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Informe especial

Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Chart 6Party Identifications##BR##Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Chart 8Trump Is Not A U.S. Dollar Paradigm Shift If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America Chart 10No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Informe especial

Dear Client, I am currently traveling in Europe visiting clients. This week, in lieu of a regular report, I am sending along a research report written by my colleague at BCA Global Asset Allocation. The topic covers one of the more fascinating "alternative" parts of the fixed income universe - catastrophe bonds. I trust that you will find this report insightful and useful. Best regards, Robert Robis, Senior Vice President Global Fixed Income Strategy Highlights Catastrophe bonds ("cat bonds") have recently been receiving a lot of investor attention because, after this summer's large hurricanes, they are now attractively priced. We explain the mechanics of this market, and analyze cat bonds' historic risk-return characteristics. Cat bonds have historical annualized returns of 7.4%, with volatility of only 3.0%, making them an attractive risk-adjusted investment. However, they are exposed to "cliff risk", creating a return distribution with negative skew and large excess kurtosis. But cat bonds offer interesting portfolio diversification benefits, since financial and economic shocks have minimal impact on cat bond returns. The reinsurance market tends to be cyclical, with premiums rising following a catastrophe and decreasing during a period of calm. Feature Introduction In 1992, Hurricane Andrew caused $17 billion in losses, more than twice the value of the insured property, and forced many insurers into bankruptcy. As the global economy has grown in size since then, the monetary value of insured events has risen steadily. However, increasing regulatory hurdles in the form of higher reserve requirements have led to capacity constraints (Chart 1) in the traditional insurance industry. In 2005, Hurricane Katrina, which caused $108 billion in losses, strengthened the case for the introduction of catastrophe bonds and other insurance-linked securities that helped ease financial burdens in the insurance industry, for several reasons. First, catastrophe bonds give access to the deepest, most liquid, and efficient sources of capital. Second, the securitization of reinsurance capital has created a secondary market where risk exposures can be transferred within the investor community. Third, insurance firms have the ability to move some exposures off their books, thereby allowing them to underwrite larger risks that they would otherwise lack the capacity to cover. According to S&P Global Ratings, the market for cat bonds and other insurance-linked securities is estimated to be about $86 billion. Other insurance-linked securities include industry loss warranties (ILW), collateralized reinsurance contracts, and reinsurance sidecars. Cat bonds are the only insurance-linked securities that publicly trade on a secondary market. The recent increase in natural catastrophes has led to surging supply in the cat bond market. Record issuance in the first and second quarters of 2017 has pushed the size of the outstanding cat bond market to over $30 billion (Chart 2) for the first time. This comes after a period prior to this year with fewer catastrophes and where bond pricing has been stable, which led to increased deal sizes. In this Special Report, we run through the mechanics of the cat bond structure and market. We analyze historical risk-return characteristics (Chart 3) and compare them to other major asset classes. Since insurance-linked securities are known to have very low correlation with other assets, we test their potential diversification benefits within a traditional portfolio. Finally, we analyze their historical performance in periods of financial market stress and rising interest rate environments, which are two of the biggest worries for investors. Our conclusions are that: Chart 1Capacity Constraints Chart 2Record Issuance In 2017 Chart 3Risk-Return Profile The reinsurance market is cyclical, with premiums increasing following a catastrophe and decreasing following a period of calm. Realized volatility in the cat bond market is low. However, returns have a negative skew with an extremely fat-tailed distribution relative to other traditional assets. The addition of cat bonds to a traditional multi-asset portfolio has tremendous diversification benefits. The largest improvement to risk-adjusted returns comes from substituting equities with cat bonds. Financial crises have minimal impact on cat bond returns. However, depending on the magnitude of catastrophe losses, there could be varied regional impacts. Investors can customize the risk-return profile by altering the attachment and exhaustion points, and also by diversifying across trigger types. Mechanics Of Cat Bonds Despite the increasing popularity of cat bonds, their non-conventional structure is understood by only a limited number of investors. A better understanding of the characteristics of this financial instrument makes analyzing risk and return more straightforward. The key features (Chart 4) of a catastrophe bond are as follows. An insurer looking to reduce certain exposures will create a special purpose vehicle (SPV), also known as the issuer, to assist with the transaction. The issuer/SPV sells reinsurance protection to the sponsoring firms and simultaneously issues a cat bond to the investor. The proceeds from the bond sale are managed in a segregated collateral account to generate the floating-rate component of the coupon payable to investors. The fixed component of the coupon is financed through reinsurance premiums paid by the sponsoring firm to the issuer or SPV. Traditionally, cat bonds used a total return swap where a counterparty guaranteed the liquidity and performance of a collateral account. This forced investors and sponsors to rely on the creditworthiness of the swap provider. In 2007, two cat bonds that used Lehman Brothers as a swap counterparty were forced into default because of illiquid collateral assets and mismatched maturities. Nowadays, the assets managed in the collateral account are invested only in U.S. Treasury money market funds or structured notes from the International Bank for Reconstruction and Development (IBRD). The final settlement of the bond is binary: 1) if no trigger event occurs before the bond maturity, the SPV returns the principal to investors along with the final coupon; 2) if a catastrophe hits and the bond is triggered, the principal in the collateral account is used to settle the claims of the sponsoring firms. Cat bonds are typically used to cover a piece of risk exposure in the sponsor's book. For example, a cat bond could cover indemnities exceeding $1 billion up to $1.2 billion, making the bond issue size equal to $200 million. The $1 billion is called the attachment point, and the $1.2 billion is called the exhaustion point, at which point the principal is exhausted and investors are not liable for any further claims. The tranche with the higher attachment point will be of higher quality, but with a lower rate of return. The reinsurance industry is cyclical, which makes contract pricing more volatile than investors might expect. The Rate on Line (Chart 5) index can be seen as a yield on the insurance contracts underwritten in the industry. Market conditions can be split into two phases: Chart 4Mechanics Of Cat Bonds Chart 5Cyclical Reinsurance Premiums Soft Market: Following many years of limited or minor catastrophes, reinsurance premiums are pressured downward and bond prices rise. In these circumstances, demand for cat bonds will be limited as coupon income will be less attractive. Hard Market: A major catastrophe will significantly erode the capital available in the insurance industry, thereby creating a supply shortage that pushes up reinsurance premiums. In these conditions, cat bond issuance will rise, driven by attractive coupon income. Investors can manage the premium cycle by slightly increasing risk at the portfolio level in a softening market (falling premiums) and reducing risk in hardening market (rising premiums). The recent catastrophes should drive up reinsurance premiums, but the sheer weight of money searching for yields in the current environment might make the uplift surprisingly modest compared to the past. Given that cat bonds have a binary payout feature, investors need to understand the trigger type (Table 1) used in the contract. In the early days, most bonds were issued with an indemnity trigger, but the type of trigger (Chart 6) has become more varied over time. The type of trigger used in the cat bond has the following impacts: If the trigger used in the bond takes longer to settle, the investor can be involved in a long drawn-out legal battle with the sponsoring firm looking to settle claims. This could in turn force the bond beyond maturity and keep investor funds locked up at significantly lower rates of return. Table 1Understanding Trigger Types Chart 6Choosing The Right Trigger Type Investors also need to understand the level of basis risk sponsoring firms are exposed to with different trigger types. In the context of cat bonds, basis risk is when the settlement payout from cat bonds differs from the actual portfolio losses incurred by sponsoring firms. If they have basis risk, investors will have to deal with moral hazard, where sponsoring firms will have incentive to underwrite excessive risks. Historical Risk & Return Investing in catastrophe bonds is essentially a "short gamma" strategy, where investors are selling insurance and collecting premium with the hope of options not being triggered during the maturity of the bond. Attractive historical returns (Table 2) have been the result of lower-than-expected principal write-downs given limited catastrophes. In the early years, cat bonds as an asset class were not fully understood by the broader market, creating a "novelty premium" up until 2010. Subsequently, low interest rates have had a profound impact on all traditional assets, making cat bond yields relatively attractive. Realized volatility has been extremely low since the investor collects regular coupons in the absence of a catastrophe that triggers a payout. This makes risk-adjusted returns very attractive compared to other major assets. However, because of the extreme tail risk, there exists a big negative skew along with high excess kurtosis. Cat bonds are exposed to "cliff risk" - the likelihood that the tranche's notional value will be exhausted once settlement claims reach the attachment point. The two main sources of risk that investors need to be mainly concerned about, however, are: 1) insurance risk that cat bonds assume, and 2) credit risk associated with the collateral account. An attractive feature of cat bonds is that poor performance tends to be self-correcting, as seen in the reinsurance cycle. Following a particularly destructive natural disaster, a number of factors such as increased insurance demand, the reduced capacity of insurance firms, and upward revisions to probability models serve to increase insurance premiums and potential returns to insurance-linked securities. For example, after the 2011 Japanese Tohoku earthquake and tsunami, insurance premiums were pushed up by around 50% for earthquake risk and 20% for other catastrophe risk. The likelihood of incurring negative returns is far lower than the chance of benefitting from positive returns. Cat bonds have achieved positive monthly returns 92% of the time (Table 3). The recent hurricane season in the U.S. was the first time returns turned negative on a 12-month basis. Table 2Historical Risk-Return Analysis (January 2002 - November 2017) Table 3Only Fifteen Months Of Negative Returns Finally, there have been many comparisons between cat bonds and high-yield credit. While high-yield debt performance is tied to market and economic cycles lasting about 10 years, that of cat bonds is tied to low probability catastrophes. Frequency of loss in junk bonds is greater than it is for cat bonds. However, the potential principal loss is greater for cat bonds, because they have almost zero recovery value. Diversification & Portfolio Impact Cat bonds' performance is linked to factors such as natural disasters, longevity risk, or life insurance mortality, and not to broader financial market risks. However, in periods of economic stress, markets experience a flight to quality and correlations between risk assets increase. Therefore, the benefits of portfolio diversification dissolve when they are needed most. This is not the case with cat bonds, however, as correlations with other assets (Table 4) have remained stable over time. This makes them a potentially useful diversification instrument in multi-asset portfolios. Table 4Cross-Asset Correlation (January 2002 - November 2017) To test this, we perform a typical portfolio analysis whereby we add cat bonds to a conventional portfolio and investigate the impact on the return and risk of the portfolio (Chart 7). Starting with the most traditional allocation of 60% equities and 40% bonds, we augment the portfolio with a 10% allocation to cat bonds and come up with the following results: Replacing equities with cat bonds leads to the largest reduction in portfolio volatility, and a small decrease in annualized returns. This new portfolio generates equity-like returns, but with a smaller correlation with stocks. Replacing traditional fixed income with cat bonds leads to a large increase to annualized returns, while the impact on volatility is virtually non-existent. The largest positive impact on risk-adjusted returns occurs when cat bonds replace equities, because the reduction in volatility is substantially greater than the increase in returns when cat bonds replace traditional