Global

Highlights We expect the high level of compliance with the OPEC - non-OPEC production agreement engineered by the Kingdom of Saudi Arabia (KSA) and Russia will endure, leading to significant reductions in global oil inventories this year and next. All else equal, this should backwardate WTI and Brent forward curves later this year. However, recent developments in the North American pipeline market - i.e., U.S. President Donald Trump's orders to revive development of the Keystone XL (KXL) and completion of the Dakota Access (DAPL) pipelines - could send as much as 1mm barrels/day (bbl/d) of crude south from Canada and the Bakken, which would boost inventories at Cushing and other Midwest storage facilities later in this decade. Depending on when these pipelines are completed - likely by 2020 in the case of KXL - the WTI forward curve could return to a sustained contango.1 The expanded flows of heavy crude via KXL, and light-tight oil south via the DAPL could undo a subtle benefit arising from the backwardation induced by the KSA - Russia production pact, which we uncovered in our modeling. Energy: Overweight. At Tuesday's close, our short Dec/19 WTI vs. long Dec/19 Brent spread elected last week at $.07/bbl (WTI over) was up 700%. Our long Dec/17 WTI vs. short Dec/18 WTI front-to-back spread, entered into at -$0.11/bbl on Feb 9/17, was up 263%. Base Metals: Neutral. BHP declared force majeure at its Escondida mine, which accounts for ~ 5% of global supply, after workers voted to strike. Union leaders agreed to another round of government-mediated talks with BHP management. Precious Metals: Neutral. Fed Chair Yellen's Senate Banking Committee testimony was more hawkish than expected, which rallied the USD and muted gold's overnight strength. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. The USDA revised grain and soybean supply/demand estimates last week, showing markets tightening slightly, with ending stocks for the 2016/17 crop year expected to be a touch lower. We remain bearish. Feature Chart of the WeekStorage Drawdowns Should Accelerate ##br##As U.S. Oil Imports Slow Regular readers of BCA's Commodity & Energy Strategy service will not be surprised by the very high compliance levels seen in the wake of the OPEC - non-OPEC production Agreement engineered by KSA and Russia late last year.2 Because the stakes are so high for KSA and Russia - and their respective oil-producing allies - we expect compliance to remain high into June, resulting in a drawdown of global oil storage, the stated goal of the deal. We believe the pact will result in both WTI and Brent forward curves returning to backwardation, as global storage levels fall some 300mm bbl (Chart of the Week). We are positioned for this outcome by being long Dec/17 WTI vs. short Dec/18 WTI. We are expecting to see the last of the Persian Gulf export surge to the U.S. this month, as the 45- to 50-day sailing time from the Gulf to the U.S. implies the last of these vessels will be arriving this week or next. This backwardation will, in all likelihood, restrain the rate at which U.S. shale-oil producers return rigs to the market next year. Chart 2Curve Shape Can Affect Rig Counts WTI Term Structure And Rig Counts: It's Complicated Recent modeling we've completed suggests curve shape can affect rig counts in the U.S. light-tight oil fields. When we regress U.S. rig count on the WTI forward curve, we find rig counts can be expected to increase when the forwards are in contango, and to decline when the market is backwardated. A flat forward curve can be expected to keep rig counts fairly constant (Chart 2).3 Obviously, the starting point for these outcomes is critical. We simulated rig counts by assuming Monday's closing prices for March through June WTI futures, then assumed different levels for July WTI futures as a starting point for estimating rig counts to end-2018. We used $50, $55 and $60/bbl in July as our starting point. All else equal, with the July/17 WTI at ~ $55/bbl and the forward curve backwardated by 10% 18 months out, we would expect to see average rig counts fall by 4.38 rigs/month in 2018, given the three-to-four month lag between rigs actually being deployed and the price signal being sent by the futures market. A contango term structure produces the opposite result. With the July/17 WTI at ~ $55/bbl and the forward curve in a contango of 10% 18 months out, we would expect to see rig counts increase by 4.57 rigs/month in 2018. There obviously is a price threshold from which the forward curve originates in this analysis, which we believe to be between $50 and $55/bbl. Below this level, we would expect shale producers to retreat back to their core production areas, and await a price signal to increase their rig counts. Above $60/bbl, backwardation and contango matters for rig counts over the next 2 to 2.5 years. A backwardated forward curve will, all else equal, incentivize a slightly lower level of rigs being deployed than a contango. For example, a 10% contango with a $60/bbl starting point results in 5.24 rigs/month being deployed, while 10% backwardation would lead us to expect 5.02 rigs/month being deployed. Sustaining Backwardation Will Be Difficult A sustained backwardation will be threatened later in this decade by the expansion of the North American pipeline grid, following U.S. President Trump's orders to revive the Keystone XL (KXL) pipeline's development and the completion the Dakota Access Pipeline (DAPL). The KXL and DAPL buildouts, if approved, will expand U.S. midcontinent crude deliveries by 1mm bbl/d, according to Genscape's tally.4 The KXL volumes would add close to 600k bbl/d to Canadian exports, and would flow directly into Cushing, OK. Another 400k bbl/d of light-tight oil from the Bakken LTO fields will flow to the midcontinent refining market via the DAPL. "Increased flows into Cushing due to the addition of Keystone XL could lead to a bottleneck of inventories at the hub, which would put downward pressure on crude prices," Genscape notes. Work on the KXL could start this year, and be completed before 2020. The DAPL is ~ 95% complete, and should be done in 6 months or less. Genscape believes the DAPL could be built and line fill could be in place in less than three months. Indeed, "drilling under Lake Oahe in southern North Dakota for Energy Transfer Partner's Bakken-to-Patoka, IL, Dakota Access (DAPL) crude pipeline began immediately upon receiving an easement from the U.S. Army Corps of Engineers on February 8, according to a company spokesman. It is expected to take 83 days for construction and linefill... ." We will monitor these pipeline buildouts closely, given the profound implications they have for U.S. midcontinent and Gulf Coast refiners, who could once again find themselves benefiting from a widening of the Brent vs. WTI differential, and Canadian E&Ps, who can be expected to increase production into this KXL buildout. The key market to watch as these pipelines are under construction will be the WCS vs. WTI spreads (Chart 3). As pipeline capacity opens up, exports of heavy crude from Canada will increase and the WCS - WTI differential will narrow, which will benefit Canadian E&Ps (Chart 4). A return of contango following the opening of these pipelines would benefit U.S. refiners, who can be expected to increase exports. Chart 3Expanding the N. American Pipeline Network##br## Will Widen WTI Differentials Chart 4Crude Differentials Will##br## Adjust To Pipeline Buildouts Bottom Line: The backwardation of the WTI and Brent forwards should accelerate as the last of the surge in exports from the Persian Gulf arrives in the U.S. President Trump's decision to expedite KXL and the completion of the DAPL in 6 months or less will have a profound impact on crude movements and storage levels in the U.S. later in the decade. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 President Trump's decision to revive KXL was endorsed by House and Senate leaders in the U.S. last month, which greatly raises the odds it will go ahead. In addition, the DAPL received an easement from the U.S. Army Corps of Engineers to complete construction. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 3 Our previous modeling indicates Granger causality goes from WTI prices to rig counts - i.e., E&P companies drilling decisions are driven by price levels and curve shape. We believe this relationship arises from the hedging behavior of shale-oil producers, many of whom hedge their forward revenues in the futures markets over a two-year interval. 4 Please see "Keystone XL, Dakota Access Could Cause Bottlenecks at U.S. Mid-Continent Storage Hubs, Shift Crude Prices," published on Genscape's blog February 14, 2017. Genscape is a near-real-time pipeline, storage and shipping monitoring service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Highlights Fears that the Trump Administration will brow-beat America's trading partners into strengthening their currencies have pushed down the dollar in recent weeks. The likelihood of another Plaza-type accord remains extremely low, however. History suggests that such agreements only work when currency interventions are aligned with the underlying macroeconomic fundamentals. With the Fed eager to hike rates, that is not the case today. The only situation where a multilateral agreement to weaken the dollar could be reached is one where the dollar ascends so high that major financial stresses begin to form, particularly in emerging markets. We are not there yet. The real trade-weighted dollar is likely to rise 5%-to-10% by the end of the year. A stronger greenback will hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. Feature Dollar Under Pressure Chart 1The Recent Dollar Dip Is Not ##br##Reflected In Interest Rate Spreads After rallying sharply following the U.S. presidential election, the greenback has given up some of its gains. Since peaking in late December, the trade-weighted dollar has fallen by around 2.5%. Notably, the dollar's swoon has not been accompanied by a narrowing of 2-year real interest rate differentials between the U.S. and its trading partners (Chart 1). This suggests that shifts in relative growth expectations have played a relatively minor role during this latest dollar selloff. In our view, the more important factor has been the "weak dollar" rhetoric coming out of the Trump administration. Historically, U.S. officials have at least given lip service to America's "strong dollar policy." As with many other political customs, Trump has thrown this one out the window. Peter Navarro, head of Trump's National Trade Council, made headlines last week by calling Germany a "currency manipulator" - even though, strictly speaking, Germany does not have a currency to manipulate. This came on the heels of Trump's comments to The Wall Street Journal earlier in January where he lamented that "our currency is too strong... it's killing us." The President reiterated that sentiment last week, telling a group of