next two weeks and focus more on transcendent issues, let me recommend two special reports. The first, entitled A Smarter World is based on a speech I delivered at the 2014 BCA New York Investment Conference. I argue that genetic changes in the human population sowed the seeds for the Industrial Revolution. This development then unleashed a virtuous cycle where rising living standards led to better health and educational outcomes, generating even further gains in living standards. Many countries now appear to be at the end of this cycle, but new technologies could one day generate huge gains in IQs, sending humanity down a path towards immortality. Of course, before we get there, we have to contend with all sorts of existential pitfalls. With that in mind, the second report, Doomsday Risk, examines what is literally a life-and-death issue: the likelihood of human extinction. Drawing on insights from biology, history, cosmology, and probability theory, our analysis yields a number of surprising investment implications. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Eddie Gerba and Corrado Macchiarelli, "Is Globalization Reducing The Ability Of Central Banks To Control Inflation?" European Parliament, Policy Department A: Economic and Scientific Policy, Brussels, Belgium (2015); Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, "Some Simple Tests Of The Globalization And Inflation Hypothesis," International Finance Vol. 13, no. 3 (2010): pp. 343-375; and Laurence M. Ball, "Has Globalization Changed Inflation?" NBER Working Paper No. 12687 (2006). 2 Please see Global Investment Strategy Weekly Report, "Main Street Bonds, Wall Street Stocks," dated December 16, 2016, available at gis.bcaresearch.com. 3 Please see Foreign Exchange Strategy, "Outlook: 2017's Greatest Hits," dated December 16, 2016, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature Dear Client, For the last publication of 2016, we have opted to do something a little different. 2016 was a year were political shocks took pre-eminence. Whether we are talking Brexit, Trump, Italian referendum, Japanese upper-house elections, or Rousseff's impeachment; it often felt like economics took the back seat to political events. While this kind of regime shift toward more politically-driven markets can feel jarring, it is not new. In the late 1970s and early 1980s, a similar event occurred. Populations in Western democracies - the U.S. and the U.K. in particular - exhausted by a decade of elevated inflation, created one of these shifts by putting Thatcher and Reagan in power. With the benefit of insight, we know how the story ended: with great economic successes in both the U.K. and the U.S. However, when Thatcher and Reagan actually took power, it was far from obvious that Western economies were about to leave stagflation and begin a low inflation boom. Today, we do not know how the Trump experiment will end. It is a similarly radical shift that politician wants to implement. Trump and his team want to beat deflation, especially wage deflation for the middle class. This is easier said than done. While we cannot claim to know how a Trump presidency will unfold, BCA has tried to provide some clarity among the noise by focusing on the implications and risks created by the various policies proposed, as well as the threat to the actual implementation of the policies. To finish the year, we would like to provide our client with some perspective. We are sending you the "Mr X" BCA Outlook published in December 1980, when Reagan was the President-elect. What is striking is that then as today, BCA was trying to make a balanced assessment of the potential for positive or disastrous changes that were about to affect the U.S. and global economy. The worries were very pronounced but ultimately proved to be unfounded. We are not saying that worries regarding Trump's proposed policies are unwarranted, but it is important to remember that investors need to remain very nimble when such shifts are emerging. Ultimately, the final direction and effect of the shifts Trump wants to implement will take years to materialize. Looking at historical reactions to similar political sea-changes is a comforting way to put things into perspective. After all, according to Zhou Enlai, it is still too early to judge the effect of the French Revolution.1 Have a great holiday period and a happy and prosperous new year. Best regards, Mathieu Savary, Vice President