bonds. We also ranked the MSCI All-Country World equity and Bloomberg Barclays Global Aggregate Bond indices from worst to best monthly returns and then overlaid the corresponding cat bond returns for each ranked month (Chart 8). This technique removes randomness from the time series in order to view the relative randomness of the other. We have the following findings: Cat bonds have had only three months that delivered a return less than -2%. These were -2.1% in September 2005 during Hurricane Katrina, -3.6% in March 2011 during the Tohoku earthquake and tsunami in Japan, and -5.8% in September 2017 after the severe hurricanes in Texas, Florida and the Caribbean. Other than catastrophe-related events, cat bond returns have been stable. Cat bonds displayed no reaction when equities had their most negative months. But they tend to have relatively stronger returns when equities also have positive months. Cat bonds performed well in both good and bad months for traditional fixed income. This shows that causes of traditional bond market losses and cat bond principal loss have little or no bearing on one another. Since cat bonds have a large negative skew and high excess kurtosis, investors can potentially lose all their capital if the bonds are triggered. When allocating to cat bonds, investors need to maintain a well-diversified position in order to minimize the risk of complete capital wipeout. This can be done by carefully picking bonds covering different perils (i.e. earthquakes, wind, extreme mortality), regions and trigger types (Chart 9). As a broader range of perils come to the market, investors will find increasing avenues for diversification within the asset class. Investors can also benefit from very low correlations within the cat bond universe, where returns from cat bonds covering a specific peril have no bearing on returns from cat bonds covering another peril. Chart 7Portfolio Diversification Chart 8Attractive Monthly Returns Chart 9Diversifying Across Perils, Coupon Rate And Expected Loss Financial Market Stress Having established that underlying market developments have no bearing on cat bond performance, we want to address two further important questions: 1) do financial crises affect cat bond returns? 2) do natural catastrophes trigger financial crises? Looking at previous global market crisis scenarios dating back to 2008 (Chart 10), we see that cat bonds had positive absolute returns during all crisis periods. The only period with negative cat bond returns was during the 2008 Lehman Brothers' collapse, when the bank was the swap counterparty for two bonds that defaulted. Large natural catastrophes do not affect broader capital markets, but do tend to have a large local impact. In August 2005, Hurricane Katrina, with damages totaling $108 billion, became the costliest hurricane to date in the U.S. The hurricane triggered a cat bond, and the index was down 2.1%, but there was no noticeable lingering impact on the U.S. economy. On the other hand, the earthquake and tsunami in Tohoku on March 11, 2011 had devastating effects. With damages exceeding $300 billion (approximately 5% of Japanese GDP), the cat bond index dropped 3.6%, and Japanese equities collapsed 7.3%. Moreover, a big earthquake in a major city or region such as Tokyo or California could have the capacity to trigger a global recession. Finally, looking at past major catastrophes (Chart 11), we see that existing cat bond prices do not fully recover to their pre-catastrophe levels. Accordingly, picking up bonds at a discount may not generate the expected return as price levels struggle to fully recover. Chart 10Outperformance Across The Board Chart 11Not A Full Recovery Interest Rate & Inflation Hedge Traditional bonds with fixed coupon payments underperform in a rising rate environment. Since cat bonds receive a floating-rate coupon along with the fixed premium, they are largely immune to rising rates. When central banks hike rates, the principal of the bonds invested in money market assets will produce a higher return, thereby offering investors a powerful shield against possible inflation, as well. Since the total coupon received by investors includes a fixed and floating component, cat bonds have a lower modified duration relative to similar maturity traditional bonds. Conclusion Despite their abnormal return distributions, we recommend investors allocate capital from their "alternatives" bucket toward cat bonds. Against a backdrop of low yields and investor complacency, cat bonds are highly attractive given their potential for consistently robust returns and, perhaps most importantly, tremendous diversification benefits. Still, allocations should be relatively small given the illiquid nature of the cat bond market, and diversification among bonds and issuers is critical due to the potential for large losses in the event that a cat bond is triggered. Aditya Kurian, Research Analyst Global Asset Allocation adityak@bcaresearch.com

Informe especial

Highlights Catastrophe bonds ("cat bonds") have recently been receiving a lot of investor attention because, after this summer's large hurricanes, they are now attractively priced. We explain the mechanics of this market, and analyze cat bonds' historic risk-return characteristics. Cat bonds have historical annualized returns of 7.4%, with volatility of only 3.0%, making them an attractive risk-adjusted investment. However, they are exposed to "cliff risk", creating a return distribution with negative skew and large excess kurtosis. But cat bonds offer interesting portfolio diversification benefits, since financial and economic shocks have minimal impact on cat bond returns. The reinsurance market tends to be cyclical, with premiums rising following a catastrophe and decreasing during a period of calm. Feature Introduction In 1992, Hurricane Andrew caused $17 billion in losses, more than twice the value of the insured property, and forced many insurers into bankruptcy. As the global economy has grown in size since then, the monetary value of insured events has risen steadily. However, increasing regulatory hurdles in the form of higher reserve requirements have led to capacity constraints (Chart 1) in the traditional insurance industry. In 2005, Hurricane Katrina, which caused $108 billion in losses, strengthened the case for the introduction of catastrophe bonds and other insurance-linked securities that helped ease financial burdens in the insurance industry, for several reasons. First, catastrophe bonds give access to the deepest, most liquid, and efficient sources of capital. Second, the securitization of reinsurance capital has created a secondary market where risk exposures can be transferred within the investor community. Third, insurance firms have the ability to move some exposures off their books, thereby allowing them to underwrite larger risks that they would otherwise lack the capacity to cover. According to S&P Global Ratings, the market for cat bonds and other insurance-linked securities is estimated to be about $86 billion. Other insurance-linked securities include industry loss warranties (ILW), collateralized reinsurance contracts, and reinsurance sidecars. Cat bonds are the only insurance-linked securities that publicly trade on a secondary market. The recent increase in natural catastrophes has led to surging supply in the cat bond market. Record issuance in the first and second quarters of 2017 has pushed the size of the outstanding cat bond market to over $30 billion (Chart 2) for the first time. This comes after a period prior to this year with fewer catastrophes and where bond pricing has been stable, which led to increased deal sizes. In this Special Report, we run through the mechanics of the cat bond structure and market. We analyze historical risk-return characteristics (Chart 3) and compare them to other major asset classes. Since insurance-linked securities are known to have very low correlation with other assets, we test their potential diversification benefits within a traditional portfolio. Finally, we analyze their historical performance in periods of financial market stress and rising interest rate environments, which are two of the biggest worries for investors. Our conclusions are that: Chart 1Capacity Constraints Chart 2Record Issuance In 2017 Chart 3Risk-Return Profile The reinsurance market is cyclical, with premiums increasing following a catastrophe and decreasing following a period of calm. Realized volatility in the cat bond market is low. However, returns have a negative skew with an extremely fat-tailed distribution relative to other traditional assets. The addition of cat bonds to a traditional multi-asset portfolio has tremendous diversification benefits. The largest improvement to risk-adjusted returns comes from substituting equities with cat bonds. Financial crises have minimal impact on cat bond returns. However, depending on the magnitude of catastrophe losses, there could be varied regional impacts. Investors can customize the risk-return profile by altering the attachment and exhaustion points, and also by diversifying across trigger types. Mechanics Of Cat Bonds Despite the increasing popularity of cat bonds, their non-conventional structure is understood by only a limited number of investors. A better understanding of the characteristics of this financial instrument makes analyzing risk and return more straightforward. The key features (Chart 4) of a catastrophe bond are as follows. An insurer looking to reduce certain exposures will create a special purpose vehicle (SPV), also known as the issuer, to assist with the transaction. The issuer/SPV sells reinsurance protection to the sponsoring firms and simultaneously issues a cat bond to the investor. The proceeds from the bond sale are managed in a segregated collateral account to generate the floating-rate component of the coupon payable to investors. The fixed component of the coupon is financed through reinsurance premiums paid by the sponsoring firm to the issuer or SPV. Traditionally, cat bonds used a total return swap where a counterparty guaranteed the liquidity and performance of a collateral account. This forced investors and sponsors to rely on the creditworthiness of the swap provider. In 2007, two cat bonds that used Lehman Brothers as a swap counterparty were forced into default because of illiquid collateral assets and mismatched maturities. Nowadays, the assets managed in the collateral account are invested only in U.S. Treasury money market funds or structured notes from the International Bank for Reconstruction and Development (IBRD). The final settlement of the bond is binary: 1) if no trigger event occurs before the bond maturity, the SPV returns the principal to investors along with the final coupon; 2) if a catastrophe hits and the bond is triggered, the principal in the collateral account is used to settle the claims of the sponsoring firms. Cat bonds are typically used to cover a piece of risk exposure in the sponsor's book. For example, a cat bond could cover indemnities exceeding $1 billion up to $1.2 billion, making the bond issue size equal to $200 million. The $1 billion is called the attachment point, and the $1.2 billion is called the exhaustion point, at which point the principal is exhausted and investors are not liable for any further claims. The tranche with the higher attachment point will be of higher quality, but with a lower rate of return. The reinsurance industry is cyclical, which makes contract pricing more volatile than investors might expect. The Rate on Line (Chart 5) index can be seen as a yield on the insurance contracts underwritten in the industry. Market conditions can be split into two phases: Chart 4Mechanics Of Cat Bonds Chart 5Cyclical Reinsurance Premiums Soft Market: Following many years of limited or minor catastrophes, reinsurance premiums are pressured downward and bond prices rise. In these circumstances, demand for cat bonds will be limited as coupon income will be less attractive. Hard Market: A major catastrophe will significantly erode the capital available in the insurance industry, thereby creating a supply shortage that pushes up reinsurance premiums. In these conditions, cat bond issuance will rise, driven by attractive coupon income. Investors can manage the premium cycle by slightly increasing risk at the portfolio level in a softening market (falling premiums) and reducing risk in hardening market (rising premiums). The recent catastrophes should drive up reinsurance premiums, but the sheer weight of money searching for yields in the current environment might make the uplift surprisingly modest compared to the past. Given that cat bonds have a binary payout feature, investors need to understand the trigger type (Table 1) used in the contract. In the early days, most bonds were issued with an indemnity trigger, but the type of trigger (Chart 6) has become more varied over time. The type of trigger used in the cat bond has the following impacts: If the trigger used in the bond takes longer to settle, the investor can be involved in a long drawn-out legal battle with the sponsoring firm looking to settle claims. This could in turn force the bond beyond maturity and keep investor funds locked up at significantly lower rates of return. Table 1Understanding Trigger Types Chart 6Choosing The Right Trigger Type Investors also need to understand the level of basis risk sponsoring firms are exposed to with different trigger types. In the context of cat bonds, basis risk is when the settlement payout from cat bonds differs from the actual portfolio losses incurred by sponsoring firms. If they have basis risk, investors will have to deal with moral hazard, where sponsoring firms will have incentive to underwrite excessive risks. Historical Risk & Return Investing in catastrophe bonds is essentially a "short gamma" strategy, where investors are selling insurance and collecting premium with the hope of options not being triggered during the maturity