pharmaceutical company executives: "You look at what China's doing, you look at what Japan has done over the years ... they play the devaluation market and we sit there like a bunch of dummies." A Deal That Worked The Trump administration's efforts to talk down the dollar have raised the question of whether another Plaza Accord is on the horizon. The original agreement was concluded at The Plaza Hotel in 1985. As fate would have it, Trump ended up buying the landmark property three years later. It would go on to be the setting for such historically momentous events as Trump's wedding to Marla Maples and his Oscar-worthy cameo in Home Alone 2: Lost In New York. The Plaza Accord prescribed that G5 nations - the U.S., Japan, Germany, the U.K., and France - intervene in currency markets with the aim of driving down the value of the dollar. At least in this respect, the Accord was a smashing success. Between early 1985 - when rumors of a deal began to swirl - and January 1987, the dollar fell by 54% against both the yen and the mark, 49% against the franc, and 44% against the pound. In fact, so effective was the Plaza Accord that it necessitated the Louvre Accord two years later, an agreement that was drawn up in order to halt the dollar's slide. Chart 2A Widening Current Account ##br##Deficit Sowed The Seeds For The Plaza Accord Then And Now: Some Similarities... There are some clear similarities between 1985 and the present. Just like today, the greenback strengthened significantly in the years leading up to the Accord. At first, the Reagan administration was content to let the dollar appreciate, seeing this as validation of its pro-growth policies. The Fed was also happy to go along with a stronger dollar since lower import prices helped to dampen inflation. As time wore on, however, the damage from an overvalued dollar became increasingly apparent: The current account balance swung from a modest surplus at the start of the 1980s to a deficit of 2.7% of GDP by the end of 1985 (Chart 2). The Big Three automakers, along with companies such as Caterpillar, IBM, and Motorola, began to lobby the U.S. government for trade sanctions against foreign competitors. With Reagan's appointment of James Baker to the post of Treasury Secretary in February 1985, U.S. trade policy moved away from being governed by a doctrinaire free market philosophy and took on a more pragmatic tone. Fearing further protectionist measures, the Japanese and Europeans agreed to take action to strengthen their currencies. ...But Some Notable Differences Despite the clear parallels between 1985 and the present, there are also a number of critical differences. First, there is the issue of magnitude. By early 1985, the greenback was entering the seventh year of a massive bull market - one that had lifted the real broad trade-weighted dollar up 53% from its lows in October 1978 (Chart 3). In contrast, the current dollar bull market is a mere 2.5 years old and has seen the dollar strengthen by "only" 20% since July 2014. Moreover, the current bull market began from a point where the dollar was highly undervalued. As a consequence, as of today, the real trade-weighted dollar remains 21% below its 1985 peak and 11% below its 2002 peak. Second, one of the reasons the Plaza Accord worked so well was because policymakers ensured that their currency interventions were consistent with the macroeconomic fundamentals. The combination of tight monetary policy and loose fiscal policy created a fertile backdrop for the dollar's ascent in the early 1980s. By 1984, however, those bullish dollar fundamentals started to break down. Chart 4 shows that the dollar continued to appreciate into 1985, even though U.S. interest rates were declining relative to other G5 economies. The dollar, in other words, had entered a full-fledged bubble - one that was ripe for a pricking. Chart 3The Dollar Is ##br##Below Past Peaks Chart 4A Full-Fledged Dollar ##br##Bubble Preceded The Plaza Accord Once the dollar bubble burst, monetary policy amplified the downward pressure on the greenback. Most notably, the Federal Reserve continued cutting interest rates, ultimately taking the effective Fed funds rate down from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year nominal interest rate differential shrank by 454 basis points against Japan over this period. For the U.K., the interest rate differential fell by 630 basis points, while for Germany it declined by 407 basis points. In contrast to the mid-1980s, the Fed is unlikely to lean into dollar weakness this time around. The output gap in the U.S. has been nearly eliminated and the economy continues to grow at an above-trend pace. This suggests that the Federal Reserve will keep raising rates. We expect the Fed to hike rates three times this year, one more than the market is pricing in. Most other central banks are nowhere near the point where they can start tightening monetary policy. As such, the interest rate differential between the U.S. and its trading partners is likely to widen further. In a world where foreign exchange trading now exceeds $5 trillion per day, any currency intervention - unless it is backed by an underlying shift in the economic fundamentals - is bound to backfire. A Political Reality Check Chart 5China's Weight Matters Political considerations also render another Plaza Accord highly improbable. In the 1980s, West Germany and Japan were politically subservient to the U.S. That is less the case today. China's role in the global economy has also expanded. The RMB now accounts for 22% of the Fed's broad trade-weighted dollar basket, the largest weight of any country (Chart 5). China's government will fiercely resist negotiating any agreement that is not in the country's best interests. The economic circumstances facing most of America's trading partners could also scuttle any hopes for a deal to weaken the dollar. Inflation expectations in Japan have risen over the past six months, but still remain well below the BoJ's 2% target. A stronger yen would undermine efforts to reflate the economy. The German economy is certainly benefiting from an undervalued exchange rate. However, a continued weak currency is necessary for Southern Europe, where unemployment is still very high. Moreover, it is not clear that Germany could stomach a much stronger euro. The German unemployment rate is at a 25-year low, but that is because the country is running a massive 9% of GDP current account surplus. Take away Germany's ability to export its excess savings abroad, and the German economy would look a lot like Japan's. The only scenario in which a new multilateral accord would be seriously entertained is if a rising dollar began to wreak havoc on the global economy. A modestly stronger dollar would boost global growth to the extent that it redistributed demand from the U.S. to economies such as Europe and Japan with greater levels of economic slack. However, if the greenback were to ascend into bubble territory, this could instigate a vicious circle where an appreciating dollar increases the local-currency value of EM dollar-denominated debt, leading to a wave of bankruptcies and defaults, and, in the process, generating even further selling pressure on EM currencies. That said, the dollar would probably need to appreciate by another 15% or so before a crisis occurred. And even if a meltdown seemed imminent, the bar for currency intervention would remain quite high. No emerging market wants to go cap-in-hand to the IMF or the U.S. Treasury. This is particularly true for China, which would likely shun any offers of assistance, even if capital were flooding out of the country. In any case, if a deal were reached, it would likely seek to prevent the dollar from rising further, rather than falling in value. That is a critical distinction. Trump, Trade, And The Fed The discussion above suggests that a new Plaza-style accord is not in the cards, at least not unless the dollar strengthens substantially from current levels. Where does that leave Trump's pledge to bring manufacturing jobs back to the U.S.? We see two possible ways that Trump could try to square this circle. First, Trump could lean on the Fed to maintain a highly accommodative monetary stance. Since inflation expectations are likely to rise further as the economy begins to overheat, it is possible that real rates would actually decline unless the Fed raised rates fast enough, pushing down the dollar in the process. The problem with this theory is that Trump's public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump's views on the hard money/easy money debate may have changed now that he is President and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans are likely to resist efforts to pack the FOMC with doves. As long as the economy is doing well, our guess is that Trump will accede to Republican demands that he nominate members to the FOMC with a somewhat hawkish disposition. This should keep the dollar uptrend intact. If a policy U-turn does occur, it will happen towards the end of the decade, by which time the economy will be due for another recession. With another presidential election looming at that point, Trump might end up taking a page out of the old Nixon playbook and browbeat the Fed chair into pursuing a massively expansionary monetary policy.1 This could set the stage for a stagflationary episode, a prediction we discussed at length in our latest Strategy Outlook.2 In the meantime, Trump will try to mitigate the effects of a stronger dollar on U.S. manufacturing by pursuing a more protectionist trade agenda. This is likely to entail expanding the use of countervailing duties which target foreign industries that are alleged to be engaging in unfair trade practices - similar to what Obama did when he slapped an extra 35% duty onto Chinese tires in 2009. Trump is also likely to continue "twitter shaming" companies that have moved, or are contemplating moving, production abroad. On the whole, however, a radical departure from existing trade policy is unlikely as long as the economy continues to expand. Nevertheless, as with his approach to Fed policy, Trump could break with all established traditions if unemployment starts rising and his poll numbers begin tumbling. In other words, a major trade war is coming, just not yet. Investment Conclusions Chart 6The Dollar Can Climb Amid ##br##Bullish Sentiment In politics, as in life, preferences are not the only things that matter. Constraints are as important, if not more so. Just as in the early 1980s, the U.S. is pursing a policy of fiscal easing and monetary tightening. As was the case back then, this has led to a stronger dollar. It would be easy to say that Trump could badger other countries into tightening monetary policy in order to keep the dollar from appreciating. Even if we ignore the political implausibility of such a strategy, it still would not work. If a country needs a low interest rate to keep growth from stalling, then raising rates is unlikely to boost that country's currency. The market will realize in short order that the central bank will eventually have to reverse course and cut rates to keep deflationary forces from setting in. The point is that trying to influence exchange rates without changing the economic fundamentals is destined to fail. We expect the real trade-weighted dollar to rise 5%-to-10% by the end of the year. Granted, bullish dollar sentiment is widespread these days (Chart 6). However, dollar bulls were around in even greater numbers in the second half of the 1990s, and this did not prevent the greenback from scaling to new highs. If the dollar resumes its ascent, as we expect, this could hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. A stronger greenback would also weigh on commodity prices, with metals being the most vulnerable. The risks to our dollar view are fairly symmetric. On the downside, the failure of the Trump administration to loosen fiscal policy could prevent the Fed from hiking rates as much as planned. The risk here is not so much that the tax cuts will be scuttled, but rather that Congressional Republicans succeed in pushing through big spending cuts as part of any budget deal. On the upside, the passage of a Border Adjustment Tax - something to which we assign 50% odds - would lift the dollar.3 Rising stress in emerging markets could also push money into safe haven markets such as U.S. Treasurys, similar to what happened during the late 1990s. This could cause the dollar to appreciate more than our baseline forecast implies. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Burton A. Abrams, "How Richard Nixon Pressured Arthur Burns: Evidence From The Nixon Tapes," The Journal of Economic Perspectives, Vol. 20, no. 4 (2006), pp.177-188. 2 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. 3 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. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Weekly swings in U.S. inventories notwithstanding, we believe global storage is on track to draw ~ 10% by early- to mid-3Q17, which will have achieved the goal of the OPEC - Russia production Agreement negotiated late last year. This will not require an extension of the pact beyond June, based on our modeling. Unexpectedly high compliance by OPEC producers to agreed cuts is being offset somewhat by increased production in those states exempted from the deal. Strong oil consumption on the back of a synchronized global uptick in GDP growth, which started to emerge late last year, provides the impetus for sustained storage draws. Markets are overestimating offshore production's resilience, particularly in the U.S. Gulf, where we see material declines beginning to set in next year. Backwardation likely persists in 2018, absent a U.S. policy-induced USD rally that crimps EM demand and spurs production ex U.S. Energy: Overweight. The return of contango in the WTI forward curve gives us the opportunity to reset our strategic front-to-back position (long Dec/17 vs. short Dec/18) at tonight's close. Our balances assessment supports our view backwardation will return in the deferred part of the curve. Our Dec/19 short WTI vs. long Brent spread buy stop was elected at $0.07/bbl. Base Metals: Neutral. We remain neutral base metals, but are keeping a close watch on copper. Unions working at BHP's Escondida mine, the world's largest, are set to strike today. Negotiations resumed this week, following BHP's request for government mediation. Precious Metals: Neutral. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. Grain fundamentals remain unsupportive for a rally. We remain underweight. Feature Chart of the WeekGlobal Oil Storage On Track For 10% Drop Global oil storage levels remain on track to hit the ~ 10% draw targeted in last year's OPEC - Russia production Agreement by early- to mid-3Q17, weekly gyrations in U.S. inventories notwithstanding. This means an extension of the agreement beyond its June expiry will not be required. Early reports suggest compliance with the deal is unexpectedly high by OPEC states that agreed to cut production by up to 1.2mm b/d - exceeding 80% by various accounts. However, OPEC states not required to cut - Libya, Nigeria, and Iran - have increased production and partially offset those declines, which took total reductions in OPEC output to ~ 840k b/d, based on a Bloomberg tally last week.1 This brought total Cartel compliance to ~ 60% of the agreed cuts, which, as we noted in our 2017 Commodity Outlook in December, would be sufficient to achieve the Agreement's goal of pulling inventories in the OECD down by ~ 10% by 3Q17.2 Non-OPEC producers also appear to be complying with the Agreement. Notable among them is Russia, which is ahead of its commitment with cuts of close to 120k b/d in January, due partly to extreme cold in Siberian fields. We expect cuts in Russia to average 200k b/d in 1Q17, going to 300k b/d in 2Q17. These cuts will allow demand to outstrip supply in 1H17 and into year-end. By early- to mid-3Q17, draws to OECD storage of 300mm bbl can be expected, without extending the OPEC - Russia production agreement (Chart of the Week). We expect to see these cuts show up in OECD inventory data this month and next and continue into the end of 2017. For non-OECD states, the draws will show up in JODI data beginning in March.3 The physical deficits - i.e., supply less than demand - will force storage to draw, backwardating the WTI forward curve later this year (Chart 2).4 If markets are not surprised by a policy-induced rally in the USD on the back of a U.S. border-adjustment tax (BAT), or a too-aggressive tightening by the Fed as it seeks to normalize monetary policy, we expect the drawdown in inventories to continue keeping markets backwardated. Even with production returning to pre-Agreement levels in 2H17 in states with the capacity to expand and reliably sustain production - Gulf Arab producers, Russia and U.S. shales - we expect storage to continue to draw through the year and into 2018 (Chart 3). Chart 2We Continue To Expect Backwardation Chart 3Storage Drawdown On Track In 4Q16 the impact of the higher Kuwaiti and UAE output is apparent, along with higher Russian production. This put more crude on the market, which found its way into storage late in 4Q16 and early 1Q17, reversing the trend in draws seen earlier in 2H16. This put the market back in a temporary surplus condition, with the result being more storage will have to be worked off in 1H17 than our earlier estimates indicated. But these draws will occur, following the implementation of the production accord. Extending The KSA - Russia Deal Beyond June Is Unnecessary In our estimates, OPEC crude production increases by ~ 850k b/d in 2H17 versus 1H17 levels. Despite this recovery, the storage drawdown continues. Our modeling assumes Gulf OPEC will account for slightly more than +1mm b/d growth, and non-Gulf OPEC will see production continue to fall by 170k b/d. Russia's total liquids production goes from 10.95mm b/d in 1H17 to 11.34mm b/d in 2H17. We estimate U.S. shale production grows at an average rate of ~ 300k b/d in 2H17, while total U.S. liquids production increases 720k b/d over the same interval. Setting aside the possibility of a policy-induced rally in the USD on the back of too-aggressive Fed tightening or a border-adjusted tax becoming the law of the land, both of which would depress demand and raise production ex U.S., we expect the crude-oil market to remain backwardated next year. The globally synchronized upturn in GDP will keep demand robust, with growth coming in close to even with this year's rate of ~ 1.50mm b/d. We have global liquids production and OPEC crude output growing less than 1.0% next year. We believe the market is overestimating the resilience of offshore production next year, particularly in the U.S. Gulf, based on the stout performance put in last year and expected for this year. Our colleague Matt Conlan notes in BCA's Energy Sector Strategy, U.S. production growth since October has almost exclusively been from the Gulf of Mexico's new projects. Output in the Gulf continues to increase due to the lagged effect of final investment decisions made during 2012 - 2014, when WTI prices were consistently trading above $100/bbl. GOM production will peak in 2017 then decline in 2018 due to lack of new investments made since 2014. Indeed, as "increasing decline rates overwhelm a shrinking inventory of new projects, GOM production should peak sometime in 2017 and then start decreasing. The EIA's estimate for another 200,000 b/d increase in GOM production in 2017 seems overly-optimistic."5 Once this becomes apparent to the market, we believe backwardation will reassert itself and persist into 2018. The backwardation of the forward curve structure will affect U.S. shale production economics in 2018. However, our base case is for U.S. shale-oil production in the "Big Four" basins - Permian, Eagle Ford, Bakken and Niobrara - to grow 700k b/d next year, given the current structure of the WTI forwards, which were taken higher along with the WTI price rally at the front of the curve. This triggered the revival of rig counts; however, we want to point out that different curve shapes at different price levels produce different expected rig-count responses.6 Chart 4Barring a Policy Shock Demand Will Remain Robust Global Demand Firing On All Cylinders Robust demand growth - ~ +1.50mm b/d in 2017 and 2018 in our modeling - provides the impetus for the continued draws in storage this year and next (Chart 4). We revised our demand estimates for 2015 - 16 in line with the IEA's just-revised assessment of global consumption published in its January 2017 Oil Market Report.7 The IEA brought 2016 oil demand growth up to 1.50mm b/d, in line with our earlier estimates, but significantly revised 2015 demand growth upward to 2.0mm b/d. The Agency expects higher prices to crimp demand this year, taking it to 1.30mm b/d; our estimate, however, is higher, largely on the back of the first global synchronized growth we've seen since the Global Financial Crisis, which will be supported by accommodative monetary conditions worldwide, all else equal.8 Investment Implications Our analysis suggests there will be no need to extend the OPEC - Russia production accord into 2H17. In addition, it reinforces our view markets will backwardate later this year and stay backwardated in 2018, provided we do not see a BAT-induced rally in the USD, or an overly aggressive Fed normalization trajectory. As we noted in previous research, a BAT would lift the value of the USD, which would lower demand ex U.S. and raise supply at the margin.9 We make the odds of a BAT becoming the law of the land in the U.S. this year 50:50, so this is a non-trivial risk. This would be unambiguously bearish for oil prices. While we do not expect oil to be included among the imported commodities subject to a BAT, we do, nonetheless, expect the imposition of a BAT to lift the USD by 10%. This, coupled with the 5% increase in the greenback we'd already penciled in due to the Fed's monetary-policy normalization, will lift the USD 15% if it goes through. Should this occur, we would be preparing for prices to again fall below $50/bbl and push back to the $40/bbl area, which would cause supply and capex to once again contract significantly. That said, we are reinstating our long front-to-back WTI recommendation (long Dec/17 WTI vs. short Dec/18 WTI), given our updated balances assessment. Our expectation for inventories to continue to draw after the OPEC - Russia production-cutting agreement expires in June supports this recommendation. In addition, if we do see a BAT in the U.S., we believe markets will take the deferred WTI curve significantly lower in expectation of reduced demand and higher marginal supplies that almost surely will ensue in 2018. While the Dec/17 contract also will trade lower, more damage to prices will occur in 2018 contracts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC Cuts Oil Output, But More Work Needed to Fulfill Deal," published by Bloomberg February 2, 2017. Iraq stands out among OPEC producers agreeing to cut, but apparently not following through as diligently as the rest of the Gulf Arab states; we are assuming production of 4.5mm b/d for 1H17, going to 4.6mm b/d in 2H17 for Iraq. 2 Please see BCA Research's Commodity & Energy Strategy "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 3 JODI refers to the Joint Organisations Data Initiative, a supranational producer-consumer oil-market data provider headquartered in Riyadh, Saudi Arabia. 