of the bond. Attractive historical returns (Table 2) have been the result of lower-than-expected principal write-downs given limited catastrophes. In the early years, cat bonds as an asset class were not fully understood by the broader market, creating a "novelty premium" up until 2010. Subsequently, low interest rates have had a profound impact on all traditional assets, making cat bond yields relatively attractive. Realized volatility has been extremely low since the investor collects regular coupons in the absence of a catastrophe that triggers a payout. This makes risk-adjusted returns very attractive compared to other major assets. However, because of the extreme tail risk, there exists a big negative skew along with high excess kurtosis. Cat bonds are exposed to "cliff risk" - the likelihood that the tranche's notional value will be exhausted once settlement claims reach the attachment point. The two main sources of risk that investors need to be mainly concerned about, however, are: 1) insurance risk that cat bonds assume, and 2) credit risk associated with the collateral account. An attractive feature of cat bonds is that poor performance tends to be self-correcting, as seen in the reinsurance cycle. Following a particularly destructive natural disaster, a number of factors such as increased insurance demand, the reduced capacity of insurance firms, and upward revisions to probability models serve to increase insurance premiums and potential returns to insurance-linked securities. For example, after the 2011 Japanese Tohoku earthquake and tsunami, insurance premiums were pushed up by around 50% for earthquake risk and 20% for other catastrophe risk. The likelihood of incurring negative returns is far lower than the chance of benefitting from positive returns. Cat bonds have achieved positive monthly returns 92% of the time (Table 3). The recent hurricane season in the U.S. was the first time returns turned negative on a 12-month basis. Table 2Historical Risk-Return Analysis (January 2002 - November 2017) Table 3Only Fifteen Months Of Negative Returns Finally, there have been many comparisons between cat bonds and high-yield credit. While high-yield debt performance is tied to market and economic cycles lasting about 10 years, that of cat bonds is tied to low probability catastrophes. Frequency of loss in junk bonds is greater than it is for cat bonds. However, the potential principal loss is greater for cat bonds, because they have almost zero recovery value. Diversification & Portfolio Impact Cat bonds' performance is linked to factors such as natural disasters, longevity risk, or life insurance mortality, and not to broader financial market risks. However, in periods of economic stress, markets experience a flight to quality and correlations between risk assets increase. Therefore, the benefits of portfolio diversification dissolve when they are needed most. This is not the case with cat bonds, however, as correlations with other assets (Table 4) have remained stable over time. This makes them a potentially useful diversification instrument in multi-asset portfolios. Table 4Cross-Asset Correlation (January 2002 - November 2017) To test this, we perform a typical portfolio analysis whereby we add cat bonds to a conventional portfolio and investigate the impact on the return and risk of the portfolio (Chart 7). Starting with the most traditional allocation of 60% equities and 40% bonds, we augment the portfolio with a 10% allocation to cat bonds and come up with the following results: Replacing equities with cat bonds leads to the largest reduction in portfolio volatility, and a small decrease in annualized returns. This new portfolio generates equity-like returns, but with a smaller correlation with stocks. Replacing traditional fixed income with cat bonds leads to a large increase to annualized returns, while the impact on volatility is virtually non-existent. The largest positive impact on risk-adjusted returns occurs when cat bonds replace equities, because the reduction in volatility is substantially greater than the increase in returns when cat bonds replace traditional bonds. We also ranked the MSCI All-Country World equity and Bloomberg Barclays Global Aggregate Bond indices from worst to best monthly returns and then overlaid the corresponding cat bond returns for each ranked month (Chart 8). This technique removes randomness from the time series in order to view the relative randomness of the other. We have the following findings: Cat bonds have had only three months that delivered a return less than -2%. These were -2.1% in September 2005 during Hurricane Katrina, -3.6% in March 2011 during the Tohoku earthquake and tsunami in Japan, and -5.8% in September 2017 after the severe hurricanes in Texas, Florida and the Caribbean. Other than catastrophe-related events, cat bond returns have been stable. Cat bonds displayed no reaction when equities had their most negative months. But they tend to have relatively stronger returns when equities also have positive months. Cat bonds performed well in both good and bad months for traditional fixed income. This shows that causes of traditional bond market losses and cat bond principal loss have little or no bearing on one another. Since cat bonds have a large negative skew and high excess kurtosis, investors can potentially lose all their capital if the bonds are triggered. When allocating to cat bonds, investors need to maintain a well-diversified position in order to minimize the risk of complete capital wipeout. This can be done by carefully picking bonds covering different perils (i.e. earthquakes, wind, extreme mortality), regions and trigger types (Chart 9). As a broader range of perils come to the market, investors will find increasing avenues for diversification within the asset class. Investors can also benefit from very low correlations within the cat bond universe, where returns from cat bonds covering a specific peril have no bearing on returns from cat bonds covering another peril. Chart 7Portfolio Diversification Chart 8Attractive Monthly Returns Chart 9Diversifying Across Perils, Coupon Rate And Expected Loss Financial Market Stress Having established that underlying market developments have no bearing on cat bond performance, we want to address two further important questions: 1) do financial crises affect cat bond returns? 2) do natural catastrophes trigger financial crises? Looking at previous global market crisis scenarios dating back to 2008 (Chart 10), we see that cat bonds had positive absolute returns during all crisis periods. The only period with negative cat bond returns was during the 2008 Lehman Brothers' collapse, when the bank was the swap counterparty for two bonds that defaulted. Large natural catastrophes do not affect broader capital markets, but do tend to have a large local impact. In August 2005, Hurricane Katrina, with damages totaling $108 billion, became the costliest hurricane to date in the U.S. The hurricane triggered a cat bond, and the index was down 2.1%, but there was no noticeable lingering impact on the U.S. economy. On the other hand, the earthquake and tsunami in Tohoku on March 11, 2011 had devastating effects. With damages exceeding $300 billion (approximately 5% of Japanese GDP), the cat bond index dropped 3.6%, and Japanese equities collapsed 7.3%. Moreover, a big earthquake in a major city or region such as Tokyo or California could have the capacity to trigger a global recession. Finally, looking at past major catastrophes (Chart 11), we see that existing cat bond prices do not fully recover to their pre-catastrophe levels. Accordingly, picking up bonds at a discount may not generate the expected return as price levels struggle to fully recover. Chart 10Outperformance Across The Board Chart 11Not A Full Recovery Interest Rate & Inflation Hedge Traditional bonds with fixed coupon payments underperform in a rising rate environment. Since cat bonds receive a floating-rate coupon along with the fixed premium, they are largely immune to rising rates. When central banks hike rates, the principal of the bonds invested in money market assets will produce a higher return, thereby offering investors a powerful shield against possible inflation, as well. Since the total coupon received by investors includes a fixed and floating component, cat bonds have a lower modified duration relative to similar maturity traditional bonds. Conclusion Despite their abnormal return distributions, we recommend investors allocate capital from their "alternatives" bucket toward cat bonds. Against a backdrop of low yields and investor complacency, cat bonds are highly attractive given their potential for consistently robust returns and, perhaps most importantly, tremendous diversification benefits. Still, allocations should be relatively small given the illiquid nature of the cat bond market, and diversification among bonds and issuers is critical due to the potential for large losses in the event that a cat bond is triggered. Aditya Kurian, Research Analyst Global Asset Allocation adityak@bcaresearch.com

Highlights Yield Curve & Fed: The yield curve will not invert until inflation has first recovered to the Fed's target. This means that a period of curve steepening is likely, driven either by rising inflation or a more dovish Fed. Corporate Sectors: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Feature Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short-term interest rates are normally accompanied by a rise in longer-term yields. [...] The broadly anticipated behavior of world bond markets remains a conundrum. - Alan Greenspan, February 20051 By the end of the week the Fed will have raised interest rates by 125 basis points since December 2015, yet the 10-year Treasury yield has risen only 7 bps (Chart 1). But unlike in 2005, there is no bond conundrum. On the contrary, the reason for low long-maturity Treasury yields is easily understood. Chart 1What Conundrum? Quite simply, the Federal Reserve has been lifting interest rates in-line with its projections for rising inflation, but markets are trading off the fact that this inflation has yet to materialize. The compensation for inflation protection embedded in 10-year yields is only 1.88%. Historically, when core inflation is close to the Fed's 2% target, compensation for inflation protection has traded in a range between 2.4% and 2.5%. Essentially, Fed rate hikes have lifted short-maturity yields but low inflation is keeping long-maturity yields depressed. The result is that the 2/10 Treasury slope has flattened all the way down to 58 bps from 128 bps in December 2015 (Chart 1, bottom panel). What should be clear is that the current paths of inflation and the yield curve are unsustainable. If the Fed continues to hike rates but inflation fails to rise, then the yield curve will invert in the coming months - a signal that bond investors anticipate a recession - and the Fed will have not achieved its inflation target. Such an obvious policy error will not be permitted to occur, which leaves us with three possible outcomes for Fed policy and the Treasury curve during the next six months. 1) The Fed Is Right In this scenario inflation starts to rebound in the coming months, pushing the compensation for inflation protection embedded in long-dated bond yields higher (Chart 2). This would certainly cause long-maturity nominal yields to increase and would probably impart a steepening bias to the yield curve, depending on how quickly the Fed lifts rates.2 BCA's Outlook for 2018 makes the case for why inflation is likely to bottom in the coming months, and we view the "Fed is Right" scenario as the most likely outcome.3 Chart 2Fed Expects Higher Inflation 2) The Fed Is Proactive In this scenario the Fed recognizes there is a risk of tightening the yield curve into inversion - and the economy into recession - if inflation stays low. It therefore proactively adopts a more dovish policy stance to prevent the yield curve from inverting. The likely first step would be signaling a slower pace of rate hikes in this week's Summary of Economic Projections. The yield curve would also steepen in this scenario, but this time a bull-steepening where short-maturity yields fall more than long-maturity yields. At least one FOMC member already seems worried enough to take this sort of action. St. Louis Fed President James Bullard said two weeks ago that: "Given below-target U.S. inflation, it is unnecessary to push normalization to such an extent that the yield curve inverts".4 But other policymakers are less concerned. Cleveland Fed President Loretta Mester downplayed the flat yield curve in a recent interview.5 We view this outcome as the least likely of our three scenarios. With economic growth accelerating (see Economy & Inflation section below), the Fed will likely cling to its forecast that inflation will move higher. If inflation fails to respond, then risky assets will eventually sell off. This brings us to the final scenario. 3) The Fed Is Reactive The Fed does not have a strong track record of proactively responding to low inflation readings, but it does have a strong track record of reacting to tighter financial conditions and risk off periods in equities and credit markets. What's more, if the yield curve continues to flatten, then we are very likely to see credit spreads widen and equities sell off quite soon. At that point the Fed would almost certainly respond by signaling a slower pace of rate hikes. That would steepen the curve and ease the pressure on risky assets. We view this third scenario as more likely than the one where the Fed is proactive. In fact, we observe that the yield curve is already flat enough that the chances of a sell-off in High-Yield corporate bonds relative to Treasuries are high. Using monthly data going back to 1988, we see that a flatter 2/10 Treasury slope is consistent with lower monthly excess returns from High-Yield (Chart 3). We also see that a flatter yield curve is consistent with more frequent risk-off periods (Chart 4). Chart 3Junk Monthly Excess Returns & ##br##Yield Curve (1988-Present) Chart 4% Of Months With Negative High-Yield ##br##Excess Returns (1988- Present) This makes sense intuitively. An inverted yield curve is a well-known recession indicator. This means that when the yield curve is very flat investors are obviously nervous that any new piece of bad news could tip the curve into inversion and signal an end to the economic recovery. In other words, a risk-off episode in junk bonds, like the one witnessed in early November, would be less likely to occur if the yield curve were steeper.6 We would recommend buying the dips on any near-term correction in junk bonds, because the Fed would then be forced to get more dovish and support the credit markets. But unless inflation returns and steepens the Treasury curve from current levels, the risk of just such an episode is high. Corporate Sector Year-In-Review With 2017 nearly in the books, this week we take a quick look back at the performance of the 10 main investment grade corporate bond sectors during the year. Chart 5 shows the excess return for each sector relative to its duration-times-spread (DTS) from the beginning of the year. DTS is a common measure of risk for corporate bonds, and can be thought of much like an equity's beta. When the overall corporate bond market is rallying, then high-DTS sectors tend to perform better. Conversely, when corporate bonds underperform Treasuries, then high-DTS sectors tend to lose more than the low-DTS alternatives. As can be seen in Chart 5, given that 2017 was a risk-on year, high-DTS sectors tended to outperform low-DTS sectors with a few exceptions. The Basic Industry sector and Financials performed much better than their DTS alone would have predicted, while the Communications sector performed much worse than its DTS would have predicted. Looking ahead into 2018, we make the following observations: Excess returns for investment grade corporate bonds are likely to be lower in 2018 than in 2017.7 In turn, this means that the Credit Risk Premium - the extra return earned for taking an additional unit of DTS risk - will also be lower. We calculated the Credit Risk Premium for each year since 2000 by performing a regression of annual excess returns for each of the 10 major sectors versus their beginning-of-year DTS. The beta from that regression represents the additional return earned that year from taking an extra unit of DTS risk. Chart 6 shows that this Credit Risk Premium is an increasing function of excess returns for the overall corporate sector. Logically, if the year ahead is likely to deliver lower excess returns for the overall index, then we should also expect less additional return from increasing the DTS risk of our corporate bond portfolios. Chart 52017 Corporate Sectors ##br##Excess Returns* Vs DTS** Chart 6Excess Returns* Vs ##br##Credit Risk Premium Second, we use our corporate sector model - a model that adjusts each sector's spread by its average credit rating and duration - to identify sectors that have the potential to outperform their DTS in the coming months. This model is updated each month in our Portfolio Allocation Summary.8 The most recent update shows that the high-DTS Energy, Basic Industry and Communications sectors are all attractively valued. The most attractive low-DTS sectors are Financials and Technology (Chart 7). Chart 7Risk-Adjusted Value In Corporate Sectors* Bottom Line: Expect less extra compensation from increasing the riskiness of corporate bond portfolios in 2018. The Energy, Communications, Basic Industry, Financial and Technology sectors offer the best risk-adjusted value. Economy & Inflation Does Consumer Credit Growth Put The Recovery At Risk? Last week's employment report showed a sharp increase in aggregate hours worked and suggests that U.S. economic growth has indeed shifted into a higher gear. We use a combination of year-over-year growth in aggregate hours worked and average quarterly productivity growth since 2012 to get a rough tracking estimate for U.S. real GDP growth. After last Friday's report this proxy is up to a healthy 3.1% (Chart 8). Last Friday's Consumer Sentiment data also suggest that consumer spending, the largest component of U.S. GDP, will stay firm in the coming months (Chart 9). While consumer credit growth has started to slow (Chart 9, panel 2) and consumer delinquencies are starting to rise (Chart 9, bottom panel), we are not yet inclined to view those trends as risks to the economic recovery. Chart 8Growth Tracking Well Above Trend Chart 9Credit Growth Falling & Delinquencies Rising First, notice that prior to the onset of recession, consumer spending growth tends to decline while consumer credit growth accelerates. It is only well after the recession begins that consumer credit growth follows spending growth lower. This chain of events is highly logical. In the late stages of the recovery households first start to see their incomes decline and then turn to credit to support their spending needs. Eventually, banks make consumer credit less available and consumer credit growth also decelerates, but we are already well into the recession by then. Chart 10Bank Lending Standards In fact, judging by the patterns observed in the lead up to the last two recessions, the warning sign for the economic recovery would be if consumer credit growth is rising while consumer spending growth is falling. So far this pattern has not been observed. Potentially more troubling is the increase in the consumer credit delinquency rate. Delinquencies do tend to rise prior to the onset of recession, although at the moment delinquencies are rising off an extremely low base. It is possible that after having kept lending standards very stringent for several years after the Great Recession, an uptick in delinquencies off historically low levels simply reflects a return to "business-as-usual" for banks. In fact, the Federal Reserve's Senior Loan Officer Survey showed a large tightening of consumer lending standards during the crisis, but then a moderate easing from 2010 until quite recently (Chart 10). Further, the most recent Senior Loan Officer Survey showed an increase in banks' willingness to extend consumer installment loans. Historically, this has been associated with falling consumer delinquency rates (Chart 10, bottom panel). Bottom Line: All signs are that economic growth has accelerated in recent months. Decelerating consumer credit growth and rising consumer delinquency rates do not yet pose a risk to future spending. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 https://www.federalreserve.gov/boarddocs/hh/2005/february/testimony.htm 2 For a look at what different combinations of Fed rate hikes and long-maturity yields mean for the slope of the yield curve please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 3 Please see BCA Special Report, "Outlook 2018: Policy And The Markets: On A Collision Course", dated November 20, 2017, available at www.bcaresearch.com 4 https://www.stlouisfed.org/from-the-president/speeches-and-presentations/2017/assessing-yield-curve 5 https://www.bloomberg.com/news/articles/2017-12-01/fed-s-mester-shrugs-off-flattening-yield-curve-in-call-for-hikes 6 Please see U.S. Bond Strategy Special Report, "Junk Bond Jitters", dated November 21, 2017, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "2018 Key Views: Implications For U.S. Fixed Income", dated November 28, 2017, available at usbs.bcaresearch.com 8 For the most recent update please see U.S. Bond Strategy Portfolio Allocation Summary, "A Higher Gear", dated December 5, 2017, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

With the Senate Republicans passing their version of the bill on December 2, the odds that a final version of the bill will pass into law are now very high, though investors remain skeptical that there will be any stimulative economic effect from tax cuts. While we admit that the direct effect on the economy will be moderate, tax cuts have the potential to sustain the healthy sector rotation and supercharge the ongoing capex cycle. The bulk of the media's analysis to date of the impact of the impending tax reform has been focused on the reduction of the corporate tax rate and the repatriation of foreign earnings. While those are obviously critical, we think more attention should be paid to the provision allowing the immediate expensing of capital investment. Our analysis suggests that the impact of bringing forward the tax shield could, at the margin, change spending behavior for firms and drive the next up-leg for the capex cycle in 2018. We expect S&P industrials (overweight) to be the greatest beneficiary from the ongoing capex boom, considering the tight correlation between capital goods orders and EPS growth (second and third panels), followed by S&P financials (overweight) via a step function higher in loan growth to finance the outsized demand for capital. Please see this week's Special Report for more details.

Highlights The November jobs report keeps the Fed on track. Despite rising government debt levels, crowding out is not a significant threat. Capex as a share of GDP rises the year before a tax cut and falls in the year after. Holiday spending on track, boosted by tax bill. Feature Last week, investors assessed the ramifications of the OPEC meeting and the Senate's passage of the tax plan. The dollar was noticeably higher, and oil moved lower during the week, but other financial markets ended little changed. Chart 1 shows that the Trump trades are making a comeback, providing ample opportunity for investors who may have missed the trade the first time around. In this week's report, we examine the impact of the tax bill on the debt, deficit, and capital spending and more importantly on corporate balance sheets and financial markets. BCA's view is that the risk that rising government debt levels will crowd out private borrowing is low and that the tax cut will provide a tiny boost to an already robust capital spending environment. We also examine what signal the equity markets are sending about household spending in the holiday season. Chart 1Markets Responding To GOP Tax Plan Living In Paradise The November employment report, released last Friday, paints a Goldilocks-type macro environment for U.S. assets. Strong economic growth, muted inflation, and a go-slow Fed should prolong the bull market in U.S. equities. The economy added 228K in net new jobs, and the unemployment rate held steady at 4.1% in November. With the average work week rising by 0.1 hours, aggregate hours worked rose by a solid 0.5% m/m. Even if hours worked hold flat in December, the average for Q4 will be up 2.6% at an annualized rate from Q3. The November payroll data are easily consistent with about 3.5% GDP growth in Q4. BCA expects above-potential real GDP growth to persist well into 2018. Despite the strong growth and tight labor market, wage pressures remain contained. Average hourly earnings rose just 0.2% m/m in November, which followed a downwardly revised 0.1% m/m decline last month. Annual wage inflation is running at 2.5% (Chart 2). Last week's report will not dissuade the Fed from raising rates again next week. As long as GDP growth remains above trend and the labor market is tightening, the Fed will remain somewhat confident that wages will accelerate and inflation will gradually return to the target level. However, there is no reason yet for the Fed to turn more aggressive for fear of falling behind the curve. Chart 2November Jobs Report Keeps Fed On Track It's Getting Mighty Crowded The recently passed U.S. Senate tax reform bill has to be reconciled with the House bill, but it appears that the Republicans may meet their Christmas deadline after all. BCA's Geopolitical Strategy service has consistently expected a tax package to pass by the end of Q1 2018 at the latest.1 Although some technical differences between the two versions remain, the two bills are close enough that compromise should not be difficult. The Republicans are under pressure to deliver a "win" ahead of the 2018 mid-term elections. Most of the tax adjustments will occur early next year, except for a reduction in the corporate tax rate that may be delayed until 2019. The Senate version, if passed, would decrease individual taxes by about $680 billion over 10 years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of all the tax cuts will probably boost real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability of the tax changes and immediate capital expensing to lift animal spirits in the business sector and bring forward investment spending. The total impact - at this stage - is difficult to estimate. According to the Joint Committee on Taxation (JCT), by the end of 2027 the legislation will add $1 trillion to the debt, including the effects of dynamic scoring. Without the boost from faster economic activity due to the tax changes, the deficit is expected to be $1.4 trillion higher than the CBO's baseline projection for 2027. While nominal economic growth would increase under the plan, the debt-to-GDP ratio would climb to 95% of GDP by 2027, up from 91% under current law (Chart 3). Chart 3Federal Debt As A Share Of GDP Set To Rise Sharply In Coming Decades So far, the Treasury market has shown little reaction to the passage of the Senate bill. Fixed-income investors do not appear to be overly concerned about the implications of the size of the public debt and do not believe that the tax changes alter the Fed's calculations. BCA is also not concerned about the size of public debt in the near term but thinks the tax changes will alter the Fed's forecasts. Nonetheless, more government red ink is likely to raise equilibrium bond yields in the long term. The Fed estimates that the equilibrium 10-year bond yield would rise on a structural basis by 3-4 basis points for each percentage point increase in the Federal government's debt-to-GDP ratio, and