4 "Backwardation" describes a forward price curve in which the price for a commodity for prompt delivery (e.g., tomorrow) exceeds the price of a commodity delivered in the future (e.g., next year). It is the opposite of a contango curve structure. 5 Please see issue of BCA Research's Energy Sector Strategy "Gulf Of Mexico Oil Production Likely To Peak In 2017," dated January 11, 2017, available nrg.bcaresearch.com. 6 In next week's report, we will present scenario analysis of shale-oil production as a function of WTI forward curve shape - i.e., the implications of backwardation for shale rig counts. This will update our assessments of price sensitivities to interest rates and USD movements. 7 Please see the IEA's Oil Market Report of 19 January 2017. 8 We discuss this in last week's Commodity & Energy Strategy feature article entitled "Gold Will Perform...," dated February 2, 2017, available at ces.bcaresearch.com. 9 Please see BCA Research's Commodity & Energy Strategy "Taking A BAT To Commodities," dated January 26, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights In line with our House view, we expect the USD will weaken near term, and are recommending a tactical long gold position if the metal trades to $1,180/oz. Longer term, the Trump administration's presumed fiscal-policy goals - e.g., lighter regulation, lower taxes - will be hitting an economy at or near full employment, and will run smack up against deflationary pressures if a border-adjusted tax (BAT) scheme is implemented. Expect higher volatility. Energy: Overweight. Fundamentals continue to point toward global oil storage drawing by ~ 300mm bbl by 3Q17. Brent was backwardated going to press in the Dec/17 vs. Dec/18 spread, while WTI is in contango.1 Our WTI backwardation trade (long Dec/17 vs. short Dec/18) stopped out at -$0.05/bbl. Markets appear reluctant to take 2018 prices below 2017 levels, but we still like the position and will look to put it on again. Base Metals: Neutral. A weaker USD and marginally softer real rates will support base metals short term. We remain neutral. Precious Metals: Neutral. We are going tactically long gold, and are bracing for more ambiguity in U.S. fiscal-policy. This will keep the Fed on hold till 2H17. Ags/Softs: Underweight. Grains and beans will remain under pressure with Argentine growing conditions improving. High stocks-to-use levels will remain a headwind. Feature Gold prices will get a short-term bounce from financial markets' recalibration of when fiscal stimulus in the U.S. actually will start contributing to growth. With nothing for the Fed to react to in terms of fiscal policy other than sundry indications the Trump administration favors lighter regulation, lower taxes and higher infrastructure spending, we believe the U.S. central bank will remain on the sidelines until mid-year before it starts guiding toward a rate hike. In the meantime, synchronized global growth (Chart of the Week) will continue to fan medium-term inflation expectations (Chart 2). Chart of the WeekSynchronized Global Growth... Chart 2...Is Lifting Inflation Expectations At this point in the cycle, it is unlikely the Fed or other systematically important central banks will tighten policy to arrest the emerging growth. Besides, the U.S. central bank is, for all intents and purposes, on hold until it sees the outlines of the fiscal policy to be proposed by the Trump administration, which has indicated strong preferences for lighter regulation, lower taxes and infrastructure spending. The market is putting the odds of a Fed rate hike by March at just over 20% (Chart 3). The odds of seeing a hike by June, on the other hand, increase to 64%. Chart 3Fed Most Likely On Hold Until June Given the constraints on the Fed for now, and indications of synchronized global growth, we expect some inflation pickup near term. This will lower real rates and weaken the USD over the short term, which will, in turn, support gold prices. Given this expectation, we are recommending a tactical long gold position if the spot contract trades to $1,180/oz. Because this is a tactical position, we will use a 5% stop-loss. Ambiguous Inflation Signals For 1H17, we expect inflation and inflation expectations to remain buoyant, given the synchronized global upturn we are seeing and the prospect - and so far it is only a prospect - for stimulative fiscal policy in the U.S. All else equal, with the U.S. labor market at or close to full employment, and the Trump administration signaling its desire for stimulative fiscal policy, we would be inclined to look for inflation hedges within commodities that are highly sensitive to rising inflation. The top candidates here would be gold and oil (WTI, in particular). But all else is not equal. President Trump and officials within the administration have floated the idea of a border-adjusted tax (BAT) scheme, which would tax imports into the U.S. and subsidize U.S. exports, and replace the existing corporate income tax. Our House view on the BAT is it has a 50% chance of becoming law. Even so, we believe there is a greater-than-50% chance apparel and energy products would be exempt from a BAT, if it became the law of the land, but we obviously cannot be sure this will occur. The first-round effects of a BAT would be felt domestically. U.S. inflation and inflation expectations would increase after it is rolled out, as prices on taxed imports rose by the inverse of (1 - Tax Rate). As an indication, a 10% BAT would lift domestic prices of taxed items by ~ 11%. If the BAT were extended to oil, the domestic price lift there would incentivize higher domestic oil production, which also would find its way to export markets. Taken together, these domestic effects arising from the imposition of a BAT would cause the U.S. trade deficit to contract, which would rally the USD, in addition to lifting domestic inflation. As we noted last week, even under the assumption a somewhat watered down version of a BAT is passed, our colleagues at BCA's Global Investment Strategy service anticipate the USD would rally another 10%.2 The second-round effects on the back of such an increase in the USD would be felt globally, particularly in oil markets and EM economies. In addition to the broad trade-weighted dollar rallying by 10%, we expected a 5% rise in the greenback prior to the discussion of the BAT. So, overall, we'd expect a 15% appreciation in toto following the implementation of a BAT in the U.S. This would stifle EM commodity demand, particularly for oil and base metals, given the stronger USD would make these commodities more expensive in local-currency terms ex U.S. In addition, it would encourage higher commodity production in the U.S. (if a BAT were to be imposed on oil imports) and ex U.S., where local-currency drilling costs once again would fall, leading to increased supplies at the margin. The possibility of deflationary blowback to the U.S. is high in this scenario. Positioning In Ambiguous Markets Investors seeking to profit from rising inflation, which we would expect in the U.S. in the first round of adjustment to a BAT, or to hedge against it often turn to commodities expecting they will rally as inflation increases. They typically do this via index exposure or individual commodity exposure, e.g., going long gold or oil. In the current environment, we believe gold offers the best commodity alternative for participating in a rising inflation environment, or hedging against it, which is why we recommend a tactical long position if the market corrects to $1,180/oz. We compared the one-year return performance of gold and oil as inflation hedges by regressing annual returns of both commodities against annual core PCE and the broad trade-weighted USD returns (Chart 4).3 The R2 goodness-of-fit statistics for both were extremely close - 0.88 (oil) vs. 0.85 (gold), indicating core PCE and USD returns do a good job of explaining oil and gold returns. However, the volatility of the gold regression (its standard error) was half that of the oil regression (0.06 vs. 0.12), indicating gold's relationship is more stable vis-à-vis core PCE inflation and the USD (i.e., subject to less dispersion). This would indicate returns for an inflation hedge using gold would be less volatile than a hedge employing oil futures.4 These tests indicate both gold and oil are well suited to hedging inflation, and that gold hedges will perform as well as an oil hedge with far less volatility in the returns. Longer term, we're concerned with the second-round effects attending a stronger USD on the back of the BAT discussed above - i.e., lower commodity demand and higher commodity supply. Over the medium to longer term, the above dynamic suggests oil and gold volatility will increase (Chart 5). Chart 4Gold Hedges Inflation And USD Risk ##br##As Well As Oil, With Lower Volatility Chart 5Oil And Gold Vol Likely Rise Besides being an inflation hedge, gold, unlike oil, also functions as a store of value. In the event of deflationary blowback arising from the imposition of a BAT, we believe gold also would hedge investor portfolios against the possibility of currency debasement. That is to say, it would hold its value while central banks and governments rolled out fiscal and monetary policy responses to deflation. It is worthwhile recalling nominal gold prices held fairly steady during the Great Depression, while real gold prices appreciated. We believe the optimal vehicle for such a hedge would be call options, but we await clarity the likelihood of a BAT and its provisions before recommending such a position. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Assistant hugob@bcaresearch.com 1 Backwardation and contango are terms describing the shape of commodity forward curves. When a curve is backwardated, prompt-delivery prices (e.g., oil delivered next week) exceed deferred-delivery prices (e.g., oil delivered next year), indicating supplies are tight. A contango curve describes a market in which deferred-delivery prices exceed prompt-delivery prices, which indicates supplies are relatively more abundant. 2 We discussed the implications of a possible border-adjusted tax scheme in last week's Commodity & Energy Strategy Weekly Report, in an article entitled "Taking A Bat To Commodities", dated January 26, 2017, available at ces.bcaresearch.com. See also BCA Research's Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" dated January 20, 2017, which examined the BAT in depth, available at gis.bcaresearch.com. 3 We ran a simple regression of the percent returns of gold and oil against core PCE and USD annual returns over the 2001 - 2016 interval to assess the performance of each as inflation hedges. By using one-year returns, we were able to regress stationary variables and use an AR(1) model. 4 Along similar lines, the sum of squared residuals for the oil returns was almost 4x that of the gold returns, indicating far less dispersion in the errors and a tighter fit with gold vs. core PCE once again. The Durbin-Watson statistic measuring the degree of autocorrelation in the errors is was slightly > 2.0 for the gold regression, for the oil regression the DW statistic was < 2.0. This suggests the gold regression is better behaved in that the error terms more closely conform to the assumptions for them in the type of regression we're running. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017

The GAA DM Equity Country Allocation model is updated as of January 31, 2017. The model has shifted to an overweight position on Switzerland at the expense of a larger reduction in Sweden. Additionally, the model reduced its underweight position in Japan and France (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the non-U.S. model (Level 2) underperformed its benchmark by 90 bps in January, due to the underweight in Japan. The large overweight in the U.S. caused the Level 1 model to underperform by 14 bps. Overall, the GAA model underperformed its MSCI World benchmark by 36 bps in January. Since Inception, the GAA model underperformed its benchmark by 16 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 31, 2017. The momentum component has shifted Energy from overweight to underweight. It has also shifted Info Tech and Consumer Discretionary from underweight to overweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia; The Trump Doctrine, as currently defined, has no room for transatlantic alliances; President Trump is pursuing both mercantilism and an isolationist foreign policy; This combination imperils the transatlantic alliance and thus the American anchor in Eurasia; If pursued to its logical conclusion, the Trump Doctrine will end American global hegemony. Feature "Who rules East Europe commands the Heartland; Who rules the Heartland commands the World-Island; Who rules the World-Island commands the world." - Sir Halford John Mackinder Geopolitics is parsimonious and predictive because it posits that states are imprisoned by their geography. For academia, geopolitics is too parsimonious. And the professors are correct! Mountainous terrain combined with ethno-linguistic heterogeneity has destined Afghanistan and Bosnia to centuries of conflict, but Switzerland seems to be doing just fine. As such, BCA's Geopolitical Strategy, despite our name, very rarely relies on pure geopolitics for its analysis. The world is just too complex and geopolitics operates on long time horizons that are rarely investment-relevant. Geography is not destiny. Rather, geography is the ultimate constraint, an immutable factor that can only be conquered with a massive effort or new technology that comes but once in a generation. To fight geography is folly, even for a hegemon. The Trump Doctrine, as it has taken shape thus far, looks to be just such a folly. In this analysis, we explain why and what the investment relevance may be for the U.S. and the world. We still think the U.S. is likely to regain power in relative terms, but Trump's "charismatic authority" and foreign policy pose a risk to this view. American Geopolitical Imperatives There are two notable "fathers" of geopolitics: Alfred Thayer Mahan and Sir Halford John Mackinder. They both dedicated their life to elucidating great power "Grand Strategy," the implicit but real geopolitical imperatives, rooted in geography, from which a country derives its day-to-day foreign policy. For Mahan, a U.S. Navy Admiral and lecturer at the Naval War College, the imperative of the U.S. was to build a navy to dominate the oceans, the global "commons" that is indispensable to modern trade, economy, and thus "hard power."1 A strong navy is the defining characteristic of a great power. It affords the hegemon military supremacy over vital trade routes and ensures that global commerce operates in its interest. If this sounds like present-day U.S. "Grand Strategy," it is because Mahan had a great influence on American policymakers in the early twentieth century. Theodore Roosevelt supported Mahan's thinking, which included building the Panama Canal. Mahan's The Influence of Sea Power Upon History, and similar work by British strategists, provided a historical and strategic framework for the naval race between the U.K. and Germany that ultimately contributed to the start of World War I.2 Mackinder, a British geographer and academic, focused on the Eurasian landmass, rather than the oceans.3 In his view - perhaps colored by Britain's history of fending off invaders from the continent - Eurasia had sufficient natural resources (Russia), population (China), wealth (Europe), and a geographic buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia, or "the World Island" as Mackinder coined it, would have no need for a navy as it would become a superpower by default (Map 1). Map 1The World According To Mackinder American Grand Strategy is today a combination of both Mahan's and Mackinder's thinking. The U.S. has had two explicit geopolitical imperatives since the end of World War II: Dominate the world's oceans (Mahan); Prevent any one power from dominating Eurasia (Mackinder). To accomplish the first, the U.S. has expended an extraordinary amount of resources to build and operate the world's greatest blue-water navy. To accomplish the second, the U.S. has entered two world wars, the Korean War, the Vietnam War, and spent a good part of the twentieth century containing the Soviet Union. In addition, Washington has fostered a close transatlantic alliance to ensure that Europe, its anchor in Eurasia, remains aligned with the U.S. These were not arbitrary decisions made by a corrupt, Beltway elite looking to enrich itself with the spoils of globalization. These were decisions made by American leaders looking to expand American power, establish global hegemony, and retain it against rivals for centuries to come. Both imperatives are necessary for the U.S. to remain a hegemon. And U.S. hegemony is the foundation of the global monetary and financial system. Not least, it underpins the role of the U.S. dollar as the world's reserve currency. Bottom Line: The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia. The Trump Doctrine: America First, Second, And Third Every U.S. president tries to enshrine a foreign policy "doctrine" during their presidency. There is no single document that does the job of elucidating the doctrine; scholars and journalists weave the ideas together from speeches, policy decisions, resource allocation, and rhetoric. This early in the Trump presidency, it is not fair to determine what his foreign policy doctrine will be. Already, with Trump's executive orders on immigration and refugees, it is clear that there is a process of trial and error underway, with the administration reversing its position on green card holders (U.S. permanent residents). We therefore take liberty in projecting the little information we have forward. Chances that we are wrong are high and our conviction level is low. Nevertheless, we have two broad conclusions. If the Trump Doctrine develops as these early clues suggest, then it will either be rejected by Congress and the American policy establishment, or it will initiate the collapse of the geopolitical and economic institutions of our era, ushering in something profoundly different. We see no alternatives. So what are the early outlines of the Trump Doctrine? We see three factors that stand out: Isolationism: Long-term alliances and commitments abroad must have a clear, immediate, and calculable benefit for the U.S. economic "bottom line." Therefore, Japan and South Korea should pay more for the benefits of U.S. alliance, and NATO is a drain on American resources. All alliances and American commitments are negotiable. Mercantilism: The U.S. has no permanent allies, only trade balances that must be positive. Trump has not only threatened China and Mexico with protectionism, but also longstanding allies like Germany and Japan.4 Any country that sports a significant trade surplus with the U.S. is in Washington's crosshairs (Chart 1). Chart 1Trump's Hit List Sovereignty: Trump said in his inaugural address, "it is the right of all nations to put their own interests first" and that America does "not seek to impose our way of life on anyone." This is a stark departure from ideologically-driven foreign policies of both the Bush and Obama White House. However, there is an ideology underpinning Trump's foreign policy: nationalism. Professor Ted Malloch, tipped as the next U.S. Ambassador to the EU, revealed in a BBC interview that the new U.S. President "is very opposed to supranational organizations, he believes in nation states." This statement makes explicit what many of Trump's speeches have implied. Under the tenets of this inchoate Trump Doctrine, NATO and the EU are not just nuisances, but are positively detrimental to U.S. interests. This marks a profound shift in U.S. foreign policy thinking, if it stands. First, both NATO and the EU break the ideological tenet of nationalism. They are international organizations that pool sovereignty for some predetermined common goal. Given that the common goal has nothing to do with the immediate, domestic and economic goals of the U.S., the two organizations are not worth supporting, under this interpretation of the emerging Trump Doctrine. Second, NATO demands a U.S. overseas commitment with little material gain in return. This is not a new argument. President Obama complained