by 25 basis points for every percentage point increase in the deficit-to-GDP ratio.2 The implication is that if the GOP plan becomes law, then the 10-year yield will be 12-16 bps higher than under current legislation. Nonetheless, there is only a modest risk that mounting U.S. government debt will crowd out private borrowing and choke off investment on a 12-month horizon. Crowding out occurs when soaring government debt sparks competition between the public and private sectors for available savings. Increased demand for private credit, a narrowing output gap, and elevated interest payments as a percentage of GDP, are all preconditions for crowding out. While the output gap has closed, demand for private credit is mixed, at best, and federal interest payments will remain in check. Private credit demand has rebounded from the recession, but it is still tepid. At 2% of corporate sales, nonfinancial corporate borrowing is at the lower end of its post-crisis range and has downshifted since 2015 (Chart 4). Before the 2007-2009 financial crisis, there was a tight relationship between corporate demand for funds and Treasury yields. Since 2009, the link has weakened; credit demand snapped back, but Treasury yields stayed low. Soft C&I loan demand also indicates less of a risk for crowding out (panel 3). Interest payments on the Federal debt are expected to climb, but remain well below all-time highs set in the early 1990s (Chart 5). The CBO's baseline projects that interest payments on the debt as a share of nominal GDP will more than double from 1.4% in 2017 to 2.9% in 2027. These payments will triple in absolute terms from $300 billion in 2017 to more than $800 billion in 2027. The GOP tax plan will boost the 2027 projection, but the CBO has not yet released a new estimate. In a study prepared prior to the passage of the tax bill, the OECD forecast that the federal government's interest payments would climb to 2.9% by 2019. Chart 4Private Credit Demand Has Rebounded,##BR##But Remains Tepid Chart 5Gradual Rise in Net Interest Payments##BR##Not A Crowding Out Threat Moreover, the Tax Policy Center, a center-left think tank, also concluded that interest costs will move up under the new tax law.3 On balance, interest payments on federal debt obligations as a share of the economy are expected to escalate in the next 10 years to 2.5-3%. This reading is in line with the average in the past 20 years, but is still below the 4-4.5% average reached in the late 1980s and early 1990s, and the 3.5-4% range observed from 1970-2000. If nothing else changes, higher federal interest payments would absorb funds that could instead be used for areas that add to the productive capacity of the economy, such as education, training and technical innovation. That said, the impact on long-term growth from "crowding out" may only represent a partial offset to the supply-side benefits of the fiscal package to the extent that the business sector lifts capex spending as a result of a lower corporate tax rate and immediate expensing (see below). Bottom Line: Tax cuts are bond bearish but support our overweight stance on equities on the surface. The effective corporate tax rate could decline by about two percentage points, which would boost after-tax cash flows by roughly 2½%. While this is not trivial, much of the good news already appears to be discounted in the S&P 500. Moreover, to the extent that faster growth in 2018 may bring forward hikes in the Fed funds rate, the equity market will have to contend with rising bond yields next year. Investors are also wondering about the tax plan's potential impact on capital spending and corporate balance sheets. Tiny Steps As discussed above, the fiscal package has the potential to generate significant supply side benefits, to the extent that the business sector turns on the capex taps. The JCT estimates that the tax bill will boost U.S. capital stock by 1.1% in 2027, an increase of about 0.1% a year. However, it is uncertain if corporations will permanently boost capex due to increased allowances for capital spending or if the tax shift will merely bring forward future spending. BCA's view is closer to the latter. We expect higher budget and trade deficits in the coming decade as a result of the Senate plan. These deficits will limit the ability of domestic saving to fund needed capital spending projects. Foreign saving will fill the gap. U.S. domestic saving is below the low end its 1960-2008 range (Chart 6). Chart 7 shows that since 1960, there have been four distinct periods of expanding net saving by foreigners. Nominal 10-year Treasury yields rose in three of the four intervals. However, real yields declined in the 1960s, rose in the mid-1970s and early 1980s as foreign saving increased, and then fell in the 1990s and 2000s. Moreover, a rise in the share of foreign saving led to higher capex in the mid-1960s and 1980s, but lower business expenditures in the 1990s (Chart 8). Chart 6Foreigners Will Finance Capex As##BR##Domestic Saving Declines Chart 7Interest Rates As##BR##Foreign Saving Rises Setting aside who will finance the spending, history suggests that business capital spending tends to climb faster in the 12 months prior to a period of rising fiscal thrust than it does in the 12 months following (Chart 9 and Tables 1 and 2). Note that our analysis shows that recessions occurred in five of the seven episodes of pro-cyclical fiscal policy. Chart 8Capex And Rising Foreign Saving Chart 9Capex During Periods Of Fiscal Stimulus In addition, as fiscal thrust escalates, stocks in the industrial and technology sectors underperform the broad market. Small caps generally beat large caps. Since 2000, the fed funds rate fell during periods of fiscal stimulus. Prior to that, the Fed both eased and tightened policy during these episodes (not shown). Table 1Business Spending 12 Months Before Pro-Cyclical Fiscal Policy Table 2Capex In The Year After Stimulative Fiscal Policy Is Enacted BCA's Corporate Health Monitor (CHM) has a tendency to improve during phases of increased fiscal thrust; Chart 10 shows that the CHM improved in five of the seven periods. Free cash flow and return on capital are the best performers during these intervals. In contrast, corporate leverage is apt to shoot up as fiscal policy takes hold. Chart 10Stimulative Fiscal Policy And The Corporate Health Monitor Our fiscal thrust measure includes both personal and corporate tax cuts, and along with increases in government spending. We use fiscal thrust as a proxy because there are a very limited number (just 3 since 1970) of corporate tax cuts to analyze. The paragraphs below covers the impact of corporate tax cuts on capital spending, capital spending-related financial metrics and corporate balance sheets. Capital spending is inclined to rise faster in the 12 months before a corporate tax cut than in the year afterward. The caveat is that there have been only 3 corporate tax cuts in the past 50 years. Charts 11 and 12 and Tables 3 and 4 examine the impact of previous corporate tax reductions on nonresidential fixed investment (and its components) as a share of GDP and on several capex-related metrics in the financial market. Chart 11Corporate Tax Cuts And Capital Spending Chart 12Corporate Tax Cuts And Financial Markets Moreover, industrial stocks underperform the broad market after a tax cut, while tech stocks outperform (Chart 12 again). Small-cap performance is mixed. Both the Fed funds rate and the 10-year Treasury yield rise after corporate tax decreases take effect. Table 3Capex The Year Before A Corporate Tax Cut Table 4Capex In The Year After A Corporate Tax Cut Corporate health weakens in the year before a business tax cut is enacted, but then it improves modestly in the ensuing year. Chart 13 and Tables 5 and 6 examine the significance of previous corporate tax cuts on BCA's Corporate Health Monitor (CHM) and several of its components. The interest coverage ratio deteriorates, on average, both before and after a corporate tax reduction, but leverage increases substantially in the 12 months following a corporate tax cut. Free cash flow deteriorates in the year prior to a drop in the business tax rate, but is little changed in the subsequent year. Chart 12Corporate Tax Cuts And Financial Markets Chart 13Corporate Tax Cuts And The Corporate Health Monitor Bottom Line: Business capital spending was already on the upswing and the output gap was already closed before the tax cut was passed. Accelerated depreciation allowance may pull capex ahead, but not materially change its trajectory over the long term. Corporate tax cuts and fiscal stimulus, in general, boost capex and corporate health, and support BCA's view that credit will outperform Treasuries in 2018. Table 5BCA's Corporate Health Monitor A Year Before A Corporate Tax Cut... Table 6...And In The 12 Months After Boxing Day The critical holiday spending season is in full bloom. Holiday retail sales make up the bulk of total consumer spending, representing about 20% to 30% of total annual retail sales (and about 40% of total personal consumption expenditures). Moreover, according to the National Retail Federation (NRF), although 54% of consumers surveyed expect to spend the same amount in this year's holiday season as in 2016, 24% are prepared to spend more. The NRF forecasts that holiday sales will increase between 3.6% and 4.0%, exceeding last year's 3.6% rate and the 5-year average forecast of 3.5%. Holiday retail sales have faded in nominal and real terms from an average of 4.9% in the 1993-1999 period to 3.7% pre-2008 (2000-2007) and to an average of 3.3% post-2008 GFC (2009-2016). However, the baseline trend, based on average annual growth rates, remains stable at 3%, with upside potential of as much as 6% during robust economic growth phases(mid 2000s) and downside risk to as low as -4% in recessions (2008) (Chart 14). Chart 14Holiday Sales: Strong Tailwinds Intact Holiday sales this season may just get an unexpected boost from stout consumer finances. The implication is that U.S. economic growth should remain above potential well into 2018. Solid consumer balance sheets remain a tailwind even at this late stage of the business cycle. Household balance sheets have been repaired in an optimal way and household net worth continues to soar to new highs. The implication is that households are much less likely to forego holiday spending this season than in periods where household net worth is under downward pressure. Furthermore, stock market returns for the U.S. consumer discretionary sector, measured between the mid-September to mid-December period, are well correlated with holiday spending trends (Chart 15). The 8.6% rise in the consumer discretionary sector since mid-September heralds another healthy holiday spending season. However, global consumer discretionary retailers are a better predictor of holiday sales than domestic consumer discretionary retailers. Prices here are up 6.6% since mid-September. Chart 15Trends Of Holiday Sales And Equity Returns Furthermore, expectations of tax reform legislation becoming law by the end of the year will incentivize low income households to spend more this holiday season. This cohort is apt to pay for holiday purchases with cash. The NRF has likened the benefit of the tax plan to a "free Christmas".4 The NRF suggests that the cumulative savings from the tax package for an average household will offset the $967.13 projected to be spent this year by the average household in the holiday season. Moreover, a 2016 Fed study finds that the financing for holiday spending varies by income. Low income households have a tendency to source holiday spending from savings/income rather than borrowing, and if access to credit is not readily available, they simply will not spend on holiday shopping.5 To ensure that a majority of U.S. households contribute towards a robust holiday spending season, strong employment growth alongside stable wage growth (and higher real income expectations) and sturdy consumer confidence is required. With an already tight labor market and the underemployment rate (U-6) close to pre-recession lows, solid consumer fundamentals remain intact. Bottom Line: A robust holiday shopping season is likely in 2017, supported by stout consumer balance sheets, the new tax bill, and rising wages and incomes. The 8.6% run up in consumer discretionary stocks also suggests that a happy holiday for retailers is in prospect. BCA's U.S. Equity Strategy service has a neutral rating on the Consumer Discretionary sector, but recommends an overweight the advertising, home improvement retail and leisure products industry groups. Additionally, BCA maintains an overweight to the holiday-sensitive Air Freight and logistics industry within the Industrial sector.6 Strong personal spending will support above potential GDP growth in Q4 and into 2018, eliminate the output gap, push the unemployment rate further below NAIRU and push up inflation and ultimately bond yields. Stay short duration. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jizel Georges, Senior Analyst jizelg@bcaresearch.com 1 Please see BCA Research's Geopolitical Strategy Weekly Report, "Xi Jinping: Chairman Of Everything," October 25, 2017. Available at gps.bcaresearch.com. 2 "New Evidence on the Interest Rate Effects of Budget Deficits and Debt", Thomas Laubach, Board of Governors of the Federal Reserve System, May 2003. https://www.federalreserve.gov/pubs/feds/2003/200312/200312pap.pdf 3 http://www.taxpolicycenter.org/sites/default/files/publication/148841/2001606-macroeconomic-analysis-of-the-tax-cuts-and-jobs-act-as-passed-by-the-house-of-representatives_1.pdf 4 https://nrf.com/media/press-releases/retailers-say-senate-passage-of-tax-reform-could-give-shoppers-free-christmas 5 https://www.federalreserve.gov/econresdata/notes/feds-notes/2016/holiday-spending-and-financing-decisions-in-2015-survey-of-household-economics-and-decisionmaking-20161201.html 6 https://uses.bcaresearch.com/trades/recommendations

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Highlights The House and Senate have passed similar tax cut bills; passage of a compromise version seems all but certain; Combined with the Trump administration's de-regulation efforts, fundamentals point ever higher for U.S. earnings; The under-reported change, in both versions of the bill, to the expensing of capital investments could have far-reaching implications; All of these support the ongoing healthy sector rotation; The lion's share of upside from the capex upcycle should go to industrials, followed closely by financials. Feature Chart 1Republicans Are Not Fiscally Responsible BCA's Geopolitical Strategy has maintained a high-conviction view since November 9, 2016 that Congress would pass budget-busting tax cuts.1 With the Senate Republicans passing their version of the bill on December 2, the odds that a final version of the bill will pass into law are now very high. What should investors expect from the new tax legislation? Much as our geopolitical team faced considerable resistance to their political forecast, investors are now skeptical that there will be any stimulative economic effect from tax cuts. While we admit that the direct effect on the economy will be moderate, tax cuts have the potential to sustain the healthy sector rotation and supercharge the ongoing capex cycle. In this Special Report, we explain why. Why Did We Get Tax Cuts Right? What did our geopolitical team get right about tax cuts? First, in November 2016, right after the election, we reminded clients that the Republican Party has a spotty record on fiscal conservativism. There is no empirical evidence that GOP policymakers are actually fiscally conservative (Chart 1), nor that Republican voters have a stable preference for fiscally conservative policies (Chart 2). As such, there was not going to be a popular revolt against tax cuts. Second, in April 2017, we saw that Obamacare repeal's failure actually increased the probability of tax cuts passing. Put simply, tax cuts are about motivating the Republican base to come out and vote in the upcoming midterms, not about satisfying the median American voter. Polling currently suggests that Republicans face an uphill battle to retain majority in the House of Representatives (Chart 3). Should investors fear that the ongoing Mueller investigation will scuttle tax cuts? The short answer is no. First, former National Security Adviser Michael Flynn lied to the FBI and has been charged with that offense, but what he did for the Trump administration in the interim between the election and the inauguration is likely not illegal. Chart 2Republican Desire For Smaller Government Wanes When In Power Chart 3Republicans Losing Popular Support Second, White House scandals and intrigue have rarely mattered to the market. Chart 4A and Chart 4B show that both the Tea Pot Dome scandal (the greatest in U.S. history at the time) and the Lewinsky affair occurred amidst the two greatest bull markets. While the Watergate scandal appears to have shaken the markets, it also escalated simultaneously with the historic 1973 oil shock and the onset of the 1973-75 recession. Besides, why would investors turn negative on the S&P 500 if President Trump - a highly unorthodox, unpredictable, and impulsive politician - looked to be replaced by Vice President Mike Pence? Earnings fundamentals drive the market, not political intrigue. Thus, we would fade impeachment risk and stick to getting the fundamentals right. Chart 4AMassive Bull Markets... Chart 4B...Attended Massive Scandals What about upside potential? Is there any left now that the market has begun to fully price in tax cuts, or will it be a reason to sell and crystalize profits? It is difficult to say, but our sense is that the healthy rotation out of tech (U.S. Equity Strategy is underweight) and into financials (overweight) and industrials (overweight) will gain steam. Also high-effective-tax-rate stocks and mostly domestically focused small caps have likely turned the corner (Chart 5), and the "Fed Spread" (2-year yield minus the fed funds rate) continues to point toward brisk economic growth in coming quarters (Chart 6). While the S&P 500 is up 18% year-to-date, synchronized global economic growth and robust earnings explain half the rise, the other half is forward multiple expansion. Were a 5%-10% pullback to materialize after all the tax-related dust settled, we would deem it a healthy development and a reset that would propel equities higher on the back of firm EPS growth next year. Furthermore, the market has cheered Trump's de-regulation drive, which, unlike tax cuts, has been concrete policy from day one of his administration (Chart 7). Chart 5Market Has Doubted Tax Reform Chart 6Growth Prospects Still Good Chart 7Market Has Cheered De-Regulation De-regulation is likely to continue in parallel with lower taxes. For example, in a potentially huge blow to the enforcement powers of the federal bureaucracy, Trump's Justice Department has switched sides in a lawsuit that may shortly come before the Supreme Court (Lucia v Securities and Exchange Commission). The DOJ is now backing the plaintiffs instead of supporting the SEC as the Obama administration had. If the plaintiffs win their argument that the SEC's "administrative law judges" were unconstitutionally appointed by bureaucrats (instead of by the president, the courts, or the head of an executive department), then all of the prior decisions and penalties enforced by these judges (and their peers in other bureaucracies) may be legally invalidated, weakening the enforcement mechanisms of the federal bureaucracy.2 Bottom Line: Tax cuts are coming while the deregulation drive is set to continue. Both are bullish for the market from a cyclical time perspective. What about the economy and equity-sector-specific winners? To this question we now turn. Lighting The Afterburners On The Capex Cycle With the eye-popping numbers involved, it is no surprise that the media's analysis to date of the impact of the impending tax reform has been focused on the reduction of the corporate tax rate and the repatriation of foreign earnings. However, the impact of those headline-grabbing reforms on changing consumption behavior and, as a result, delivering real economic growth remains hotly debated. We think more attention should be paid to the provision in the versions from both chambers of Congress allowing the immediate expensing of capital investment. Unlike the reductions in tax rate (Table 1), U.S. firms only benefit from this change when they deploy capital on qualified property and equipment at home, an unambiguously stimulative change. Table 1Sector Tax Rates And Pro Forma EPS Changes From Tax Reform We believe most market observers have overlooked this reform as it is simply a "time value of money" shift. The IRS already allows significantly accelerated depreciation of capex (please see the Appendix on page 12 for more detailed information); this reform merely brings it forward. Our analysis suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next up-leg for the capex cycle in 2018. In our analysis, we use the example of a railroad. The current tax code allows the firm to depreciate the cost of a locomotive over 7 years, roughly the average for all assets under the depreciation schedule published by the IRS. This already incents the firm to deploy capex aggressively because fleet ages are well in excess of 7 years. Further, as long as the asset is new and to be used in the U.S., the company can depreciate a bonus 40% in the first year.3 Assume this railroad is paying the new marginal tax rate in the U.S. of 20% and has the same cost of capital as the U.S. government, approximating 2.4%. If the railroad purchases a locomotive for $10,000, the current regime offers a present value tax benefit of $1,919 (Table 2). The proposed tax reform allows the railroad to collect that benefit immediately (at least for the next 5 years), yielding a present value 4.2% greater than the current regime. Using an estimate of the S&P 500's weighted average cost of capital (8.5%) as a discount rate (an obviously more realistic scenario), and this advantage climbs to 14.2% (Table 3). Table 2Tax Shield Implications Are Modest With A Low Discount Rate... Table 3...But Grow Substantially As Discount Rates Rise In theory, any profit maximizing firm should alter their capital budgets such that returns are adjusted to incorporate a significantly higher tax shield. We, thus, expect tax reform to drive significant new order growth in the near term as foreseeable capex is pulled forward. A case could be made that this reform changes the math sufficiently that U.S. firms will add capacity that is incremental to existing plans, hinging on a positive feedback loop from the new order growth the pull-forward effect noted above. Who Wins? While our cyclical view of an ongoing EPS upcycle morphing into a virtuous broad-based capex upcycle remains intact (Chart 8)4, there are two sectors that will almost immediately benefit from the tax bill getting signed into law. The greatest, and perhaps most obvious, beneficiary of any capital largesse that will follow this reform will be S&P industrials (overweight) as the principal destination for increases in capital deployment. We expect higher capex to lead to higher sales growth courtesy of firm end-demand and high operating leverage, flow-through to the bottom line, which boosts EPS and sustains the virtuous upcycle. True, wage growth would also get a bump mildly denting profit margins. However, at this stage of the business cycle and given accelerating pricing power (Chart 9), capital goods producers will likely succeed in passing through wage inflation. S&P financials (overweight) too should be significant beneficiaries via a step function higher in loan growth to finance the outsized demand for capital and generalized lift in animal spirits (Chart 10), though they have a partial offset arising from the reduction in value of their net operating loss (NOL) tax assets. A sustained push for more bank deregulation, along with shareholder-friendly activities will also boost the allure of financials equities. Chart 8Earnings Are The Critical Capex Driver Chart 9Capex Upcycles Drive Industrial EPS... Chart 10...And Boost Loan Demand Bottom Line: S&P industrials and financials sectors get an early Christmas present in the form of demand-enhancing tax reform, combined with corporate tax cuts that allow them to keep their profits. The result should be outstanding EPS growth and rising stock prices. The S&P industrials and financials sectors remain core portfolio overweights. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Chris Bowes, Associate Editor U.S. Equity Strategy chrisb@bcaresearch.com Anastasios Avgeriou, Vice President U.S. Equity Strategy & anastasios@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, and "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 2 We thank our colleague Matt Conlan, of BCA's Energy Sector Strategy, for the tip on this crucial court case. 3 First year depreciation is set to step down to 40% from 50% in 2018, according to the phasing out of the bonus depreciation under the 2015 PATH Act. 4 Please see BCA U.S. Equity Strategy, "Top 5 Reasons To Favor Cyclicals Over Defensives," dated October 16, 2017, and "Later Cycle Dynamics," dated October 23, 2017, available at uses.bcaresearch.com. Appendix: Why Does Accelerated Depreciation Matter? Accelerated depreciation is a tax incentive for firms to invest in capital assets. In essence, the IRS provides depreciable lives of assets that are shorter than useful lives, allowing firms to gain the tax benefit of the depreciation expense earlier in the asset's life. Assuming tax reforms are passed as currently written, firms will be able to deduct 100% of the capital cost of new equipment in the first year. Using our railroad example from earlier in this report, the capital cost was $10,000 and, with a tax rate of 20%, the tax shield is thus $2,000. Continuing with that example, imagine the locomotive has an estimated useful life of 10 years. In the absence of any accelerated depreciation (including that which is already on the books), the tax shield would be roughly half of what accelerated depreciation allows (Table 4). Note that the gross tax benefit is unchanged, it is merely shifted from the future to the present. Table 4Straight Line Depreciation Halves Tax Shield

We downgraded the S&P homebuilders index to underweight last week, owing to three factors: higher interest rates on the back of a pickup in inflation expectations, the threat to mortgage deductibility in pending tax reform and sky-high lumber prices. Weak earnings from Toll Brothers (TOL, not a member of the index but still a proxy) suggest that our move was well-timed as the index has fallen since hitting its 10-year peak last Monday. The first two of our reasons for downgrading homebuilders were because of a darkened affordability outlook. A red-hot economy should stoke inflation expectations, which our bond strategists anticipate will take the 10-year Treasury yield and mortgage rates higher (second panel). Further, the House version of the pending tax plan includes a reduction in deductibility of mortgage interest to the first $500,000 of the loan. Both of these point to ever-decreasing new home demand; TOL announced their slowest order growth since early-2015. Similarly, the S&P homebuilding index's new orders and the NAHB sales expectations survey have clearly rolled over (third panel). At the same time as top lines look under threat, still elevated lumber prices (bottom panel) appear to be biting into margins. In its earnings call, TOL pointed to declining gross margins next year, implying industry pricing power is insufficient to pass through rising costs. Sector EPS should be trending downward as a result; we reiterate our recent downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5HOME-DHI, LEN, PHM, LEN / B.