about the failure of NATO member states to pay their fair share (2% of GDP on defense) for collective self-defense (Chart 2). However, Obama's intention was to cajole European allies to boost defense spending; NATO's existence was not in question. Trump does not see a point in America paying for Germany's defense, especially when Germany sports a sizeable trade surplus with the U.S. Chart 2NATO States That Need To 'Pay Up' Third, the EU runs a large current account surplus in general and a trade surplus with the U.S. in particular (Chart 3). For the Trump administration, the EU is therefore a rival, perhaps more so even than Russia, which, when viewed through a purely mercantilist lens, is not a foe. Trump's foreign policy is based on an understanding that the world is multipolar and that the U.S. is in relative geopolitical decline. Our data supports President Trump's assertion (Chart 4). In that way, Trump's doctrine is similar to that of the Obama presidency. Both recognize that the U.S. can no longer act unilaterally and that it must retrench from its global responsibilities. But while Obama sought to enhance U.S. power by relying on allies and supranational organizations, Trump seeks to withdraw into Fortress America and geopolitically deleverage. Such a deleveraging, when combined with mercantilism, may cause America's traditional allies to try harder for its approval, like Trump assumes, or it may push America's traditional allies away from Washington's orbit. Chart 3Mercantilism Makes The EU A 'Bad Guy' Chart 4American Power In Relative Decline Bottom Line: President Trump believes in a "what can you do for me" world.5 This world has no room for twentieth-century alliances, which did not anticipate the disenchantment and polarization of the American public (or the benefit of Trump's wisdom!) in their original design. Transatlantic Drift The most important feature of the Trump Doctrine is that it seeks to replace transatlantic links between the U.S. and Europe with bilateral, ad-hoc alliances. The one such alliance that has received much media attention is the thaw between the U.S. and Russia. To be clear here, we are very much aware that many U.S. presidents have had deep disagreements with Europe and that every president since Reagan has tried to thaw relations with Russia early in his presidency. However, Trump is different in that he is the first U.S. president to: Openly question the very existence of NATO; Openly oppose European integration;6 Openly engage in mercantilist trade policies towards allies while simultaneously undermining geopolitical alliances with them. The problem with this course of action is that other countries will pursue alternative economic and security relationships to hedge against America's perceived lack of commitment, or outright hostility. Japan and South Korea, for example, concerned that they may face tariffs and a drop in U.S. military support, will need to turn more friendly toward China to avoid conflict and access new consumer markets. The same goes for Europe, with Germany and others eager to substitute for the U.S. by selling more to China amid U.S.-China trade conflicts.7 Thus, if we are to take the Trump Doctrine to its conclusion, we end up with an American foreign policy that pushes Eurasia towards the kind of integration - if not exactly alliance - that Mackinder feared. Since greater Eurasian coordination could eventually develop into a dynamic of its own, this process directly contravenes the second tenet of American grand strategy: Prevent any one power from dominating Eurasia. But wait, Trump supporters will cry, Trump is going to throw a wrench in Eurasian coordination by allying with Russia! No, he won't. Russia and America will not be allies. At best, they will be friends with benefits. The two countries have no shared economic interests. Russia sees both Europe and China as its economic partners. The former for supply of badly needed technology and investment (Chart 5), the latter as an energy market and another source of investment (Chart 6).8 Chart 5Russia Needs European Technology ... Chart 6... And Chinese Energy Demand Russian policymakers may be cheering Trump for the moment, but that is only because he brings relief from the extremely anti-Kremlin policies of the Obama (and potentially Hillary Clinton) presidency. The Kremlin will take advantage of the change in the White House. Bear in mind, all that Russian policymakers know of the U.S. in recent memory is conflict and realpolitik: It was the U.S. that pushed for NATO to expand into Ukraine and Georgia. Chancellor Angela Merkel, in fact, vetoed those plans at the 2008 NATO Summit; It was the Bush Administration that pushed for Kosovo's independence in 2008; Both the Bush and Obama administrations sought to construct a ballistic missile defense shield on Russia's doorstop in Central and Eastern Europe. If Trump stumbles in the next four years, who is to say that Moscow won't have to deal with an antagonistic Washington by the end of 2020? Trump's olive branches will not alter Russian thinking about the country's long-term interests. Russian President Vladimir Putin is going to do what is good for Russia, no matter how much he may think that Trump is a great guy to party with. And what is good for Russia is deeper economic integration with China and Europe. In fact, with the U.S. becoming an energy producer - and potentially a significant LNG exporter soon - America may become Russia's competitor for Europe's natural gas demand. Trump, his supporters and advisors, may believe that the twentieth century is over and that post-WWII American alliances have atrophied. They have! Russia is not the Soviet Union. It is no surprise that NATO is having an identity crisis when it no longer has a peer enemy to defend against. But geography has not changed. The U.S. is still far from Eurasia and Eurasia is still the "World Island." The Trump Doctrine ignores the entire twentieth century during which the U.S. had to intervene in Europe twice, and Asia three times, at a huge cost of blood and treasure, due to the threat of the continent unifying under a single hegemon. The international organizations that the U.S. set up after the Second World War, including NATO and the EU but also the UN, IMF, and others, were created to ensure that the U.S. did not have to intervene in Europe again. The security alliance and commercial system in Asia Pacific served a similar purpose. Bottom Line: Trans-oceanic alliances and organizations are not vestiges of a past that has changed, but vestiges of a geography that is immutable. The Trump Doctrine, such as it is, threatens to undermine an imperative of American hegemony. If pursued to its professed conclusion, it will therefore end American hegemony. Eurasian Alliance How can Europe, Russia, and China overcome their vast differences and unite in an anti-American alliance? It is not easy, but nor is it impossible. Russian point of view: The U.S. remains Russia's chief strategic threat. Sino-Russian distrust and tensions are overstated, as we discussed in a 2014 Special Report.9 Russia depends on China and Germany for 32% of its imports and 17% of its exports (Chart 7). It is deeply integrated with both economies. The U.S., meanwhile is about as relevant for the Russian economy as Poland in terms of imports and as Belarus in terms of exports. China's point of view: The U.S. is also China's chief strategic threat - and probably the only thing standing between China and regional hegemony over the course of this century. For China, integrating with the denizens of Eurasia makes a lot of sense. First, it would allow China to avoid the folly of competing with the U.S. in direct naval and maritime conflict. Overland transportation routes - which Beijing seeks to develop via its ambitious "The Silk Road Economic Belt" project - will bypass China's contentious and cramped South and East China Seas. Second, Europe has everything China needs from the U.S. (technology, aircraft, IT), and could offer them at discount rates due to a weak euro and general economic malaise (entire continent is for sale, at a discount!). Third, neither Europe nor Russia care what China does with its neighborhood in East Asia. If China wants to take some shoal from the Philippines, Berlin and Moscow will be okay with that. Europe's point of view: The European Union has never spent much time thinking seriously about the U.S. as a threat to its existence. The possibility, at very least, will promote efforts at economic substitution. Europe and Russia must overcome their differences over Ukraine in order to cooperate again. However, as we pointed out above, it was not Europe that sought to integrate Ukraine and Georgia into NATO, it was the United States. Europe needs Russian energy and Russia needs Europe's technology and investment. As long as they delineate where each sphere of influence begins and ends, which they have done before (in 1917 and 1939 if anyone is still counting!) they will be fine. Finally, trade with emerging markets is already more important for the EU than with the U.S. (Chart 8). And China remains a major potential growth market for EU products. Chart 7U.S. No Substitute For Russian Partners Chart 8Europe Relies On EM More Than U.S. We do not think that a formal EU-Russia-China axis is around the corner, or even likely. However, if the U.S. should pursue a policy of undermining its transatlantic and transpacific alliances, cheerleading the dissolution of the EU, and treating foes and allies equally when it comes to trade protectionism, the probability that it faces a united front from Eurasia increases. We are not sure that the Trump Administration understands this, or even cares. From what we can tell right now, the Trump White House is singularly focused on trade and commercial matters. It is mercantilist, pure and simple. But geopolitics is not a single dimension. It is like a game of three-dimensional chess. Foreign policy and security are on the top chess board, trade and economic matters are in the middle, and domestic politics are played on the bottom board. When the Trump administration threatens the "One China" policy or encourages EU dissolution because the bloc has "overshot its mark," it corners its counterparts on the geopolitical and political chess boards for the sake of trade and commercial interests. This is a mistake. Europe and China will give up chess pieces on the economic board to preserve their position on the geopolitical and political boards. In other words, Trump's strategy of tough-nosed negotiations - which he learned in the global real estate sector - will only strengthen opposition against the U.S. in the real world. We don't think that Trump is playing three-dimensional chess. He is singularly focused on America's economy and commercial interests and his own domestic political coalition. This is unique in post-World War Two American foreign policy. Ronald Reagan, who cajoled Japan and West Germany into the 