Dear Client, I recorded a webcast with my colleague Caroline Miller earlier this week. Caroline and I discussed the recent tax legislation in the U.S. and other key investment topics. I hope you will find the time to listen in. I am also happy to announce that going forward, in addition to sending you my regular reports, I will be sharing my thoughts on the economy and markets through Twitter. Best regards, Peter Berezin, Chief Global Strategist Highlights Some profit taking is likely over the next few weeks as U.S. equities discount a more realistic assessment of how lower tax rates will affect corporate cash flows. The cyclical picture for the U.S. and the global economy remains bright, implying that any correction will be short-lived. History suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for equity investors. With another recession still at least a year away, it is too early to get bearish on stocks and other risk assets. Feature Tax Cuts Arrive Early We had expected the Republicans in Congress to deliver on their pledge to cut taxes, but thought that the legislative process would drag on for longer than it did. In the end, the Senate was able to pass a hastily negotiated bill, giving Donald Trump his first major political victory. The question is where things go from here. The Senate and House bills still need to be reconciled. We do not anticipate much drama in that regard, given the broad similarities between the two versions. The bigger issue is how the legislation will affect the economy and markets. The Joint Committee on Taxation (JCT) estimated in mid-November that the original Senate version of the bill would raise the level of real GDP by an average of 0.8% over the ten-year budget window.1 It is reasonable to assume that the final bill will boost GDP by a similar amount. The impact on growth is likely to be somewhat front-loaded, given that several provisions will either expire or be phased out after five years. We expect real GDP growth to be 0.2%-to-0.3% higher in 2018 and 2019 as a result of the legislation. This is not a particularly large effect, which explains why the bond market reaction has been fairly muted. The impact on corporate profits will be more pronounced, but even here, one should keep things in perspective. The final bill is likely to reduce corporate taxes by about $350 billion over the next ten years. The JCT's baseline assumes corporate tax receipts of $3.9 trillion over the next decade. Thus, the bill will probably reduce the effective corporate tax rate by a bit less than two percentage points, taking it down from 19% to 17%. This, in turn, implies an increase in after-tax corporate cash flows of about 2.5% (i.e., 83 divided by 81). The market ran up a lot more than that over the past few months. Thus, we would not be surprised to see some profit-taking over the coming weeks. Cyclical Picture Still Bright If such a stock market correction occurs, it would represent a buying opportunity. Historically, recessions and bear markets have gone hand in hand (Chart 1). Right now, none of our recession indicators are warning of an imminent downturn (Chart 2). Chart 1Recessions And Bear Markets Usually Overlap Chart 2ANo Imminent Risk Of A U.S. Recession Chart 2BNo Imminent Risk Of A U.S. Recession This reassuring conclusion is consistent with the signal from our forthcoming MacroQuant Model, which we will be discussing in greater detail in the months ahead. This ground-breaking model examines dozens of variables, including a number of BCA's proprietary indicators, in order to consistently and accurately project returns across the key asset classes, geographies, and time horizons. Currently, the model is flagging a somewhat elevated risk of a temporary pullback, but continues to give a highly bullish reading on the cyclical (6-to-12 month) outlook (Chart 3). Chart 3BCA's MacroQuant Model Still Likes Equities The model's auspicious assessment largely stems from the strength of recent economic data in the U.S. and around the world. Global growth estimates continue to grind higher (Chart 4). In the U.S., the new orders component of the ISM manufacturing index rose to 64 in November, while the inventory component sank to 47. We have found that the gap between the two is a powerful predictor of stock market returns (Chart 5). The current gap is in the 87th percentile of its historic range. By the same token, core durable goods orders, initial unemployment claims, capex intentions, consumer and business confidence, global PMIs, and most other leading indicators paint a fairly upbeat picture. Chart 4Global Growth Projections Are Trending Higher Chart 5ISM As A Predictor Of Market Returns The euro area and Japan also continue to grow at a robust pace (Chart 6). Somewhat worryingly, China has seen growth tick down a notch in recent months (Chart 7). However, the evidence so far suggests that growth has merely slowed from an above-trend pace back towards potential. Nominal GDP rose by 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation has gone from as low as negative 5.9% in September 2015 to 6.9% at present. Core CPI inflation has also accelerated, rising to 2.3% in October (Chart 8). In this light, recent efforts by the authorities to expedite structural reforms are coming at an opportune time. Chart 6Positive Growth Momentum ##br##In The Euro Area And Japan Chart 7Growth Has Ticked Down##br## In China... Chart 8... But Merely From##br## An Above-Trend Pace Too Early To Bail Out Of Stocks Table 1Stocks And Recessions: Case-By-Case All good things must come to an end. As we discussed in our latest Strategy Outlook, the global economy is likely to fall into recession in late 2019.2 Markets will sniff out a recession before it happens, but in general, the lag time between when markets peak and when recessions begin does not tend to be very long. Table 1 shows that the lag has averaged seven months during the post-war era, with the past three recessions featuring an average gap of only four months. In fact, history suggests that the 7th and 8th innings of business-cycle expansions are often the most profitable for investors. The S&P 500 has delivered an average annualized real total return of 14.2% since 1950 in the 13-to-24 months prior to past U.S. recessions (Table 2). This exceeds the average return of 10.1% during business-cycle expansions. The S&P has returned 8% at an annualized pace in the 7-to-12 months prior to past recessions. While this is below the average return during past expansions, it is still well above the average return on bonds and cash during the corresponding periods. Moreover, the performance of stocks in the 7-to-12 month period preceding recessions has improved sharply over the past few business cycles. The S&P 500 generated an annualized real total return of 22.2%, 20%, and 13.6% in the 7-to-12 months prior to the beginning of the 1990-91, 2001, and 2007-09 recessions, respectively. Table 2How Have Stocks Performed Prior To Recessions? Stocks only begin to underperform in a meaningful way in the six months before the recession and continue to underperform in the initial phase of the downturn. Thus, even if one had known with complete certainty that a recession was coming, getting out of stocks more than six months in advance of the downturn would have been a mistake. Bottom line: With another recession still at least a year away, it is too early to get bearish on equities and other risk assets. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see "Macroeconomic Analysis Of The "Tax Cut And Jobs Act" As Ordered Reported By The Senate Committee On Finance On November 16, 2017," The Joint Committee On Taxation, U.S. Congress (November 30, 2017). 2 Please see Global Investment Strategy Outlook, "A Timeline For The Next Five Years," dated December 1, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Informe especial

Highlights Dear Client, I'm on the road this week teaching the BCA Academy in Chicago. Instead of our regular Weekly Report, we are sending you a Special Report written by my colleague Juan Manuel Correa. His piece, "Riding the Wave: Momentum Strategies in Foreign Exchange Markets," focuses on the application of momentum strategies in the FX space. More specifically, Juan lays out the case that momentum is now pointing to upside in the U.S. dollar. I trust you find his report both informative and enjoyable. Best regards, Mathieu Savary, Vice President, Foreign Exchange Strategy Feature Merchant: In this chaos of opinions, which is the most prudent? Shareholder: To go in the direction of the waves, and not fight against powerful currents - Confusion de Confusiones, Joseph de la Vega, 1688. Since the invention of financial markets, momentum has captivated the minds of investors, economists and general speculators. As early as 1688, the Spanish merchant Jose de la Vega became the first market observer to document the powerful forces of momentum in the primitive financial markets of Amsterdam.1 Since then, a number of academic studies have confirmed that momentum strategies deliver significant excess returns, even when traditional risk factors are taken into account.2 Because the success of momentum flies in the face of the Efficient Market Hypotheses, academia has tried to understand this phenomenon. Transaction costs, short-selling constraints and unsophisticated market participants have been among some of the explanations advanced and more widely accepted. However, there is still no real consensus as to why momentum strategies work. Foreign exchange markets present themselves as a fascinating space to study momentum, given that FX markets are:3 a) Very liquid, and possess very low transaction costs; b) Include no short selling constraints; c) Are populated by very sophisticated investors. So how successful are momentum strategies in foreign exchange markets? More specifically: In what time frame does momentum work best? In which currencies or crosses are momentum strategies more effective? Are there any macroeconomic factors that influence the success of a momentum strategy? Generally, momentum in financial markets is defined as the positive correlation between past and future returns. Momentum can either refer to time series momentum (buy/sell a currency which has had positive/negative returns) or cross-sectional momentum (buy the best-performing currencies and sell the worst-performing currencies). In this report, we will focus on time-series momentum. We use moving average crossovers to generate signals. We chose this technique as it is commonly used by practitioners, and it provides an easy and flexible buy/sell signal. When a short-term moving average crosses a long-term one from below, we buy the cross. Conversely, when it crosses it from above, we short the cross. While it is true that this technique does not follow the strict definition of momentum, it is a close enough proxy, as it takes into account the relative acceleration of the price. Furthermore, we tested 15 different combinations of moving averages on all 45 crosses in the G10, on a sample of nearly 29 years. By doing this we do not bias our analysis to dollar pairs or to any particular strategy. For more details on the methodology, please see Appendix A. Wave Watching: Observations On Historical Returns Our strategies consist of 15 different combinations of 1-month, 2-month, 3-month, 6-month, 12-month and 24-month moving averages. On average, momentum strategies had an annualized spot return of 0.5% and a carry return of 0.9% from when our sample period started in January 1989 to its end in October 2017 (Chart I-1). Furthermore, most strategies provided positive returns on average (see Appendix B) while substantially decreasing drawdowns (see Appendix D, Table 1). Chart I-1Momentum Across History However, some strategies performed better than others. On average, we found that momentum strategies based on the "medium-term" - i.e. when the slower of the two moving averages necessary to generate the crossovers was either 130-days (6-months) or 260-days (12-months) - tended to perform best. In terms of nomenclature in our comparative study, we named each strategy by summing the number of days in the faster moving average and the slower one. The resulting number is the total amount of days considered by the strategy. This way shorter term-focused strategies have lower numbers while longer-term focused strategies have higher numbers (Appendix A, Table 1). We found that risk-adjusted returns for strategies focused on the short term tend to be low: they rise as strategies become more focused on medium-term horizons, and then they drop again when longer term moving-average crossovers are used, following a "hump" pattern (Chart I-2). This pattern holds across the majority of FX crosses (see Appendix C). Our results are consistent with the literature on momentum on other assets classes. Generally, short-term returns tend to be reverting: if an asset's return last month was positive it will likely be negative the following month. The reversal effect tends to also be present in the long-term: if an asset experienced strong positive returns on a multi-year horizon, it is likely to offer negative returns in the subsequent time period. On the other hand, positive return auto correlation, the staple of traditional momentum strategies, tends to be strongest in medium-term time frames.4 Next, we examined the carry component of the strategies. On average, momentum strategies are long carry currencies slightly more often than not, and vice versa with funding currencies. As a result, momentum strategies tend to generate a positive carry (Chart I-3). Chart I-2Medium Term Focused Strategies ##br##Perform Best Chart I-3Momentum Strategies Favor ##br##Carry Currencies... This result is robust across strategies and across currency pairs (see Appendix B & C). Of the 675 different return indexes generated by our various moving average crossover signals, only 108 had a negative carry. So, are momentum strategies and carry strategies one and the same? Not quite. When we tested the correlation between the returns of our G10 carry strategy Index and the returns of all 15 of our momentum indexes, we found it to be nearly zero. Furthermore, we found that the spot returns of momentum strategies tended to increase in periods of increasing G10 implied volatility (Chart I-4). This stands in stark contrast to carry strategies, which are allergic to any increase in volatility.5 Chart I-4...But Momentum Also Likes Volatility We also tested for which crosses momentum strategies worked best. We found that commodity crosses tend to be the worst performers, with the least reliable and least rewarding signals. Meanwhile, pairs involving the yen or the U.S. dollar in one of the legs tended to perform the best by a wide margin, in both spot terms and carry terms (Chart I-5). Chart I-5AMomentum Winners: ##br##USD And JPY Crosses Chart I-5BMomentum Winners: ##br##USD And JPY Crosses Bottom Line: Historically, momentum strategies have provided positive returns. However, medium term-focused strategies tend to perform best. Momentum strategies also tend to produce positive carry, even