1985 Plaza Accord, did so because both Berlin and Tokyo understood they owed their security to America. If Reagan threatened to withdraw America's security commitment to either, he would not have gotten the economic deal he wanted. Bottom Line: If pursued to its logical conclusion, the Trump Doctrine will end U.S. hegemony. Trump's foreign policy has raised a specter, however faint at present, which has not been seen since the Molotov-Ribbentrop Pact between Russia and Germany in 1939: a united Eurasian continent marshalling all its human, natural, and technological resources against the U.S. The last time that happened, 549,865 U.S. lives were needed to preserve American hegemony, not to mention the global cost in blood and treasure. Investment Implications In our 2017 Strategic Outlook we posited that investors should get used to the revival of charismatic authority.10 We borrow the concept from German sociologist Max Weber, who identified it in his seminal essay, "The Three Types of Legitimate Rule."11 Weber argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office. Today, we are seeing the revival of charismatic authority, which Weber defined as flowing from the extraordinary characteristics of an individual. Such leaders are difficult to predict as they often rise to power precisely because of their opposition to the institutions and laws that define the legal-rational authority. The Trump Doctrine is one example of how charismatic authority can lead to uncertainty. Twentieth century institutions may be flawed, but they have underpinned and continue to underpin American hegemony. The U.S. cannot, at the same time, maintain global hegemony, pursue mercantilist commercial policy, and seek to undermine its global alliances. The Trump White House threatens to push allies and foes, pursuing their own interests, to work in concert to isolate the United States. Perhaps President Trump and his advisors are comforted by the fact that the U.S. has always profited from global chaos. The U.S. benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 9). This is why Trump's election led us to believe that global multipolarity would peak in the coming year and set the stage for an American revival.12 Chart 9The U.S. Benefits From Global Chaos However, to maintain primacy while sowing global discord, the U.S. needs more than just Anglo-Saxon allies in the world. It needs an anchor in Eurasia, which is and always will be Europe. Without an anchor, Trump's policies will not sow discord, they will create concord, and unite the "World Island" against America. That is why it is important to see how the Trump Doctrine develops in terms of real policy, as opposed to a year's worth of mostly campaign statements. Already the administration has made some appropriate noises about standing "100% behind NATO" and having an "ironclad commitment" to Japan. But make no mistake, Trump's open doubts have reverberated farther and deeper than these minimal reassurances. It is critical to monitor how the Trump administration approaches NATO, the EU, and bilateral negotiations with key partners. We are already seeing evidence of serious coordination - particularly between Germany and China - that could be a counterweight to U.S. power in the marking. These two outcomes - renewed U.S. hegemony, or U.S. downfall - are essentially binary and it is too soon to know which will prevail. What is the probability of downfall? It is low, but rising. If Trump does not adjust his foreign policy - or, barring that, if the U.S. Congress or American foreign policy, defense, and intelligence establishment do not "correct" Trump's course - then U.S. hegemony will begin to unravel. And with it will go a range of "certainties" underpinning global economic growth and trade, including the U.S. dollar's reserve currency status. If America loses its hegemony, one victim may be the U.S. dollar's role as a safe haven asset. The notion that the greenback is a safe-haven asset even when the chief global risks emanate from the U.S. will be tested. We recommend that long-term investors diversify into other currencies, including the Swiss franc, euro, and, of course, gold. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Alfred Thayer Mahan, The Interest Of America In Sea Power: Present And Future (Boston: Little, Brown and Co., 1918). 2 Mahan, The Influence Of Sea Power Upon History, 1660-1783, 15th ed. (Boston: Little, Brown and Co., 1949). 3 Halford John Mackinder, Democratic Ideals And Reality: A Study In The Politics Of Reconstruction, 15th ed. (Washington, D.C.: National Defense University Press, 1996). 4 Trump has surprised U.S. ally Japan by coupling it with China in some of his statements threatening tariffs. Meanwhile Peter Navarro, chief of the new National Trade Council, has recently accused Germany of currency manipulation and structural trade imbalances. Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017 available at www.ft.com. 5 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 6 Trump has said that the U.K. was "smart" to leave the EU, and has expressed indifference to the existence of the EU and a belief that "others will leave" following the U.K. Please see "Full Transcript of Interview with Donald Trump," The Times of London, January 16, 2017, available at www.thetimes.co.uk. Also, the aforementioned Professor Malloch, potential U.S. Ambassador to the EU, said in his interview with the BBC that "Trump believes that the European Union has in recent decades been tilted strongly and most favorably towards Germany" and that "the EU has overshot its mark." 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 9 Please see Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 Please see Max Weber, "The Three Types Of legitimate Rule," Berkeley Publications in Society and Institutions 4 (1) (1958): 1-11. Translated by Hans Gerth. Originally published in German in the journal Preussiche Jahrbücher 182, 1-2 (1922). 12 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com.

Highlights Duration: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth, which is supported by accelerating corporate profits. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Country Allocation: Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporates: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Feature Optimism reigns supreme in the markets at the moment, particularly in the U.S. where bullish investors traded in their "Make America Great Again" hats for "Dow 20,000" ballcaps last week. The string of better-than-expected economic data across the world is continuing - a fact confirmed by the latest corporate profit releases showing that an earnings recovery was already underway before Donald Trump's election victory. We have been looking for a meaningful pullback in government bond yields, and a widening of credit spreads, before returning to a below-benchmark portfolio duration stance and raising corporate allocations. That opportunity may not come to pass as economic data remains solid and leading indicators are accelerating. With no major inflation hiccups likely in the near-term to force the major central banks to rapidly shift to a more hawkish stance, and with equity markets remaining supported by accelerating earnings growth, the current "sweet spot" for risk can continue. Return expectations must be tempered, though, as much of the recent growth improvements is already reflected in bond and equity valuations. Any sign that the optimism shown in confidence surveys is not translating into improving hard economic data could trigger an equity market correction and a risk-off move to lower government bond yields and wider credit spreads. Given our view that global growth will be faster than consensus expectations in 2017, however, we think that a pro-risk overshoot phase is more likely than a risk-off correction in the near term. Any upset in equity markets would represent a medium-term opportunity to increase credit risk and reduce duration. This week, we are adapting a more pro-growth, pro-risk stance in our recommended portfolio allocations this week, making the following changes: Reduce overall portfolio duration to below-benchmark Reduce U.S. Treasury exposure to below-benchmark (2 of 5) Upgrade U.S. Investment Grade corporate exposure to above-benchmark (4 of 5) Upgrade U.S. High-Yield corporate exposure to neutral (3 of 5), favoring B- & Ba-rated names Importantly, we are maintaining our current allocations to Euro Area corporates (above-benchmark) and Emerging Market sovereign and corporate debt (neutral for both), given that we see more potential for upside surprises in the U.S. economy relative to the rest of the world. Duration: Re-Establish A Cyclical Below-Benchmark Stance We moved to a neutral stance on our overall duration recommendation back on December 6th, which we viewed as a tactical profit-taking exercise on our previous successful bearish bond call dating back to last July.1 Our view at the time was that global bonds were still in a cyclical bear phase, led by rising inflation expectations and better economic growth prospects in the developed world (especially in the U.S.). Given the extreme bearish positioning in government bond markets, at a time of oversold momentum, our stated plan of attack was to look to move back to a below-benchmark stance after a meaningful pullback in yields. The likely trigger for that move was expected to be some disappointment on actual economic data, especially given the heightened growth expectations in the U.S. after Trump's electoral victory. Global economic data continues to trend in a positive direction, however, which is preventing any pullback in bond yields despite a deeply oversold market (Chart of the Week). The Citigroup Data Surprise index for the major developed economies is at the highest levels since early 2014. The Global ZEW indicator, one of our favorites, is at the highest level since mid-2015. The global leading economic indicator from the OECD is back to levels last seen in 2013, suggesting that the positive growth momentum can continue to put upward pressure on real bond yields. There are few signs of disappointment at the country level, with the Purchasing Managers Indices for all major developed markets, as well as for China, all pointing to expanding global activity (Chart 2). Chart of the WeekYields Supported By Faster Growth Chart 2A Broad Based Upturn It will be interesting to see if this uptrend can withstand the "bull in the China shop" approach of the new Trump administration with regards to U.S. trade policy. Already, in just the first week of his presidency, Trump has aggressively pushed to implement much of his protectionist campaign promises, like pulling out of the Trans-Pacific Partnership, pushing to renegotiate the North American Free Trade Agreement and threatening the imposition of tariffs or border taxes in an effort to reduce the U.S. trade deficit. Global confidence surveys will be critical to monitor in the next month or two for any sign that Trump uncertainty is having a detrimental effect on business optimism outside the U.S. Importantly, the starting point is strong, with both consumer and business confidence measures in Europe and China rising steadily, as are net earnings revisions for global equities (Chart 3). A combination of improving economic sentiment, confirmed by stronger corporate profits, may be enough for the global economy to withstand the shifting plate tectonics of U.S. economic policy. In the U.S. itself, the GDP report released last week showed that 2016 ended on a soft note, with annualized growth of only 1.9% in the 4th quarter. However, a sector-by-sector forecast for U.S. GDP presented last month by our colleagues at BCA U.S. Bond Strategy shows that there is upside risk for most major elements of the U.S. economy (Chart 4).2 Rising consumer confidence amid a tight labor market should help boost consumption, while the large drag from inventory destocking seen last year will not be repeated in 2017. Chart 3An Improving Corporate Profit Backdrop Chart 4Upside Risks For U.S. Growth The wild cards for U.S. growth will come from all the sectors most impacted by potential policies from the Trump administration: business investment, government spending and net exports. Trump has been going full steam ahead with his protectionist leanings in his initial days in office, but how much he can quickly implement remains to be seen. For now, the U.S. dollar is not rising rapidly enough to generate much of a drag on U.S. GDP growth, unlike the 2014/15 surge in the greenback (see the bottom panel of Chart 4). More importantly, the improving trend in U.S. corporate profit growth and post-election surge in business confidence should support faster growth in U.S. capital spending, which is already showing signs of perking up a bit (Chart 5). As we discussed in a Weekly Report earlier this month, the bigger upside surprise for the U.S. economy this year will come from capital spending, not government spending, as Trump will have a much easier time passing pro-growth corporate tax cuts than getting his infrastructure spending program green-lighted quickly through the U.S. Congress.3 U.S. growth will be much faster than the Fed's current forecast of 2.1%, which will embolden the Fed to deliver on additional rate hikes later this year. The Fed will likely want to see some sign of clarity on the fiscal policy outlook before contemplating the next rate hike, and we are not expecting a rapid acceleration of U.S. inflation in the next few months that would force to Fed to act more quickly. The next rate hike will come at the June FOMC meeting, with the Fed delivering at least the 50bps of rate hikes by year-end currently discounted in the market, and possibly the full 75bps of hikes shown in the latest FOMC projections if the economy delivers faster growth in 2017, as we expect. When looking at the other major bond yields in the "Big-4" developed markets, all elements of valuation have repriced higher (Chart 6): Chart 5U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next Chart 6All Yield Components Are Rising Central bank policy rate expectations have shifted away from cuts in the Euro Area, Japan and the U.K., with a small hike from the Bank of England now discounted in the U.K. Overnight Index Swap (OIS) curve; Term premiums have risen from the mid-2016 lows, but remain negative in the countries where central banks are still actively engaging in asset purchase programs; Inflation expectations are well off the 2016 lows in all markets, but with higher levels in the U.K. and U.S. We see much higher upside risks for growth and inflation, and tighter monetary policy, in the U.S. and U.K. than the Euro Area or Japan. To reflect this in our model portfolio, we are downgrading our U.S. country allocation to below-benchmark (2 of 5) this week, while maintaining our underweight in the U.K. (also 2 of 5). We are keeping the Euro Area at above-benchmark (4 of 5) and Japan at benchmark (3 of 5). Government bond yield curves should see mild steepening pressure from rising inflation expectations before central banks are forced to turn more hawkish. We are focusing our decision to reduce overall portfolio duration more at the longer end of yield curves, especially in the U.S. and U.K. (Chart 7). A large headwind to any significant move higher in bond yields remains investor positioning, with only the "active client" portion of the JP Morgan duration survey showing a flip back to a net long duration stance in recent weeks (Chart 8). A full unwind of the large short positions in government bond markets is unlikely in the absence of much weaker economic data or a big correction in equity markets. The latter is impossible to time, but nothing that we are seeing in the forward-looking data is pointing to an imminent slowing of economic growth. Thus, we are choosing to shift back to our desired strategic below-benchmark duration stance this week. Chart 7Rising Inflation = Steeper Yield Curves Chart 8Large Short Positions Still An Issue Bottom Line: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth and inflation. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporate Bonds: A Cyclical Upgrade In The U.S., Despite Tight Valuations Global corporate debt has enjoyed solid relative performance versus government bonds over the past several months, driven by the improvements in economic growth and earnings. Credit spreads have narrowed in response, for both Investment Grade and High-Yield. In the Euro Area, the U.K. and Japan, central bank asset purchases of corporate bonds have also helped to keep spreads tight and help support the overall positive backdrop for credit markets. High levels of corporate leverage remain an issue, especially in the U.S., but an improving profit backdrop and faster nominal GDP growth will help paper over problems associated with high company debt. In the U.S., the items in our "Corporate Checklist" are providing a generally positive signal (Chart 9): Our Corporate Health Monitor (CHM) is starting to signal a slight improvement in corporate credit metrics after several years of deterioration; Bank lending standards are no longer tightening, according to the Fed's Senior Loan Officer Survey, after a brief period of more stringent standards in 2015 & 2016; Bank equities are outperforming the overall market, which in the past has been a positive signal for credit availability and corporate debt performance; Monetary conditions are still only just neutral, even with the U.S. dollar at very expensive levels. The monetary backdrop could become a concern later on in the year if Fed rate hikes lead to another period of rapid U.S. dollar appreciation. Until then, the more positive backdrop for profits will continue to boost balance sheet health, resulting in reduced equilibrium risk premiums (i.e. spreads) on corporate bonds. Already, U.S. corporate debt has priced in the better news (Chart 10). In High-Yield, the massive rally in energy-related names after the recovery in oil prices last year (top panel) has driven the spread on the Energy sub-component of the Barclays Bloomberg benchmark index back to levels last seen when oil was at $100/bbl ... even though the price of oil is still in the low $50s! Meanwhile, junk spreads ex-energy now reflect the benign macro volatility environment, as proxied by the VIX index (middle panel). Chart 9A Better Fundamental Backdrop Chart 10Corporate Valuations Are Not Cheap... In Investment Grade, spreads have also tightened alongside falling volatility, although spreads are still somewhat higher than during the previous period when the VIX was this low back in 2014 (bottom panel), suggesting that spreads could compress even further if the macro backdrop stays benign. We have maintained a generally cautious stance on U.S. corporate credit for much of the past year, given the combination of poor corporate health, contracting profits and slowly tightening monetary conditions. Now that the backdrop has changed, the case for upgrading U.S. corporates versus U.S. Treasuries is more compelling. This is especially so given the improvement in global economic growth momentum, which usually correlates with periods of positive excess returns for both Investment Grade and High-Yield versus Treasuries (Chart 11). Given our more optimistic tone on global economic growth, led by the potential for upside surprises in the U.S., this week we are upgrading our recommended stance on U.S. Investment Grade corporates to above-benchmark (4 of 5) and U.S. High-Yield to at-benchmark (3 of 5). Within High-Yield, we are focusing our exposure on the high-to-middle quality tiers, as both B-rated and Ba-rated spreads look far more attractive than Caa-rated debt. That can be seen in Chart 12, which shows the option-adjusted spread (OAS) for the overall U.S. High-Yield index and the three main credit tier buckets, divided by the 12-month trailing volatility of excess returns for each grouping. These "vol-adjusted" spreads are at the long-run median level for B-rated and Ba-rated debt, while Caa-rated bonds (which are dominated by the now-expensive debt of energy-related companies) offers poor value relative to their volatility. Chart 11...But The Growth Outlook Remains Supportive Chart 12Avoid The Lower Credit Tiers In U.S. Junk Differentiating within the credit tiers is important, as the overall U.S. High-Yield spread is not particularly cheap once expected default losses are taken into account (Chart 13). If U.S. economic growth surprises to the upside, as we expect, then the default outlook will look better and High-Yield spreads will look more attractive. For this reason, we would look to shift to an above-benchmark stance on any risk-off correction in global equities or corporates. With the business cycle improving, buying any dips in U.S. corporate credit markets should pay off in 2017. One final point: we have had a long-standing recommendation to overweight Euro Area Investment Grade corporate debt versus U.S. equivalents. That view was based on the underlying support for Euro Area corporates from ECB purchases, coming at a time when Euro Area balance sheets were improving in absolute terms, and relative to the U.S., as shown by our Euro Area Corporate Health Monitor (Chart 14). However, with our U.S. CHM now showing some modest improvement, and with U.S. likely to show more upside growth surprises in 2017, we are not upgrading Euro Area debt from the current above-benchmark (4 of 5) ranking, even as we boost our U.S. corporate allocation. Chart 13Expect Carry-Like Returns, Given Tight Spreads Chart 14A Bullish Case For Both U.S. and Euro Area IG Bottom Line: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 2 Please see BCA U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "A "Post-Truth" Economic Upturn?", dated January 17, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

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)