though their spot return rises along with volatility. Finally, crosses involving a USD or JPY leg tend to provide the best momentum returns. Characteristics Of Momentum: Wave Patterns And Surfing Lessons We opted to take an unconventional approach from the plethora of academic research trying to understand momentum. However, to do so, we needed to momentarily step away from financial markets and instead dive in another field where riding waves is paramount: surfing. Diagram 1Oceanic Wave Patters Oceanic waves are produced by the wind. When wind blows across the surface of the ocean, the force is transferred to the water and generates swell, which is a group of travelling waves.6 However not all swell is created equally. There are two main types of swell: groundswell and windswell. Groundswell is the result of powerful winds or storms thousands of miles away from shore. These strong storm systems far away in the ocean tend to generate smooth and infrequent waves. These are the best waves for surfing, as these waves create enough power for a surfer to gain great balance and thus, ride the wave for a long period of time (Diagram 1 - Top Panel). On the other hand, windswell refers to swell created by local winds. These local winds tend to generate smaller waves and choppy waters, which makes for lower-quality surfing (Diagram 1 - Bottom Panel). This insight from surfing can be translated to financial markets. Much like a surfer at the beach, a momentum player would prefer smooth waves in the currencies he or she trades, as these types of waves can provide consistent signals that he or she can take advantage of. We therefore tested whether currencies that behave like groundswell tend to have higher risk-adjusted momentum returns than currencies that behave like windswell. How can we test this numerically? We found that volatility is not the right measure to capture this particular wave pattern, as it does not account for smoothness (see Appendix D). Instead, we measured smoothness by calculating a cross's average 1-year fractal dimension,7 a modification of an indicator championed by BCA's European Investment Strategy's Dhaval Joshi. A low average fractal dimension over that 1-year window indicates that more often than not a cross has been following a smooth trend, while an elevated fractal dimension indicates a cross that has been range-bound.8 We invert this number, giving higher numbers to smoother, trending crosses and lower numbers to jagged, noisy crosses. We call this the "Wave Smoothness Indicator," and it turns out to be highly correlated to risk-adjusted momentum returns for crosses in the G10, particularly if we take out managed crosses like EUR/CHF, EUR/SEK, and EUR/NOK (Chart I-6). To further illustrate this point, we sorted all crosses by their median risk-adjusted returns across all the moving-average crossover strategies we tested. We then looked at the five crosses where our momentum strategies delivered the higher risk-adjusted returns against the five crosses where the strategies fared the worst (Chart I-7A & Chart I-7B). The best currencies to execute momentum strategies have long and smooth cycles, while the worst ones exhibit much more noise. Chart I-6Wave Dynamics And Momentum Returns Chart I-7AGroundswell: Paradise For Momentum Surfers Chart I-7BWindswell: No Wave Riding In Choppy Waters As a result, it is apparent that smoothness is a crucial factor behind successful momentum trading, at least in the FX space. For example, while AUD/NZD displays long cycles, these gyrations are not smooth. Consequently, moving-average crossover strategies work badly for this cross, as it is too noisy to provide reliable buy/sell signals. Bottom Line: Analogous to the dynamic between surfers and oceanic waves, currencies that have long and smooth cycles (groundswell) tend to provide better returns than currencies which have small and noisy cycles (windswell). Storm Warning: Macro Determinants Of Momentum What factors make a currency behave more like groundswell as opposed to windswell? In order to gain some understanding, let's look at the crosses where momentum strategies worked best in our sample: the USD crosses and the JPY crosses. The yen and the dollar experience such strong and broad-based trends that for any cross, simply being correlated to the trade-weighted dollar and the trade-weighted yen makes for a good predictor of whether this currency pair will experience strong momentum-continuation behavior. Moreover, in line with our results above, crosses with a high correlation to these currencies also tend to exhibit stronger groundswell patterns (Chart I-8). What is so special about the dollar and the yen? The oceanic waves once again offer a clue. Recall that groundswell is generated by powerful oceanic storms. Similarly, the trade-weighted dollar and yen are ultra-sensitive to two of the most powerful forces in the global economy: global trade dynamics and global risk aversion (Chart I-9). Chart I-8JPY And USD Determine Wave ##br##Patterns In Currency Markets Chart I-9The Powerful Winds Of ##br##The Global Economy Global trade and risk aversion generate strong and well-defined waves, which makes any cross that is highly correlated to them fertile ground for implementing momentum strategies. Moreover, due to their sheer strength, these economic forces are subject to extremely strong feedback loops that reinforce the groundswell pattern present in "momentum" currencies. How exactly do these feedback loops work? Let's begin with the USD. The U.S. economy has a low beta to global growth, as it is a relatively closed economy where manufacturing represents a small share of both employment and gross value-added. Thus, when global trade accelerates, the U.S. economy does not benefit as much as other large blocs, and the dollar depreciates (Chart I-10). However, a fall in the dollar also helps global trade, as the world economy, particularly EM economies, carry large liabilities in U.S. dollars. Thus, when the dollar falls, the cost of financing global trade decreases, which in turn generates more trade, more investment, and more growth. This is a very powerful feedback loop. Although related, the yen cycle is slightly different, as it is more related to risk aversion and liquidity, given that the yen is the funding currency of choice for carry traders. When global economic activity is strong, carry trades distribute funds from places where liquidity is plentiful like Japan to places that offer high-return at the cost of higher risk (Chart I-11). So long as returns are elevated in the nations sporting high-carry currencies, more liquidity flows into these economies, supporting additional growth and returns. However, this virtuous cycle can become a vicious one when volatility rises, as liquidity can be quickly drained when Japanese investors repatriate home funds from abroad, and carry traders close their positions, selling the high-carry currency and covering their shorts in the funding ones. This not only appreciates the yen relatively to riskier currencies but also worsens the economic outlook and return profile of the carry currencies.9 Chart I-10The U.S. Economy Is Less ##br##Sensitive To Global Growth Chart I-11Japan Is The World's ##br##Provider Of Liquidity These dynamics also explain why momentum strategies tend to be more frequently long-carry currencies than funding ones. Simply put, risk-on cycles tend to be longer than risk-off ones. Chart I-12 shows how momentum strategies tend to overweight funding currencies on the rare occasions when volatility spikes, which makes their spot returns higher than their carry returns during those instances. On the other hand, when volatility is low, momentum strategies buy carry currencies, adding an additional benefit beyond their spot returns. Chart I-12Momentum Overweighs Carry More Often, ##br##Because Greed Is More Common Than Fear Meanwhile, risk-off cycles may be short-lived but they tend to be very intense. Thus, buying the funding currencies as they start generating higher momentum can deliver very quick, very powerful gains. This also helps elucidate the seeming paradox whereby momentum trades in the FX space see an accelerating pace of gains when volatility rises. This makes momentum strategies more agile than carry strategies. Importantly, understanding the link between momentum and the exposure to global factors like global trade as well as risk aversion explains why pairs where both legs of the cross are commodity currencies perform so badly as momentum plays. Much like windswell is generated by local winds, crosses from commodity producers like AUD/NOK or AUD/NZD have a diminished sensitivity to global factors, and instead are mostly driven by relative commodity dynamics or even relative domestic dynamics - forces akin to a localized wind system. With all of the above considered, we conclude the following: In the G10 currency space, momentum strategies will provide high profits on crosses that are driven by powerful systematic forces, and will provide lower returns from crosses driven by more idiosyncratic forces. It thus seems that an investor profiting from momentum in the FX space is not exploiting a market inefficiency, in the strictest academic terms, but rather a fundamental trait of each currency. Finally, we are not suggesting moving-average crossovers are the only mean to generate momentum-based buy and sell signals for currencies. But MA crossovers are a simple yet powerful indicator that provides timing signals in the foreign exchange market. Bottom Line: Currencies that are driven by powerful systematic forces will provide better momentum returns than currencies driven by weak idiosyncratic forces. Global forces like trade dynamics and risk aversion will generate groundswell-like wave patterns that are optimal for momentum strategies. Investment Implications Based on the observations made in this report, we have created a list of five rules of thumb for investors to consider when using momentum in currency markets: When using moving averages to assess momentum, the slower of the two moving averages should have a rolling window between 6-months and 12-months in order to generate superior signals. This gives credence to the commonly used 200-day moving average. Meanwhile, the faster of the moving averages should not exceed 3-months. Currencies that have long, powerful and smooth cycles (groundswell) will tend to provide better returns that currencies that have short, choppy and weak cycles (windswell). Moreover, currencies with a groundswell pattern will tend to be driven by powerful systematic factors, while currencies with a windswell pattern will be driven by weaker idiosyncratic factors. More specifically, investors should try to capture momentum in global risk aversion and global trade. The currencies that best follow these criteria are the JPY and USD crosses. What is momentum telling us now? The financial world continues to be in a risk-on mood. As glee rather than fear has taken hold of investors, momentum continues to point to further downside in the yen (Chart I-13). Chart I-13Plentiful Liquidity Is Supporting Momentum##br## In This Risk-On Environment... Chart I-14...But Global Growth Is##br## Starting To Peak On the other hand, momentum seems to be favoring the dollar right now. Global trade is very strong, but signs are accumulating that it may begin to slow after a spectacular couple of years. The faster moving 1-month/6-month moving-average crossover signals that the dollar is a buy, while the 1-month/200-day is also relatively close (Chart I-14). This means that at the very least, investors should be reducing their short dollar exposures. Juan Manuel Correa, Research Analyst juanc@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Gray, Wesley R., and Jack R. Vogel. "Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System." Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System, Wiley, 2016. 2 Jegadeesh, Narasimhan and Sheridan Titman, "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency" Journal of Finance, 48(1): 65-91 (1993) 3 Lukas Menkhoff, Lucio Sarno, Maik Schmeling and Andreas Schrimpf, "Currency Momentum Strategies" (2011) 4 Gray, Wesley R., and Jack R. Vogel. "Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System." Quantitative Momentum a Practitioner's Guide to Building a Momentum-Based Stock Selection System, Wiley, 2016. 5 Please see Foreign Exchange Strategy Special Report, titled "Carry Trades: More than Pennies And Steamrollers", dated May 6, 2016, available at fes.bcaresearch.com 6 "Wave Energy, Decay and Direction." Surfline.com, 2017, www.surfline.com/surfology/surfology_forecast_index.cfm. 7 Bruno, R. and Raspa, G. (1989). Geostatistical characterization of fractal models of surfaces. In Geostatistics, Vol. 1 (M. Armstrong, ed.) 77-89. Kluwer, Dordrecht. 8 For more insights into application of fractals in finance please see European Investment Strategy Special Report, titled "Fractal Dimension And Market Turning Points", dated July 24, 2014, available at eis.bcaresearch.com 9 For a more detailed discussion of how carry trades generate virtuous and vicious circles in the economies of high-carry currencies, please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at fes.bcaresearch.com Appendix A: Methodology Appendix AFormula 1 Table 1Days Used By Each Strategy Appendix B: Momentum By Strategy Chart II-1A1-Month/2-Month Momentum Strategy Chart II-1B1-Month/2-Month Momentum Strategy Chart II-2A1-Month/3-Month Momentum Strategy Chart II-2B1-Month/3-Month Momentum Strategy Chart II-3A1-Month/6-Month Momentum Strategy Chart II-3B1-Month/6-Month Momentum Strategy Chart II-4A1-Month/12-Month Momentum Strategy Chart II-4B1-Month/12-Month Momentum Strategy Chart II-5A1-Month/24-Month Momentum Strategy Chart 5B1-Month/24-Month Momentum Strategy Chart II-6A2-Month/3-Month Momentum Strategy Chart II-6B2-Month/3-Month Momentum Strategy Chart II-7A2-Month/6-Month Momentum Strategy Chart II-7B2-Month/6-Month Momentum Strategy Chart II-8A2-Month/12-Month Momentum Strategy Chart II-8B2-Month/12-Month Momentum Strategy Chart II-9A2-Month/24-Month Momentum Strategy Chart II-9B2-Month/24-Month Momentum Strategy Chart II-10A3-Month/6-Month Momentum Strategy Chart II-10B3-Month/6-Month Momentum Strategy Chart II-11A3-Month/12-Month Momentum Strategy Chart II-11B3-Month/12-Month Momentum Strategy Chart II-12A3-Month/24-Month Momentum Strategy Chart II-12B3-Month/24-Month Momentum Strategy Chart I-13A6-Month/12-Month Momentum Strategy Chart II-13B6-Month/12-Month Momentum Strategy Chart II-14A6-Month/24-Month Momentum Strategy Chart II-14B6-Month/24-Month Momentum Strategy Chart 15A12-Month/24-Month Momentum Strategy Chart II-15B12-Month/24-Month Momentum Strategy Appendix C: Momentum By Currency Legs Chart III-1 Chart III-2 Chart III-3 Chart III-4 Chart III-5 Chart III-6 Chart III-7 Chart III-8 Chart III-9 Chart III-10 Appendix D: Other Data Chart IV-1Volatility Does Not Fully Explain ##br##Momentum Returns Chart IV-2Volatility Does Not Fully Explain ##br## Momentum Returns Table 1Worst Sample 1-Month Return Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades