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Highlights Risk assets have rallied smartly, yet key indicators like the relative performance of Swedish stocks or the price of kiwi equities are not corroborating these moves. With the Fed now very likely to increase rates in March, the broad-trade-weighted dollar could be about to resume its rally. This would prompt a correction in metals, and EM as well as commodity currencies. We think the tactical correction in the broad-trade-weighted dollar is over, and the cyclical dollar rally can resume. EUR and JPY will not suffer as much as the commodity currencies, go long EUR/AUD, short NZD/JPY. Feature In the Roman calendar, the Ides of March corresponds to the 15th of that month. Consigning that date to posterity in the year 44 BCE, Julius Caesar was assassinated on the floor of the senate in Rome, with his adoptive son Brutus, being among the conspirators. This event prompted yet another round of civil war in the republic, and ultimately a regime shift: the end of the Roman Republic and the Beginning of Imperial Rome under Augustus in 27 BCE. Fast forward 2061 years to the present. March 15th will be the day when the FOMC meeting ends. Will the period around the Ides of March represent a regime shift once again - albeit on a much different scale - where risk assets finally correct? Can the dollar resume its ascent? We believe the answer to both questions is yes. Unusual Market Moves Strange market dynamics have piqued our interest. In recent weeks, DM stock prices, and bond yields have been moving up (Chart I-1). This is consistent with investors pricing in an improving growth outlook and a Fed moving toward a tighter policy. On the other hand, EM stocks, metals, and gold in particular have also been moving up (Chart I-2). This move is more disturbing as it tends to imply an easing in monetary conditions, especially the strength in gold, even if it may have ended yesterday. This strange performance could be explained if the dollar was weakening or inflation expectations were moving up. However, the dollar has been strengthening in recent days and inflation expectations have been flat. Additionally, the U.S. yield curve has flattened, suggesting that the adjustment in the Fed's expected rate path is beginning to have marginally negative implications for future growth (Chart I-3). Chart I-1More Growth, More Hikes Chart I-2More Reflation As Well Chart I-3No Sign Of A Fed Behind The Curve So based on current information, how are these market moves likely to resolve themselves? Let's look at indicators. In the past, we have followed the common-currency performance of Swedish relative to U.S. equities as a gauge for the global growth outlook, and particularly non-U.S. growth relative to U.S. growth. This reflects the fact that U.S. stocks tend to be defensive, while Swedish stocks are very pro-cyclical. This dynamic is accentuated by the nature of the Swedish economy. Sweden is a small open nation that trades heavily with EM. While its biggest trading partner is the euro area, where it tends to export many intermediate goods and machinery, which are then re-exported as finished products to the EM space. Currently, Swedish equities continue to underperform U.S. ones. What is most striking is that this underperformance has happened despite a strong performance in EM stocks and metals, a very rare divergence (Chart I-4). Another worrying signal comes from New Zealand stocks in USD terms. New Zealand is another small open economy with deep trade links to the EM space. It is therefore very sensitive to global growth dynamics. While Kiwi equities did flag the rebound in EM growth and global manufacturing activity that happened in 2016, since late January, they have stopped participating in the rally in global risk assets despite a booming New Zealand economy. They have even begun swooning in recent weeks (Chart I-5). Chart I-4A Strange Divergence Chart I-5Are Kiwi Stocks Telling Us Something? Finally, two other reliable indicators of global growth are also not corroborating any further improvement in global growth from here: Small caps are underperforming large caps and oil is underperforming gold (Chart I-6). Obviously the next question becomes: are all these indicators likely to converge back toward EM equities, the AUD and the BRLs of the world or are the risk assets mentioned above likely to be the ones experiencing a downward adjustment? Here economics should give us a clue. For one, the 2016 rally in EM and risk assets can be explained by the large improvement in economic conditions. G10 and EM surprise indexes have moved up vertically in recent months (Chart I-7). However, this move might reflect the past not the future. Chart I-6Some Growth Indicators Are##br## Not Doing Well Anymore Chart I-7Too Much Of##br## A Good Thing? China has been a key reason explaining why EM assets and economic activity have been so positive. However, the large dose of fiscal stimulus that has supported that economy has dissipated (Chart I-8). Based on the IMF's October Fiscal Monitor, the fiscal thrust in China was 1.7% of potential GDP in 2015 (heavily loaded to the second half of that year), and 0.3% in 2016. It is moving to 0% in 2017. This means that as the lagged effects of the late 2015 fiscal surge dissipate, a key reflationary wind behind the global economy will disappear. The Keqiang index is mirroring these dynamics. After flirting with cyclical highs, and therefore highlighting a sharp improvement in the Chinese industrial sector, it has begun to roll over (Chart I-9). More weakness is likely in the cards. Fiscal dynamics have followed a similar pattern on a global level. The overall EM fiscal thrust was at its strongest in 2015, at 0.6% of EM potential GDP, fell to 0.1% in 2016, and is expected to hit -0.2% in 2017. In the DM, the pattern is slightly different. The high point of fiscal stimulus was 2016, when the fiscal impulse hit 0.4% of potential GDP. However, this measure is moving back to -0.1% in 2017. Chart I-8Losing A Source ##br##Of Reflation Chart I-9Chinese Industrial Activity ##br##May Be Rolling Over Additionally, the monetary environment is not as stimulative as it once was. Bond yields have risen in the whole DM space, with Treasury yields now more than 110bps higher than in July, Bund yields having moved from -0.18% to 0.31%, and JGB yields having adjusted 37bp higher to 0.07%. High-frequency loan data out of the U.S. already shows some strains caused by this rise in borrowing costs (Chart I-10). This combination points toward a deceleration in the growth impulse, especially in the goods sector. As such, we do expect the EM and G10 surprise indexes to roll over in coming weeks. Even if this phenomenon may prove temporary, the market is not priced for this event. Highlighting this vulnerability is the high level of complacency we have already flagged last week, which suggests that global investors are positioned for a continuation of the improvement in the growth outlook (Chart I-11). So high seems the conviction that growth will continue to accelerate that it is outweighing the move toward a tighter Fed going forward. Finally, the implied correlation in the S&P 500 has fallen to post 2010-lows. This could incentivize investors to take on more leveraged bets on portfolios of stocks. A low correlation results into higher diversification benefits and therefore, a lower portfolio volatility (Chart I-12). A rise in correlation would cause volatility to rise and thus a mini-deleveraging and de-risking cycle to take hold amongst investors. Chart I-10Response To Higher Yields Chart I-11Lots Of Complacency Globally Chart I-12Correlation-Induced Derisking On Its Way? Bottom Line: DM stocks are up, yields are up, the dollar is firming, yet EM equities, metals and gold especially have risen as well, and the U.S. yield curve is flattening while inflation expectations have recently been stable. We expect risk assets to end up buckling. Some reliable indicators of the trend in risk assets are pointing south, global investors are expecting further growth improvement in the coming months while global growth may in fact temporarily decelerate, and finally, if the low level of implied correlation in stocks normalizes, a correction may be catalyzed. What About The Fed Because Lael Brainard has been such a reliable dove on the FOMC, when she says that a hike is coming soon, we must listen. The fact that the market has come to price in an 83% probability of a Fed hike in March will only give the FOMC more comfort in increasing interest rate when it meets in two weeks (Chart I-13). While we have been expecting the Fed to move in line with its Summary of Economic Projection's interest rate forecast, and thus increase three times this year, we are surprised by the fast change of tune in recent days. Nonetheless, we are acknowledging this reality. Is this publication moving toward expecting four rate hikes in 2017? Not yet. We want to see how the market handles the coming hike going forward. A correction in risk assets, commodities, and EM is likely to force the Fed to pause again before resuming its hiking path. We are clearly expecting such a development. The broad dollar is likely to be caught in a bullish cross current. However, differentiation between the minors vis-à-vis the EUR and JPY might be essential for investors. Chart I-14 shows that recently, the broad-trade-weighted dollar has not kept pace with the increase in interest rate expectations for the U.S. With our capitulation index for this measure of the dollar moving closer to "oversold" territory, the weeks leading up to the Fed meeting could witness a stronger broad trade-weighted dollar. We are therefore removing our tactical short bias and moving in line with our cyclical bullish dollar stance. Chart I-13The Fed Tends To Telegraph ##br##Its Intention To Hike Chart I-14The Dollar Should ##br##Catch Up We believe that in this process, the dollar will be strongest against EM and commodity currencies. To begin with, the USD is trading near 19, 18, and 17 months lows against the BRL, ZAR, and RUB respectively. As recently as Wednesday, the AUD was also trading near the top of its distribution of the past two years (Chart I-15). Moreover, EM and commodity currencies are heavily geared to global growth. As such, the combination of a tightening Fed, rising bond yields, and a potential roll-over in global economic surprises may weigh especially heavily on them. On the other hand, in 2015 and 2016, the dollar has tended to be softer against the EUR and the JPY in periods of market turbulence. Thus, the call on EM and commodity currencies seems much cleaner than on these two currencies. In this regard, two crosses have caught our eye. One is EUR/AUD. Not only is it at the bottom end of a trading range established since June 2013, it has only traded lower at the apex of the euro area crisis between 2011 and the first half of 2013 (Chart I-16). The recent rollover in French / German bund spreads is potentially a good signal to buy this cross. The picture for JPY is now muddied. While higher interest rates should hurt the JPY, a period of risk-asset selloff should support the JPY. To play the cross-current described above, we are opening a short NZD/JPY position, a cross historically levered to rising volatility (Chart I-17). Chart I-15AUD Is Elevated Chart I-16To Fall From Here, EUR/AUD Needs A Euro Crisis Chart I-17Short NZD/JPY: A Risk-Off Play Bottom Line: The Fed moving forward its planned rate hike to March could be the ultimate catalyst to prompt a correction in risk assets, especially the segment of the market most levered to EM and growth conditions: EM and commodity currencies. We are removing our tactical USD stance and we are moving in line with our bullish cyclical stance. We are also buying EUR/AUD and shorting NZD/JPY. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data paints a healthy picture for the U.S. economy: Fourth quarter annualized GDP came in unchanged from the previous quarter at 1.9%; PCE Price Index increased at a 1.9% annual pace, near the Fed's target; Core PCE remained steady at 1.7% annually and increased to 0.3% monthly, indicative of a robust economy; ISM Manufacturing PMI went up to 57.7. The market is now pricing in an 83% probability of a rate hike. Further enhancing growth prospects were Trump's remarks at his Joint Address to Congress, where he stated that there will be a "big, big cut" in corporate tax, and that he will seek to gain approval for a $1 trillion infrastructure plan. Hawkish comments from the previous FOMC meeting strengthened the dollar in February; Trump's comments may be an additional tailwind to the dollar's upside this month. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 The Euro EUR Technicals 1 EUR Technicals 2 Fundamentally, the euro area economy remains resilient: Services sentiment, business climate, and industrial confidence all picked up in February, outperforming expectations; Germany recorded a decrease in unemployed persons of 14,000; German CPI picked up to a 2.2% annual pace, also beating expectations Nevertheless, EUR/USD is unlikely to see any substantive upside in the coming months. With the Dutch elections in around 2 weeks, considerable volatility could rise up, something which has not been priced in. The Euro Stoxx 50 Volatility Index is showing a low reading of 16.55, just above the all-time low of 12. The ECB will meet next week and is likely to display a dovish bias due to potential political turmoil. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 The French Revolution - February 3, 2017 GBP: Dismal Expectations - January 13, 2017 The Yen JPY Technicals 1 JPY Technicals 2 On a cyclical basis we are still bearish on the yen, as the BoJ will continue to pursue radical measures to pull Japan out of its liquidity trap. Recent data seems to indicate that these measures have been somewhat successful: Retail trade YoY growth outperformed expectations coming in at 1%. Housing starts YoY growth also outperformed, coming in at 12.8%. On a tactical basis the picture is more nuanced. While it is very possible that the coming rate hike could lift rate expectations in the U.S., lifting USD/JPY, there is a risks that the hike might trigger a sell-off in risks assets, which could be very positive for the yen. For this reason we are shorting NZD/JPY, as this cross is very vulnerable to an increase in volatility. Report Links: JPY: Climbing To The Springboard Before The Dive - February 24, 2017 Updating Our Long-Term FX Value Models - February 17, 2017 Dollar Corrections, EM Outlook, Global Liquidity, And Protectionism - January 27, 2017 British Pound GBP Technicals 1 GBP Technicals 2 The past week has not been kind to the pound, with GBP depreciating by about 2% against both the Euro and the U.S. Dollar. This was in part due to the prospect of a Scottish Independence referendum. On the economic side, data for the U.K. continue to be mixed: House prices annual growth outperformed expectations coming in at 4.5% M4 broad money annual growth continues to climb higher and it is now at 7%. On the other hand manufacturing PMI, although still high, underperformed expectations, coming in at 54.6. Although the cyclical dollar bull market should continue to weigh on cable, we are more bullish on the pound, particularly against the euro, as expectations for the U.K. economy continue to be too pessimistic, while the dark cloud of this year's election cycle looms on the euro. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Australian Dollar AUD Technicals 1 AUD Technicals 2 AUD lost 1.3% of its value Thursday morning amid disappointing trade data. It seems that the market largely ignored stronger data this week: GDP grew at a 2.4% annual rate Q42016 and both NBS and Ciaxin Chinese Manufacturing PMI beat expectations. Exports, however, contracted at a 3% pace and the surplus missed expectations by 66%, most likely due to the AUD's strength this year, even alongside higher commodity prices. This is also particularly worrying seeing that exports failed to pick up despite a previously strong Chinese PMI reading. Now, alongside a Keqiang Index that is topping out, the future for Australian exports could be limited. Additionally, this outlook is further supported by investment diverting to the non-resource sector. It is difficult to see whether the RBA will respond to this export slump, as the contractionary Q32016 GDP data was largely overlooked and dismissed. Nevertheless, we stand by our bearish outlook on AUD. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 The RBNZ continues to assert its neutral bias. On Wednesday, RBNZ Governor Graeme Wheeler stated that "there is an equal probability that the next OCR adjustment could be up or down". This caused the kiwi to come close to reaching 0.71, its lowest point since mid-January. We continue to believe that the RBNZ stance is not hawkish enough, as powerful inflationary forces continue to brew in New Zealand. That being said, it is very likely that the RBNZ will continue with its neutral tone up until the middle of the year, when we start to have a clearer picture about the outcome in European elections. Therefore, given that the Fed is likely to hike in March, diverging monetary policies should continue to weigh on NZD/USD until then. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Risks To The Cyclical Dollar View - February 3, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Canadian Dollar CAD Technicals 1 CAD Technicals 2 The BoC left their overnight rate target unchanged at 0.5% despite a high CPI reading of 2.1% in January. A further surprise was a particularly dovish tone, highlighting that higher energy prices will have a temporary effect on inflation, and indicating "material excess capacity in the economy". Additional weaknesses were highlighted with regards to competitiveness challenges for the export sector and subdued wage growth accompanied by contracting hours worked. Trade developments are an additional headwind for the Canadian economy that the bank is monitoring and will continue to do so until the outlook clarifies. CAD has lost more than 2% of its value against the USD in 3 days due also to a stronger dollar based on Fed rate hike expectations and Trump's potential infrastructure spending and tax cuts. It is unlikely that CAD will see any strength in the near future as the Bank has set forth a rather cautious tone. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data has been mixed, which indicates that although economic activity in Switzerland is improving, it still is very tepid: The KOF leading indicator outperform expectations coming in at 107.2 Retail sales outperformed expectations. However they are still contracting by 1.4% GDP annual growth was 0.6%, falling significantly from last quarter reading of 1.4% The SNB is currently in a tight spot, as improvements are very marginal and it is evident that the economy is still plagued by strong deflationary forces. Meanwhile EUR/CHF is under 1.065 and has been unable to climb above this level this month, as the SNB continues to fight risk off flows coming into the franc due to the risks of the European election cycle. As these risks increase, the floor in this cross will continue to get tested. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Norwegian Krone NOK Technicals 1 NOK Technicals 2 Risks continue to point for further upside in USD/NOK. Oil is unlikely to rally much further from current levels, even if the OPEC agreement continues. Thus the movements in USD/NOK should be dominated by monetary divergences between the United States and Norway. These are likely to continue to favor the dollar, as the Fed should continue its hawkish tone. Meanwhile the Norges Bank is likely to stay dovish, as their economy has been to be very weak. GDP growth is negative, the output gap is over -2% of GDP and employment and real wages continue to contract. Meanwhile, the high inflation that Norway experiences last year is likely to continue its slowdown, as the effects of the currency depreciation should start to dissipate. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swedish Krona SEK Technicals 1 SEK Technicals 2 In past reports, we have argued that the Swedish economy is robust and inflation is picking up. This has been corroborated by strong consumer and business confidence, and high resource utilization and inflation expectations. Recent data has supported this view: Retail sales picked up 2.2% annually; Producer price index was up 8.2% from last year in January; Annual GDP growth came in at 2.3% at the end of last year. Growth and inflation have been supported by expansionary monetary policy. With the Riksbank stating that "there is still a greater possibility that the rate will be cut than... raised in the near future", these conditions are unlikely to falter. Nevertheless, it is important to note that it is this cautionary stance by the Bank that is the reason for the SEK's recent weakness, not fundamentals. It is now the probable case that any upside in the SEK will be noted and limited by the Riksbank, capping the upside on the krona. Report Links: Updating Our Long-Term FX Value Models - February 17, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights In this week's report, we update the "Three Controversial Calls"1 we made at BCA's New York Investment Conference held on September 26-27th, 2016. Call #1: "Trump Wins, And The Dollar Rallies." We still see 5% more upside for the greenback. Call #2: "Japan Overcomes Deflation." Inflation expectations have moved higher over the past five months, while the yen has weakened. This trend will persist. Call #3: "Global Banks Finally Outperform." Bank shares have beaten their global benchmark by 14% since we made this prediction. European financials have finally turned the corner. Feature Call #1: "Trump Wins, And The Dollar Rallies" Chart 1From Unrealistic To Even More Unrealistic We never bought into the notion that a Trump victory would cause investors to flee the dollar. On the contrary, we argued that most of Trump's policies were bond bearish/dollar bullish. In particular, we reasoned that Trump's attempts to browbeat companies into moving production back home would help reduce the U.S. trade deficit, boosting aggregate demand in the process. Efforts to curb illegal immigration would also push up the wages of low-skilled workers. Meanwhile, fiscal stimulus would fire up the labor market at a time when it was already approaching full employment. Fiscal Deficit On Upward Path With nearly four months having passed since the election, what have we learned? First, and foremost, a big increase in the budget deficit still looks likely. As Trump's address to the joint session of Congress on Tuesday night underscored, the president has plenty of specific areas in mind where he would like to increase spending (more money for defense, infrastructure, etc.) and a long list of taxes he would like to cut (corporate and personal income taxes, estate taxes, a new childcare tax credit,2 etc.). We do not take seriously Trump's pledge to pay for increased military spending by cutting annual nondefense discretionary spending by $54 billion relative to the existing CBO baseline. Chart 1 shows that under current budgetary rules, nondefense discretionary spending is set to decline from 3.3% of GDP in 2016 - already close to a historic low - to only 2.7% of GDP in 2026. Cutting that portion of the budget above and beyond what has already been legislated is unrealistic. There simply aren't enough programs like the National Endowment for the Arts that Republicans can take to the woodshed without facing a severe political backlash (Chart 2). As long as big ticket entitlement programs such as Social Security and Medicare remain unscathed - which Treasury Secretary Steven Mnuchin confirmed would be the case earlier this week - overall government spending will rise, not fall. Chart 2Nondefense Discretionary Spending: Where The Money Goes Trump And Trade The one category where Trump would be more than happy to see taxes go up is on imports. The constraint here is political. A unilateral move to legislate large-scale import duties would be in gross violation of WTO rules and could spark a global trade war. Many of Trump's Republican colleagues, as well as a fair number of Democrats, also favor free trade and would resist such an effort. One solution that Trump vaguely alluded to in his speech is to raise duties on imports within the context of a broader tax reform bill. A border adjustment tax, for example, would bring in $1.2 trillion in revenues over ten years.3 As we argued in a Special Report earlier this year, the introduction of a BAT would be highly dollar bullish.4 Pulling Back The Welcome Mat? On immigration, Trump has sent mixed messages. On the one hand, he continues to insist that he will build "the wall" and has maintained his hardline stance on refugee policy. On the other hand, he has backed off his campaign promise to reverse Obama's executive order protecting the so-called "dreamers." This order allows immigrants who came to the U.S. illegally as children to remain in the country indefinitely, provided they do not commit a serious criminal offence. During his speech, Trump signaled a willingness to shift the U.S. immigration system towards one based on merit, similar to what countries such as Canada and Australia already have. This is an excellent idea, but it raises the question of what will happen to the 11 million illegal aliens currently residing in the country, the vast majority of whom are poorly educated. It is important to remember that U.S. immigration laws are already very strict. Trump has given the U.S. Immigration and Customs Enforcement agency (ICE) greater leeway in enforcing these laws, while also pledging to hire 5,000 more border agents and 10,000 additional ICE officers. As such, a "status quo immigration policy" under Trump could prove to be much more restrictive than the one under Obama even if no new legislation is passed. A key implication is that labor shortages in areas such as construction and hospitality services may intensify. Solid U.S. Growth Outlook Favors A Stronger Dollar Meanwhile, the U.S. growth picture remains reasonably bright (Chart 3). This may not be obvious from current Q1 tracking estimates, which are pointing to real GDP growth of below 2%. However, the weak Q1 numbers are mainly due to an unexpectedly large jump in imports and a sharp decline in inventory accumulation. According to the Atlanta Fed's model, taken together these two factors have shaved a full percentage point off growth. Real private final demand is still rising at nearly 3% (Chart 4). If U.S. growth stays solid as we expect, the Fed will raise rates three or four times this year, starting in March. This is slightly more than the market is currently pricing in, which should be enough to ensure that the trade-weighted dollar strengthens by another 5% or so over the remainder of the year (Chart 5). We see the greatest upside for the dollar versus EM currencies, and as we discuss next, against the yen. Chart 3U.S. Economic Data Are Upbeat Chart 4Trade And Inventories Detract From ##br##A Bright Q1 Growth Picture Chart 5Real Rate Differentials Are ##br##Driving UpThe Dollar Call #2: "Japan Overcomes Deflation" Many of the forces that have exacerbated deflation in Japan, such as corporate deleveraging and falling property prices, have run their course (Chart 6). The population continues to age, but the impact that this is having on inflation may have reached an inflection point. For most of the past 25 years, slow population growth depressed aggregate demand by reducing the incentive for companies to build out new capacity. This generated a surfeit of savings relative to investment, helping to fuel deflation. Now, however, as an ever-rising share of the population enters retirement, the overabundance of savings is disappearing. The household saving rate currently stands at 2.8% - down from 14% in the early 1990s - while the ratio of job openings-to-applicants has soared to a 25-year high (Chart 7). Chart 6Japan: Easing Deflationary Forces Chart 7Japan: Low Household Saving Rate ##br##And A Tightening Labor Market Chart 8Investors Still Not Entirely ##br##Convinced Japan Is Eradicating Deflation Government policy is finally doing its part to slay the deflationary dragon. The Abe government shot itself in the foot by tightening fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. The Bank of Japan's efforts to pin the 10-year yield to zero also seem to be bearing fruit. As bond yields in other economies have trended higher, this has made Japanese bonds less attractive. That, in turn, has pushed down the yen, ushering in a virtuous circle where a falling yen props up economic activity, leading to higher inflation expectations, lower real yields, and an even weaker yen. Stay Short The Yen Consistent with this narrative, market-based inflation expectations have risen over the past five months. But with inflation swaps still pricing in inflation of only 0.6% over the next 20 years, there is plenty of scope for real rates to fall further (Chart 8). This implies that investors should maintain a structurally short position in the yen. A weaker yen will help boost Japanese stocks, at least in local-currency terms. As a relative play, investors should consider overweighting Japanese exporters versus domestically-exposed sectors. Multinational manufacturers stand to gain the most, as they will benefit from increased overseas sales, while the highly automated, capital-intensive nature of their operations will limit the burden of rising real wages. Call #3: "Global Banks Finally Outperform" Global bank shares have risen by 25% since we made this call, outperforming the MSCI All Country World Index by 14% (Chart 9). The thesis that we outlined five months ago still remains intact (Charts 10 and 11): Chart 9Global Bank Shares Have Bounced Chart 10Factors Supporting Bank Stocks Chart 11Global Banks Are Still Fairly Cheap Improving business and consumer confidence should continue to support credit demand. Stronger economic growth will reduce nonperforming loans. Capital ratios have improved significantly, reducing the risk of further equity dilution. Yield curves have steepened since last summer, which should flatter net interest margins. Despite the run-up in share prices over the past five months, valuations remain attractive. Looking across regions, European banks stand out as being particularly attractive over a cyclical horizon of about 12 months. BCA's European Corporate Health Monitor continues to improve, foreshadowing further progress in mending loan books (Chart 12). The ECB's lending survey indicates that a majority of banks are seeing stronger loan demand (Chart 13). This suggests that credit growth is not about to stall anytime soon. Meanwhile, euro area banks are trading at a miserly 0.8-times book value, which gives valuations plenty of upside. Chart 12Euro Area: Improving Corporate Health Chart 13Euro Area: Banks See Rising Loan Demand Political Risks Chart 14This Will Not Get Le Pen Into The Elysee Palace The risk is that European political developments sabotage this thesis. Our view here is "near-term sanguine, long-term cautious." We continue to think that populism is in a long-term secular bull market. However, unlike in the case of Brexit or Trump, populist leaders in continental Europe will have to wait until the next economic downturn (probably in two or three years) before they seize power. To that extent, the prevailing - though admittedly rather myopic - consensus view is correct: Marine Le Pen will not become president this year. Keep in mind that the National Front underperformed during regional elections in December 2015, just weeks after the terrorist attacks in Paris. Despite a recent uptick in the polls, support for Le Pen is actually lower now than it was back then (Chart 14). As long as the French economy continues to show signs of tentative improvement, the establishment parties will succeed in keeping Le Pen out of power. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 2 Despite the populist sounding nature of this proposal, the Tax Policy Center estimates that 70% of the childcare credits will go to households earning $100,000 and up. See Lily L. Batchelder, Elaine Maag, Chye-Ching Huang, and Emily Horton, "Who Benefits from President Trump's Child Care Proposals?" Tax Policy Center (February 27, 2017) for details. 3 James R. Nunns, Leonard E. Burman, Jeffrey Rohaly, Joseph Rosenberg, and Benjamin R. Page, "An Analysis of the House GOP Tax Plan," Tax Policy Center (September 16, 2016). 4 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Energy services shares have pulled back as oil prices have marked time over the last few weeks, but in the background, the conditions to sustain a rally are falling into place. The growth in total OECD oil stocks has rolled over decisively, and a continued supply/demand rebalancing should occur given that world oil production growth has slipped to nil courtesy of OPEC output cuts. The bond market has increased confidence that oil prices will not tumble anew, as reflected in the sharp narrowing in energy corporate bond spreads. Many companies have used the recovery in oil prices to refinance and bolster balance sheets, underscoring that the financial means to boost exploration exist. With energy services pricing power trying to make an early exit from deflation on only a small boost to the global rig count, there is scope for the attractively valued S&P oil & gas field services index to surprise on the upside. We have this at high-conviction overweight. The ticker symbols for the stocks in the S&P oil & gas field services index are: BLBG: S5ENRE - SLB, HAL, BHI, NOV, FTI, HP, RIG.

Highlights The supply of U.S. dollar outside America has been curtailed, yet there is large pent-up demand for dollars. This warrants another upleg in the greenback. The Trump administration's desire to shrink America's current account deficit will be very deflationary for the rest of the world, and mildly inflationary for the U.S. Such policies, if adopted, will exaggerate the paucity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. The RMB is at risk because Chinese banks have created too many yuan, and deposit rates in real terms have turned negative as inflation has risen. Our negative view on EM has been and continues to be driven by our outlook on EM/China domestic demand, commodities prices and the U.S. dollar - not growth in advanced economies. Feature In recent weeks we met with clients in Asia and Australia. This week's report addresses some of the more common questions that we were asked to address. Question: You have written about "global U.S. dollar liquidity shortages." Why have these "global dollar shortages" occurred given the Fed expanded its balance sheet enormously from 2008 until 2014? How does one measure "global dollar shortages," and what does it mean for financial markets? By "global U.S. dollar shortages," we refer to deficiency in U.S. dollars outside the U.S., where U.S. dollar supply growth has fallen short of growth in demand for the greenback. We have the following pertinent observations on this issue: U.S. dollar shortages in the global banking system (eurodollar market) can be represented by U.S. banks' and other financial firms' claims on foreigners. This measure has been shrinking since early 2015 (Chart I-1). This corroborates the fact that U.S. banks, prime money market funds and other financial institutions have been unable/unwilling to supply dollars to the eurodollar market. This is consistent with rising LIBOR rates, which still continue to climb. U.S. non-financial entities' foreign assets have also fallen in the past year and a half but they are much smaller than banks and other financial institutions claims. As to U.S. banks' and other financial firms' claims on EM, they have also been shrinking since early 2015 (Chart I-2). Chart I-1Weak Supply Of U.S. Dollars To Rest ##br##Of World By U.S. Financial Institutions Chart I-2Shrinking Supply Of U.S. Dollars ##br##To EM By U.S. Financial Institutions Another way that the U.S. emits dollars to the rest of the world is by running a current account deficit. The U.S. current account deficit as a share of global GDP is now much smaller now than it was before the Great Recession (Chart I-3). This also means a smaller U.S. dollar supply relative to the size of the world economy. On the demand side, the widening in cross currency basis swaps indicates structural demand for U.S. dollar funding among euro area and Japanese investors (Chart I-4). Chart I-3The U.S. Emits Less ##br##Dollars To World Via Trade Chart I-4Pent-Up Demand For Dollars From Japanese ##br##And European Fixed-Income Investors These investors have been opting for exposure to dollar assets due to the higher yield on U.S. dollar fixed-income instruments - but they have been reluctant to take on exchange rate risk. In brief, they have avoided getting long exposure to the U.S. dollar. The reluctance to accept the exchange rate risk by European and Japanese investors means they are not bullish on the dollar. This goes against the widespread opinion among investors that the overwhelming majority of global investors are bullish on the U.S. currency. By hedging the exchange rate risk - in this case the risk of potential greenback depreciation - these investors are giving up a considerable portion of higher yield that they obtain in U.S. fixed-income market. In fact, if these basis swaps continue to widen or remain wide it might make sense for European and Japanese fixed-income investors to buy U.S. fixed-income securities and not hedge the currency risk. If and when these investors stop hedging their exchange rate risk, the U.S. dollar will appreciate versus the euro and the yen. Provided European and Japanese fixed-income investors are sizable players in global fixed income and hence currency markets, they have the potential to make a difference in exchange rate markets. In short, there is potential pent-up demand for U.S. dollars from these European and Japanese institutions. Such a widening in basis swaps is also consistent with the above observations that U.S. banks have been reluctant to take the other side of this trade - i.e., offer U.S. dollars to European and Japanese investors - even though it is a very profitable opportunity. Finally, the drop in EM central banks' foreign exchange reserves reflects demand for U.S. dollars in their economies, primarily in China (Chart I-5). The Chinese central bank has sold U.S. securities to meet mushrooming demand for U.S. dollars from Chinese households and companies. This entails there has been and remains considerable pent-up demand for dollars by mainland companies and households. With respect to the supply of currency, it is important to note that it is up to commercial banks - not the central bank - to create money. Central banks provide liquidity for commercial banks, but it is the latter that creates money.1 In a nutshell, by undertaking QE, the Fed provided reserves for U.S. commercial banks (Chart I-6), yet the latter have been reluctant to create too much money. Banks create money by originating loans and other types of claims. Chart I-5China: Selling U.S. Securities To ##br##Meet Domestic Demand For Dollars Chart I-6The Fed's Balance ##br##Sheet In Perspective U.S. banks have been very conservative in money creation especially outside America. In the U.S., banks shrunk their balance sheets and loans in the 2009-2011 period. That is why the Fed's QE programs have not led to inflation. Notably, U.S. banks' total assets - including bank loans - and broad money (M2) growth have lately rolled over (Chart I-7). This worsens the lingering dollar scarcity outside the U.S., which should in turn prop up the value of the dollar. The reasons why U.S. banks and financial institutions have been conservative is due to their own deleveraging objectives and because of regulatory changes in the financial industry. In regard to interest rates, U.S. nominal and real (inflation-adjusted) interest rates are very low yet they are high relative to European and Japanese real rates (Chart I-8). Given a relatively tight labor market, odds are that U.S. interest rate expectations will rise further in both absolute and relative terms. This will cause the dollar to appreciate. Chart I-7U.S. Banks Control ##br##The Supply Of U.S. Dollars Chart I-8U.S. And German ##br##Inflation-Adjusted Interest Rates Bottom Line: The pace of supply of dollars beyond the U.S. is falling short of growth in demand for this currency. Typically, this warrants greenback appreciation. Question: What about the U.S. administration's preference for a weaker dollar to improve America's trade position? Won't the greenback depreciate as the Trump administration expresses its desire for a weaker currency? Certainly U.S. officials can verbally influence the exchange rate and drive markets for a (short) period of time. Yet fundamentals and flows will re-assert themselves and the greenback will ultimately appreciate even if its rally is delayed by policymakers. The new U.S. administration intends to run mercantilist policies to create jobs in America and doing so will shrink the current account deficit. Nevertheless, a narrowing U.S. current account deficit ultimately entails diminishing flows of U.S. dollars to the rest of the world, which is bullish for the greenback. In brief, the U.S. administration can delay the dollar rally, but it will not be able to prevent it if and when it shrinks the U.S. current account deficit. This will be enormously deflationary for the rest of the world and ultimately for the global economy. The supply of dollars outside U.S. borders will become even more dearth. As their exports tumble, manufacturing-heavy Asian and European economies will have to run even more stimulative policies - reduce their real interest rates further - to offset such a deflationary shock to their economies. In the case where the Trump administration successfully manages to weaken the U.S. dollar, the ensuing boost to U.S. manufacturing and employment will be mildly inflationary given the already relatively tight labor market. Thereby, trade protectionism or policy-driven currency depreciation, if these occur, will lift U.S. inflation and U.S. interest rates will go up. Rising U.S. interest rates and lower interest rates throughout the rest of the world will propel the dollar's value higher. On the whole, in the case of U.S. trade restrictions, the exchange rates have to adjust to mitigate deflation in the rest of world and cap inflation in America. This ultimately entails a stronger U.S. dollar and weaker currencies abroad. A final note on exchange rates valuation. Based on unit labor costs, the U.S. dollar is not yet expensive (Chart I-9A). The same measure for other currencies is also shown in Chart I-9A and Chart I-9B. Chart I-9AReal Effective Exchange ##br##Rates Based On Unit Labor Costs Chart I-9BReal Effective Exchange ##br##Rates Based On Unit Labor Costs Financial markets tend to overshoot and undershoot before a major trend reversal. We believe the U.S. dollar is in a genuine bull market and will likely become more expensive before topping out. Bottom Line: The U.S.'s desire to shrink its current account deficit is very deflationary for the rest of the world. Such policies, if adopted in the U.S., will exaggerate the scarcity of U.S. dollars beyond America's borders and lead to notable dollar appreciation. Question: The RMB/USD exchange rate has been stable lately. Does this mean the authorities have reasserted their control over the exchange rate and will not allow it to depreciate? The authorities in China have partial and temporary control over the exchange rate. Ultimately, it will be Chinese households and companies that drive the exchange rate, barring full-out government controls over all export/import transactions, money transfers as well as financial and capital account flows. If mainland households and companies opt to convert a small portion of their liquid savings (deposits at banks) into foreign currency, there is little the authorities can do to defend the RMB, barring a complete closing of balance-of-payments transactions to companies and households. The primary risk to the yuan exchange rate is not currency valuation but an overflow of yuan in the system - i.e., excess supply of RMBs is the main factor that will cause currency depreciation. Unlike U.S. banks, Chinese banks have created too many yuan. Broad money (M2) in China has risen from RMB 48 trillion as of December 2008 to RMB 158 trillion currently - i.e., it has surged by 3-fold. M2 has risen from 150% to 210% of GDP in the past eight years (Chart I-10). In the meantime, the ratio of foreign exchange reserves to M2 has dropped to 14% (Chart I-11). Chart I-10Chinese Banks Have ##br##Created Too Many Yuan Chart I-11China: Foreign Reserves Are ##br##Small Relative To Money Supply The latter ratio implies that if Chinese companies and households decide to convert 14% of their deposits at banks into foreign currencies and the People's Bank of China (PBoC) sells its international reserves to offset it, the latter will simply evaporate. We are not suggesting this will actually happen. The point to emphasize is that mainland banks have created so much money that even the country's US$ 3 trillion foreign exchange reserves are not sufficient to back those deposits up. Chinese households and companies may already be sensing there is too much in the way of RMBs floating around, and intuitively may not trust the currency. They have paid astronomical multiples for real assets like property in China, and have recently been willing to shift assets into foreign currencies/assets. Importantly, the one-year deposit rate at banks is 1.5% in nominal terms but in real terms it has now become negative as inflation has picked up. Chart I-12 (top panel) demonstrates that the deposit rate deflated by core inflation is negative for the first time in the past 10 years. The bottom panel of Chart I-12 shows that the deposit rate deflated by headline CPI inflation is also negative. Interestingly, any time the real deposit rate turned negative in the past, the central bank hiked interest rates. It is impossible to know whether the latest pick up in China's inflation represents a temporary spike or is the beginning of a major and lasting uptrend (Chart I-13). We are surprised by how fast and sharply inflation has risen lately, given the growth improvement has so far been modest. Chart I-12China: Real Deposit ##br##Rates Have Turned Negative Chart I-13China: Inflation ##br##Is Rising, For Now The trillion- dollar question is what is the true output gap in China and, correspondingly, whether the latest rise in inflation is genuine and lasting or simply a statistical aberration. No one including Chinese policymakers knows the answers to these very essential questions. What type of adjustment China embarks on depends on monetary policy and banks in China. As and if Chinese banks slow down money creation, economic growth will tumble and deflationary tendencies will resurface. This scenario is good for creditors - households and companies with large amounts of deposits - because deposit rates in real terms will rise again. Yet this is a bad outcome for indebted companies, capital spending and employment. If mainland banks continue to create money at a double-digit pace as they have been doing, inflation will likely become persistent and durable. These dynamics are positive for debtors as real borrowing costs will drop further/stay negative, and growth will hold up. However, in such a case, negative real rates will buttress capital outflows and pressure the value of the RMB. By and large, the Chinese authorities are facing a profound choice: Policymakers can choose to help debtors (indebted companies) by accommodating continuous money supply expansion by banks, i.e., opt for negative real interest rates. The outcome will be much stronger downward pressure on the RMB. The latter will depreciate at a double-digit pace annually in the next several years. They can opt to force the banking system to slow down the pace of money/credit creation. This will lead to some sort of debt deflation. Money growth and inflation will drop and the currency will not be at a risk of major depreciation. Yet, economic growth/profits/employment will tumble. A third choice for the authorities is to resort to full-out government controls over all trade, transfers as well as financial and capital account transactions - i.e., take the country back to socialism. Only in such a case can the authorities control the exchange rate and interest rates simultaneously - i.e., they can inflate the credit bubble away while preventing households from converting their liquid savings into foreign currency. In brief, this entails financial repression, and it will erode the real value of Chinese deposits. It is not clear to us whether this is a politically more viable option than allowing some bankruptcies/layoffs and debt deflation. Besides, this will devastate China's vibrant private sector as businessmen and high-income employees become reluctant to invest and expand as they observe the real value of their savings/wealth decline. Chart I-14U.S. Dollar And Commodities ##br##Prices Unusual Decoupling As if there were not enough domestic challenges, Chinese policymakers are also facing a hawkish Trump administration on the issue of trade and the exchange rate. Putting it all together, we conclude it will be extremely difficult for the Chinese authorities to navigate through these challenges. One area where we disagree with many investors is that the Chinese authorities have a viable plan and strategy. Given the above constraints, there are no easy choices and it is hard to know which route the Chinese government will take. The latest bout of stability in the RMB has been due to a notable shutdown in outflows. Yet this is a temporary solution. The inability to convert liquid savings into foreign currency will only make households and companies more set on converting their yuan. Odds are that capital outflows will skyrocket on any relaxation of recent harsh restrictions. Bottom Line: In any country, the monetary authorities cannot simultaneously control the price of money (interest rates), the quantity of money, and thereby the exchange rate. This will prove to be true in China too. We continue betting on further RMB depreciation. Question: Why do you not think this commodities rally has further to go, given supply has been curtailed and demand is picking up as global growth improves? The strength in commodities prices in recent months when the U.S. dollar has been firm is a major departure from historical correlations (Chart I-14). Remarkably, oil forward prices have recently dropped and global energy share prices have relapsed in absolute terms, even though the spot price has held up (Chart I-15). This foretells that the marketplace does not believe in the sustainability of the current spot price level of crude. As to industrial metals, our hunch is that Chinese demand will weaken again as the nation's credit and fiscal impulse relapses (Chart I-16). Besides, the recent resilience in copper has been due to supply disruptions that may be temporary. Chart I-15Has Sell Off In Oil Market Begun? Chart I-16China's Growth To Peak Later This Year Notably, hopes that U.S. infrastructure spending - even if such spending turns out to be considerable - will boost demand for industrial metals are misplaced, because the U.S. is a small consumer of metals. China consumes six to seven times more copper, nickel, zinc, aluminum, tin and lead than the U.S. Hence, we view industrial metals as a pure play on China's capital spending. Bottom Line: We expect a combination of a stronger dollar, weaker Chinese growth and elevated oil inventories to produce a major reversal in industrial metals and oil prices. Chart I-17EM Stocks And U.S. ##br##TIPS Yields: Negative Correlation Question: Is your negative stance on EM contingent on weakness in DM growth? No, our negative stance on EM is not contingent on a relapse in DM growth. Some combination of the following key factors will trigger and drive weakness in EM risk assets: Higher U.S. real rates or a stronger U.S. dollar. Chart I-17 demonstrates the strong negative correlation between higher U.S. TIPS yields and EM share prices in the recent years. Lower commodities prices. Renewed weakness in China's economy. Our negative view on EM has and continues to be driven by our views on EM/China domestic demand/credit cycles, commodities and the U.S. dollar. Investment Conclusions Chart I-18EM/China Plays Are At Critical Juncture Exchange rates have been critical to financial market dynamics in recent years. This is unlikely to change. Odds favor another upleg in the U.S. dollar and a weaker RMB. As such, the outlook for EM risk assets is poor. EM currencies will be driven by a stronger dollar, a weaker RMB and lower commodities prices. EM share prices as well as global mining, and machinery stocks are at a critical juncture (Chart I-18). China-plays may soon start reacting to the PBoC's recent modest tightening as well as regulatory credit curtailment and begin to sell off in anticipation of weaker growth later this year. Global equity portfolios should continue underweighting EM stocks. Similarly, global credit (corporate bonds) portfolios should underweight EM sovereign and corporate credit. Finally, the outlook for weaker currencies does not bode well for EM local currency bonds. However, for fixed income investors we have several swap rate trades, relative value recommendations and yield curve positions that are published regularly in our Open Position Table on page 16. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to Trilogy of Special Reports on money/loan creation, savings and investment, titled "Misconceptions About China's Credit Excesses," dated October 26, 2016, and "China's Money Creation Redux And The RMB," dated November 23, 2016, links available on page 17. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

After an M&A driven outperformance phase, semiconductor stocks appear to be putting in a major top. M&A activity has plunged, warning that deal premiums are likely to be removed from valuations. The recovery in global chip sales growth also looks to be at risk. Our global chip sales model has rolled over, reflecting softening new order growth in a number of chip-intensive industries. If top-line growth begins to recede, then the tentative trough in chip inventories is likely to turn into a full blown rebound. History shows that the highly anticipatory chip index fares poorly when chip supply accelerates. The latter signals that future chip output will decelerate, revealing the downside of a cyclical business with high operating leverage. Our Chip Stock Timing Model, a combination of technical and fundamental forces, has dropped sharply in recent weeks, reinforcing that relative performance is at serious risk. Stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5SECO - INTC, QCOM, TXN, AVGO, NVDA, ADI, MU, SWKS, LLTC, MCHP, XLNX, QRVO, FSLR.

The large gap between the BCA Defense and BCA Aerospace indexes is likely to grow much larger. The U.S. is aiming to boost defense spending as part of its stimulus efforts, and is pressuring other NATO members to boost defense spending after a long contraction. While U.S. defense spending has been through a soft patch for the past several years, new orders for defense goods have been one of the strongest components of overall durable goods orders (second panel). Even global demand has boomed, even in the face of the strong U.S. dollar, as evidenced by surge in exports of military goods (bottom panel). On the flipside, aerospace new orders are on a downward trajectory, reflecting a downturn in the commercial aerospace cycle. While long lead times and lengthy delivery schedules offer some earnings protection, dwindling order backlogs will ultimately undermine confidence in the long-term outlook. Our global airline consumer price index, a composite of airline pricing power in a number of major countries, is in negative territory. A negative CPI reflects excess capacity, and warns of grim prospects for a recovery in new airplane orders. The bottom line is that earnings support remains intact for the defense index, but is rapidly dwindling for aerospace equities. Stay overweight the former and underweight the latter. The ticker symbols for the stocks in the BCA defense index are: LMT, GD, RTN, NOC, LLL and the BCA aerospace index are: BA, UTX, HON, TXT.

Highlights Tensions are still high between the U.S. and China; China's neighbors are in the line of fire; Korea and Taiwan stand to suffer; We are bullish Thailand, Vietnam, and the Philippines; We are bearish Indonesia and Malaysia. Feature Over the past two weeks we have taken clients on a tour through Europe, where we think political and geopolitical risks are generally overstated in the short term. This provides ample room for European financial assets to outperform this year.1 This week we turn to Asia Pacific, where the situation is quite different. We see this region as the chief source of geopolitical "Black Swans," mainly due to rising U.S.-China tensions, which we have highlighted since 2012.2 While U.S. President Donald Trump and Chinese President Xi Jinping have recently reassured the world that relations will be cooperative and stable, it is far too soon to declare that the two have resolved anything substantial. While we have addressed U.S.-China relations before, it is essential to watch the rest of EM Asia, where proxy battles between the U.S. and China continue to play out.3 If the Philippines shocked the world in 2016 by pivoting away from the U.S. and toward China, South Korea is the country that will do the same in 2017. In this report, we review the opportunities and risks afforded by this regional dynamic. I. Will Trump And Xi Cool Their Heels? Fundamentally, geopolitical risk in Asia Pacific is driven by the "Thucydides Trap," a struggle between the established regional and global power (the United States), and an emerging power that seeks to rewrite the region's geopolitical order (China).4 This dynamic emerged well before President Donald Trump's election.5 Trump is an unpredictable agent thrown into a structural dynamic. His election on an avowed platform of protectionism, his comments singling out China as a U.S. threat, and his break with the U.S. foreign policy establishment all suggest that the secular rise in Sino-U.S. tensions is about to get worse.6 Yet, since taking office, Trump has sent mixed signals. On the one hand, he threatens a policy of isolationism that would see the U.S. withdraw from its global security commitments. On the other hand, he has threatened to escalate geopolitical conflicts in order to get what he wants on business and trade. Table 1Market Implications Of ##br##Trump's Options Toward China As Table 1 illustrates, it is extremely important for investors which of these foreign policies Trump ultimately pursues - nationalist or isolationist - and whether he combines it with the trade protectionism (or mercantilism) that he has threatened. In the short term, the most bullish combination would be the economic status quo with a scaled-down U.S. presence. The most bearish would be mercantilism combined with nationalist foreign policy. Trump's recent interchanges with Xi were notable because for once he adhered to diplomatic protocol. He and Xi gave some initial - and we would add tentative - assurances to the world that Sino-U.S. relations will not explode in a ball of flames this year: Taiwan - Trump reaffirmed the One China Policy, i.e., that Taiwan has no claim to independence from the mainland. Trump's phone call with the Taiwanese President Tsai Ing-wen in December, and subsequent comments, had put this principle in doubt, raising the prospect of a new Cold War or actual war. North Korea - China has offered to enforce a stringent new set of economic sanctions on North Korea, namely barring coal imports for 2017. This is significant, given the short duration of China's previous punitive measures against the North and the hit that North Korean exports have already suffered from China's slowing economic growth (Chart 1). The Obama administration had begun sanctioning China as a result of its unwillingness to enforce, so with enforcement may come the Trump administration's deactivation of such threats for a time. The RMB - Trump did not accuse China of currency manipulation on "day one" of his administration as he had promised during his campaign, though he has informally called the Chinese the "grand champions" of manipulation.7 This strongly suggests that he will allow the Treasury Department's semi-annual foreign exchange review process to run its course (Diagram 1). On that time frame, the U.S. would issue a warning in the April report and then begin negotiations that legally should take a year. Of course, China does not qualify by the usual measures. Since 2015 it has been propping up its currency rather than suppressing it (Chart 2), and its current account surplus has dropped sharply from 10% to 2% of GDP over the past ten years (though still massive in absolute terms). Diagram 1Calling China A Currency Manipulator: The Process The Trans-Pacific Partnership (TPP) - Trump yanked the U.S. out of the major multilateral trade initiative of the Obama administration, which was an advanced trade deal that excluded China and primarily benefited smaller Chinese competitors like Vietnam and Malaysia. Though Trump acted unilaterally - and therefore cannot have gotten any real concessions from China in exchange for killing an "anti-China" trade deal - he avoided the frictions with China that would have resulted over the coming years from implementing the deal. Chart 1Will China Cut Imports From Here? Chart 2The 'Grand Champions' Of Currency Manipulation In addition, the Trump administration is already embroiled in domestic politics with a number of its early actions. Thus it would not surprise us if Trump - exactly like Ronald Reagan, Bill Clinton, Barack Obama, and George W. Bush - needed to pacify relations with China despite his early tough talk. Meanwhile President Xi wants stability even more than usual this year as the Communist Party holds its "midterm" five-year National Party Congress. We will return to the party congress in an upcoming report, but for now we will simply reiterate that stability means neither excessive stimulus nor excessive reform (Chart 3). Chinese policymakers could trigger unintended consequences with their financial tightening, but that's why we think they will be exceedingly cautious.8 If Trump does not try to sabotage this politically sensitive year, China should be relatively stable. Chart 3China Wants Stability, Not Speed, Ahead Of Five-Year Party Congress So have U.S.-China ties become bullish all of a sudden? No. At least, not yet. Consider the following: South China Sea still a powder keg - On both sides, the idea of excluding "access" to the sea is being openly discussed, if disavowed.9 While there is conceivably a path for both sides to de-escalate, it will take very tough negotiations, and we are not there yet. Trade fight hasn't even begun - Though previous presidents got sidetracked, Trump was the first to campaign aggressively on a protectionist, anti-China platform, and to put a team in place to pursue that platform.10 We think he will get tough. We also think he will endorse the House Republicans' plan of a Border Adjustment Tax - a tax on imports - which would hurt China most of all as the country with the biggest trade surplus with the U.S.11 Japan is proactive - Japan has virtually no domestic political constraints and has an incentive to play up security threats. Why? Because Prime Minister Abe wants a nationwide popular referendum on revising the constitution to legitimize the Japanese Self-Defense Forces.12 And this is not even to mention that Taiwan and the Koreas are still major risks. Structurally, we still see Sino-U.S. tensions as the chief source of geopolitical risk and "Black Swan" events this year that could rattle markets in a very big way. Bottom Line: A modus vivendi between Trump and Xi is conceivable, but the U.S. and China are not out of the woods yet. II. What About The Neighbors? Short of the formidable "left-tail" risk of direct U.S.-China conflict, China's periphery is the chief battlefield and source of risk for investors. Asian EM economies have the most to risk from the reversal of the past decade's trade globalization (Chart 4). Investors also tend to underrate the fact that they are in the thick of the geopolitical risk arising from Sino-U.S. tensions and global "multipolarity" more broadly.13 A look across the region suggests that most Asian EM economies are shifting their policy to become more accommodative with China. This should reduce their geopolitical risk in the short term, though it is too soon to sound the "all clear." We remain strategically short EM stocks relative to DM. Within the EM space, we are bullish on Thailand, less so on the Philippines and Vietnam, and neutral-to-bearish on Taiwan, South Korea, Malaysia, and Indonesia. Chart 4De-Globalization Hurts Asia Pacific Most Of All Koreas - Here Comes The Sunshine Policy South Korea is at the center of the U.S.-China struggle as it faces a domestic political crisis, economic pressure from China, rising North Korean nuclear and missile capabilities, and a likely clash with the new U.S. administration. First, the Constitutional Court must decide the fate of impeached President Park Geun-hye. The market has rallied since the ruling Saenuri Party turned against her in early December, paving the way for her December 9 impeachment in the assembly. However, the politics of the court makes her removal from office less likely than the market expects, especially if the court does not rule by March 13, when a second judge this year retires from the bench.14 If the impeachment falters, it will lock South Korea into greater political instability throughout the year, at least until the scheduled election on December 20. Chart 5Leftward Policy Shift In South Korea ... However, it is virtually impossible for the Saenuri Party candidate, Acting President Hwang Kyo-Anh, to win the election, despite his fairly strong polling (Chart 5). His party has been discredited and split, and there are now calls for his impeachment as he defends Park from further investigation. The leading contenders are all left-of-center. They are contending in a primary election over how to redistribute wealth, crack down on the Chaebol (corporate conglomerates), engage North Korea, and improve relations with China. These policies are receiving a tailwind because Korean society has seen the economic system shocked by the end of the debt supercycle in the United States and the slowdown in China. Moreover, inequality has been rising in Korea (Chart 6). As in neighboring Taiwanese elections last year, the election is shaping up to be a backlash against the pro-trade and globalization policies of the preceding decade. Korea's share of global exports has increased, and its tech companies are profitable, but the government has engaged in conservative fiscal policies, its workers are overworked and underpaid, and its social safety net is non-existent (Chart 7). Redistribution and reforming the Chaebol could bring serious benefits over the long run, but both will negatively affect corporate profits on the margin. Internationally, improving relations with North Korea and China will mean that the new South Korean government, in H2 of this year or H1 of next, could be on a collision course with the United States and especially Japan. We expect Korea to go its own way for a time, giving the impression globally that another American ally is "pivoting to China" (after the Philippines in 2016).15 While this may seem bullish for Korea, as it did for the Philippines due to the fact that China is a growing economy, Korean exports to the U.S. and Japan are still a significant portion of its total exports (Chart 8). Korea is also constrained by the fact that China is increasingly a trade competitor, and Korea's exports to China mainly consist of goods that China wants to make itself: high-end electronic manufacturing, cars, and car parts. Thus, China will welcome greater ties as it looks for substitutes for the increasingly protectionist West in acquiring technology and expertise, but Korea's new government will see rising fears of economic "absorption" as it attempts to improve access to Chinese markets. Chart 6... As Inequality Has Risen Sharply Chart 7Workers Want More Largesse Chart 8Korea's Balancing Act What are the market implications? South Korea is in a decent place in the short run. Global growth, exports, and corporate earnings are improving, and stock valuations have come down, especially relative to EM. Over the long run, however, we are turning bearish. Korean labor productivity is in a downtrend (Chart 9), its population is not growing, and there is no reservoir of young people left to tap. There are three basic options for securing future growth. First, Korea could become a net investor nation like Japan (Chart 10). However, it is not yet wealthy enough to do so, and needs to build the aforementioned social safety net. Second, South Korea could reunify with the North, which would alleviate its labor force problems, though the costs of reunification would be extreme (Chart 11). Chart 9Reforms On Hold Until New Government Sits Chart 10Korea's Japanese Dream Chart 11Reunification Would Increase Labor Force Third, it could continue on its current path of trying to secure large markets like the U.S. and China, while conducting a balancing act between them as geopolitical tensions rise. The problem right now is that the first two options are not ready and the balancing act is getting too hard, too soon. The South stands to suffer from both protectionism and multipolarity, i.e., being sandwiched between resurgent Sino-U.S. and Sino-Japanese tensions. Furthermore, the Trump administration has not yet decided whether its North Korea policy will be one of engagement, aggression, or continued neglect. Yet the U.S. defense and intelligence establishment's threat assessment is reaching a level that will cause greater public concern and more demand for action. Until Trump's policy is clear, South Korea's attempts to launch a new "Sunshine Policy" toward eventual reunification will be extremely vulnerable. Over time, North Korea is likely to become more of a black swan than the red herring it has been in the past (Chart 12). Chart 12North Korean Incidents: Mostly Red Herrings Bottom Line: Now is ostensibly a good entry point for Korean stocks relative to EM stocks, but we remain reluctant due to the political and geopolitical factors. Also, the path of least resistance for the Korean won is down, so we recommend going long THB/KRW, discussed further below. Taiwan - "One China" Or More? Our prediction that China-Taiwan relations would deteriorate dramatically, and that Taiwan could be one of five "Black Swans" of 2016, has essentially played out.16 The two sides cut off formal contact, Trump accepted a phone call from the Taiwanese president in a sharp break with U.S.-China convention, and the Taiwanese navy accidentally fired a missile toward the mainland during a drill on the Chinese Communist Party's 95th birthday on July 1. Despite the tensions, hard data coming out of Taiwan have been strong. Its export-oriented economy is buoyed by strong global growth. Both its equities and currency are the few bright spots in the EM universe and investors have been responding positively to the strong data (Chart 13). Yet Taiwan remains highly vulnerable to geopolitical tensions, as its economy is "too open," especially to China. China has imposed discrete economic sanctions, as we expected. The number of mainland tourists to Taiwan have dropped by 50% (Chart 14). This trend will continue, hurting consumer sentiment. While Trump has backed away from his threat to break the One China Policy, a move markets view as very reassuring, he cannot unsay his words and China will not forget them. Moreover, his administration will attempt to shore up the U.S.-Taiwan alliance in traditional ways, including with new arms sales that will provoke angrier responses than in the past from Beijing (Chart 15). Chart 13Investors Do Not Fear Independence Talk Yet Chart 14China's Silent Sanctions Chart 15Plenty More To Come Crucially, Taiwan's domestic politics are not a major constraint on its actions, which heightens the risks of a cross-strait "incident." The Democratic Progressive Party (DPP) is in control at almost every level of government on the island. President Tsai Ing-wen and the DPP swept to power on a popular mandate to stall and roll back trade liberalization with China, which the public felt had gone too far under the previous Kuomintang government. Perhaps if Trump had never entered the picture, Taiwan and China would have found a new equilibrium in which Taiwan distanced itself while assuring the mainland it did not seek independence. Now, however, the odds of that solution are declining. Taipei may become overly aggressive if it believes Trump has its back, and this dynamic will ensure continuous Chinese pressures and sanctions, all negative for Taiwanese assets. Bottom Line: Despite the fact that Taiwan's economy has some bright spots (exports, capital formation), we are sticking with our "One China Policy" trade of going long Chinese equities / short Taiwanese and Hong Kong equities. BCA's China Investment Strategy agrees with this call and is shorting Taiwanese stocks relative to its mainland counterparts.17 We expect China to penalize these territories for expressing the desire for greater autonomy. We also suggest going short the Taiwanese dollar versus the Philippine peso, to be discussed further below. Thailand - The Junta's Persistence Is Bullish For most of the past fifteen years, the death of Thailand's King Bhumibol Adulyadej, which occurred on October 13 of last year, was feared as a catalyst for a total breakdown of law and order due to the deep socio-political and regional division in Thai politics that has pitted an urban royalist faction against a rural populist faction. But the 2014 coup was intended to preempt the king's death and ensure that the royalist, pro-military faction held firm control over the country during the risky succession period. The market responded positively during the coup in 2014 and upon the king's death last year (Chart 16). We recommended going long Thai stocks and THB last October, in a joint report with BCA's Emerging Markets Strategy, and both trades are in the black.18 Chart 16Thailand: Investors Cheered The Succession Crisis The junta's strategy has been to root out the leaders of the populist movement and rewrite the constitution to legitimize its ability to intervene in the future. The new monarch has cooperated with the military so far, upholding the status quo, but if at any point he favors the populists to the detriment of the military, political uncertainty will spike from its current historically low levels (Chart 17). The junta is fully in charge for the time being. It has pushed back elections to February 2018 or later, delaying the re-introduction of political instability into the Thai market. It is also surging public spending and transfers to the rural poor to ensure social stability. Historically, strong public capital investment and global exports coincide with strong Thai manufacturing output (Chart 18). Favorable domestic and external macro environments should be bullish for Thai equities, creating a near-term buying opportunity in the Thai market. Chart 17Junta Keeps A Lid On Politics... Chart 18... And Buys Friends With Public Money Thailand is distant from China's quarrels with its neighbors over the South China Sea. It was the first of the U.S. allies to hedge against President Obama's pivot and seek better relations with China instead, a strategy that has paid off. Thailand, like many regional actors, may be forced to choose between China and U.S. at some point, but for now it enjoys the best of both worlds. With a fundamentally strong macro-backdrop, including a large current account surplus of 12% of GDP, we are bullish on Thai assets relative to EM. Bottom Line: Thailand is the most attractive Asian EM economy right now from an investment-oriented geopolitical point of view. It is not too late to go long THB/KRW or long Thai stocks relative to EM. Philippines - The War On Drugs Is A Headwind The Philippines continues to display strong macro-fundamentals and market momentum in the EM universe. However, domestic political risks are significant and prevent us from returning to an overweight stance relative to EM.19 The inauguration of populist southerner Rodrigo Duterte as president of the Philippines in July of last year led the country into a bloodbath that has since claimed over 7,000 lives in a "war on drugs." Only recently has it shown any sign of abating, and it is not clear that it will. The political backlash is gradually building. Duterte's policy preferences are left-leaning and mark a partial reversal of the pro-market, reform orientation of the preceding Aquino government.20 As a result, foreign investment has dropped off from its sharp rise, though it remains elevated (Chart 19). The Philippines may also fall victim to its own success. Due to the booming economy under the Aquino presidency, bank loans and deposits have enjoyed strong growth in recent years. However, the loan-to-deposit ratio is getting overextended and the economy is showing signs of heating up with inflation creeping above 2% in 2016 (Chart 20). Populist policies and the advanced cyclical expansion may add more heat. Thus, it is becoming more likely that monetary policy will tighten as the economy moves into the advanced stage of its cyclical expansion. Duterte could create a problem if at any point he decides to interfere with the central bank or technocratic management of the economy more broadly. In terms of geopolitical risk, Duterte is engineering a pivot away from the United States toward Russia and China, aggravating relations with the former, its chief ally (Chart 21). As relations with China improve, they will bring some investment in infrastructure and a calming of the near seas. Chart 19Duterte Marked The Top Chart 20Credit Is Strong, Inflation Creeping Back Chart 21Duterte's 'Pivot' To Asia Ultimately, however, we view this calming as temporary, since China's assertiveness is a long-term phenomenon. We also think that the fundamental U.S.-Philippine alliance will survive any major disagreements of the Duterte era. Duterte is constrained by his weakness in the Philippine Senate and the popularity of the United States among Filipinos, which is among the highest in the world. In essence, the public is not anti-American but "anti-colonialist" - many feared that the U.S. "Pivot to Asia" of the Obama and Aquino administrations would put the Philippines into a subordinate "colonial" role highly vulnerable to Chinese aggression. Like other U.S. allies in the region, the Philippines wants to be a partner of the U.S. and not just a naval base. Thus, for now, we see the Philippines in a gray area of frictions with the U.S. yet disappointing hopes with regard to China. Until Duterte removes the headline risk to internal stability from his belligerent law and order policies - and compromises on his more anti-market economic stances - we are at best open to tactical possibilities. Bottom Line: Considering its strong macro-fundamentals, advanced cyclical expansion, and politically driven uncertainty, we are only willing to entertain short-term, tactical opportunities in the Philippines. Now is a decent entry point for equities relative to EM. Also, our colleagues at BCA's Foreign Exchange Strategy point out that the peso is currently trading at a 10% discount.21 We recommend going long the peso versus the Taiwanese dollar to capitalize on the dynamics outlined for both countries above. Indonesia - A Dream Deferred Indonesia outperformed our expectations throughout 2016.22 President Joko Widodo ("Jokowi") managed to corral his party behind him despite an internal leadership struggle. And the large bureaucratic party, Golkar, joined his coalition in parliament, creating a strong legislative majority. These were our two preconditions for a more effective government; Jokowi has also found allies within the military, as we surmised. As a result, he managed to make some progress on his tax-raising, union-restraining, and infrastructure-building initiatives. Nevertheless, the market has sniffed out the difference between a pro-reform government and the enormous difficulties of pulling off reform in Indonesia. Long-term investment has fallen even as short-term portfolio investment has rallied on the back of the EM reflation trade (Chart 22). While Jokowi reduced the size of costly domestic fuel subsidies in his first year, it was easy to do so amid the oil-price collapse in 2014. Since then, Indonesian retail gasoline prices have remained subdued, indicating that subsidies are still significant. As the global oil prices continue increasing, so will the subsidy (Chart 23), adding to the country's budget deficit. Jokowi also put forth minimum-wage reforms in 2015, introducing a formula which requires the minimum wage to be adjusted every year based on inflation and economic growth (rather than ad hoc negotiations with local unions and governments). Predictably, wages have skyrocketed since the indexing policy was implemented, which is negative for profit margins (Chart 24). Chart 22Investors Skeptical Of Jokowi's Reforms Chart 23Fuel Subsidies Still In Effect Chart 24No Wage Rationalization Yet Indonesia is on the outskirts of China's claims in the South China Sea and has a domestically driven economy that should suffer less than that of its neighbors in a context of de-globalization. In that sense, we are inclined to view it favorably. However, its currency is at risk from twin deficits - current account and budgetary reforms have stalled, and the credit impulse is weakening. If Jokowi's favored candidate wins the heavily contested gubernatorial run-off in Jakarta in April, it will not be very bullish, but a loss would be bearish for Jokowi's reform agenda ahead of the 2019 elections. Bottom Line: We are still short Indonesia within the EM space - its underperformance since the second half of last year can persist. Vietnam - No American Guarantee Vietnam is highly vulnerable to a geopolitical conflict with China which would impact markets. Unlike the Philippines and Thailand, it cannot count on an underlying bedrock of American defense to anchor its pivot toward China - and yet, it has the greatest historical and territorial conflicts with China of all the Southeast Asian states. Chart 25Fighting In The Teeth Of The Dragon Nevertheless, in the short term, geopolitical risks are abating. Relations have improved since a recent low point in 2014.23 And Vietnamese leaders, having invested heavily in the TPP as the trade pact's biggest potential beneficiaries, are trying to make amends with China now that it is canceled. Thus, we remain long Vietnamese equities relative to EM. This is mostly due to the country's strong domestic demand and export competitiveness (Chart 25), attractive environment for foreign investment, and ability to capitalize on diversification away from China. The country's reforms are not perfect, but it has at least recognized NPLs and begun privatizing some SOEs. Bottom Line: We are sticking with long Vietnamese equities versus EM, though downgrading it to a tactical trade due to our wariness of a turn for the worse in China relations or the broader trade environment. Malaysia - Going To The Pawnshop Malaysia, with Vietnam, was to be the top beneficiary of the TPP. It, too, has lost greater access to the U.S. market that the deal would have provided and must now make amends with China. The latter process has already begun, as Malaysia's government has turned to China for a $33 billion deal in exchange for energy assets and valuable land in the state of Johor. The general election of 2013 and the economic slowdown have catalyzed domestic political divisions, especially ethnic and religious ones, igniting a drastic push over the past two years to have Prime Minister Najib Razak ousted for his alleged embezzlement of funds from the state-owned 1MDB corporation. Najib chose to crack down on the opposition and ride out the storm, which he has managed so far, causing unprecedented political instability. Najib's decision to sell land to the Chinese will not sit well with much of the Malay population. Many will see it as undignified; and historically, there is much animosity toward the local Chinese. Najib already faces an intense political struggle due to the exodus of high-ranking politicians from his ruling United Malay National Organization (UMNO). Former strongman leader Mahathir Mohammad and ex-Deputy Prime Minister Muhyiddin Yassin are leading the defectors to form a new Malay party that will pose a serious challenge in the 2018 elections. Recent flirtation between the ruling UMNO and the Islamist Pan-Malaysia Islamic Party (PAS) also injected new uncertainty into the already turbulent domestic political environment. In essence, the one-party state that investors once knew (and loved) is forming new factions that will contest the upcoming elections with abandon. Chart 26Growth Slowing, Credit Drying Up This struggle over the 2018 election promises to be emphatically unfriendly to investors. And until Najib gets a new mandate, he can do very little to arrest the economic breakdown. As long as the support and continuity of Najib's policies are in question, it is difficult to take a directional view of Malaysian assets. A victorious UMNO does not mean that investors should be bullish, but it will resolve the question of "Who is in charge?" At that point, we can reassess the market attractiveness based on the higher "certainty" of the policy preferences of the country. Meanwhile the constraints to Malaysia's economy are clear from a host of weak data, from domestic trade to the property market to the current account and the currency, along with a rise in NPLs that will undermine the inadequately provisioned banks' willingness to lend (Chart 26). While palm oil and petroleum prices have recovered, which is positive for Malaysian markets, this is not enough to outweigh the negative factors. Bottom Line: We are bearish on Malaysian assets and currency. Matt Gertken, Associate Editor mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, and BCA Geopolitical Strategy Weekly Report, "A Fat-Tails World," dated February 22, 2017, available at gps.bcaresearch.com. 2 Please see BCA Global Investment Strategy Special Report, "The Looming Conflict In The South China Sea," dated May 29, 2012, available at gis.bcaresearch.com, and BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 4 Please see Graham Allison, "The Thucydides Trap: Are The U.S. And China Headed For War?" The Atlantic, September 24, 2015, available at www.theatlantic.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "The Geopolitics Of Trump," dated December 2, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see BCA China Investment Strategy Weekly Report, "Be Aware Of China's Fiscal Tightening," dated February 16, 2017, available at cis.bcaresearch.com. 9 In the short time since Trump's and Xi's phone call, the U.S. has announced that it intends to intensify the Freedom of Navigation Operations around the rocks in the South China Sea to assert its rights of navigation and overflight. Meanwhile Chinese lawmakers have revealed that they want to pass a new maritime law by 2020 that would encourage maritime security forces to bar foreign ships from passing through Chinese "sovereign" waters if they are ill-intentioned. 10 Trump's Treasury Secretary Steve Mnuchin was only just confirmed by the Senate and could not have taken any significant action yet. His appointees, notably Commerce Secretary Wilbur Ross, National Trade Council chief Peter Navarro, and U.S. Trade Representative Robert Lighthizer, are China hawks. If not currency, Trump's team will rotate the negotiations to focus on China's capital controls and failure to liberalize the capital account, its lackadaisical cuts to industrial overcapacity, and the negative business environment for U.S. firms. 11 Please see BCA Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com, and Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. 12 The first nationwide evacuation drill in the event of a North Korean missile attack will take place sometime in March of this year. 13 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 14 Bringing the total number of judges from nine to seven, and thus reducing the threshold for a vote in favor of retaining Park in office from four to two, for constitutional reasons. All but one of the judges were appointed by Park or her party's predecessor. 15 For instance, if the new administration reverses the deployment of the U.S. Terminal High Altitude Area Defense (THAAD) system, it will provoke a crisis with the U.S., but if it does not, China will continue its underhanded economic sanctions on the South, and the new South Korean president's North Korean policy will be stillborn. 16 Please see BCA Geopolitical Strategy Special Reports, "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, and "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Taiwan's 'Trump' Risk," dated February 2, 2017, available at cis.bcaresearch.com. 18 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW," in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, available at ems.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 20 For instance, he is imposing controls on the mining sector that will scare away investors, in an echo of Indonesia's mining fiasco implemented since 2013, and he is working on eliminating a "contract worker" system that enables employers to avoid the costs of full-time hiring. Please see BCA Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 21 Please see BCA Foreign Exchange Strategy Special Report, "Updating Our Long-Term FX Value Models," dated February 17, 2017, available at fes.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Stick To Long Modi / Short Jokowi," dated November 23, 2015, available at gps.bcaresearch.com. 23 Vietnam has moved toward better crisis management with China since the HYSY-981 incident in 2014, when a clash broke out over a mobile Chinese oil rig in the South China Sea. Significantly, the Vietnamese Communist Party's leaders removed former Prime Minister Nguyen Tan Dung, the highest-ranked China hawk and pro-market reformer on the Politburo, in the January 2016 leadership reshuffle.

How Long Is The Sweet Spot? Table 1Recommended Allocation The sweet spot on a baseball bat, scientists find,1 is the small area about two inches (5 cm) long, some six inches from the tip. The sweet spot for global risk assets may not be much bigger. The 22% rise in global equities since February last year has been driven by a "goldilocks" combination of recovering economic activity, quiescent inflation, and still-accommodative monetary policy. But, after such a strong rally, markets must walk a fine line - no slowdown in growth and no surprising tightening of monetary conditions - for prices to rise further. Our analysis suggests that they can, but the risk of a correction is rising. A lot of the better news of the past year has already been priced in. The price-to-sales ratio for U.S. stocks is close to an all-time high, and even the plain-vanilla 12-month forward PE ratio has reached 17.5x, the highest since 2002 (Chart 1). Volatility has fallen to a low level, with the VIX not rising above 12 over the past month, and the S&P500 index going 98 days without a one-day decline of 1% or more, the longest such period since 1995 (Chart 2). To a degree, this is justified by the recent strong pick-up in global growth. Sentiment indicators have accelerated since the election of President Trump, and even hard data is now showing the first signs of recovery (Chart 3) with, for example, U.S. retail sales rising 5.6% year-on-year in January, and core durable goods orders starting to follow the rise in companies' capex intentions (Chart 4). Similar positive economic surprises are visible in Europe, Japan, China and elsewhere. The problem is that further upside surprises are likely to be limited. Regional Fed NowCast surveys for Q1 real GDP growth are already at 2.5-3.1%. Consensus forecasts for S&P500 earnings growth in 2017 look about right at 10.5% but, with a stronger dollar and rising wages, are unlikely to be beaten. Chart 1Historically High Valuations Chart 2Time For A Pull-Back? Chart 3Hard Data Starting To Recover Too Chart 4Orders To Follow Capex Intentions Headline inflation has picked up (to 2.5% in the U.S. and 1.9% in the Eurozone), mainly because of higher oil prices, but core inflation remains sufficiently under control that central banks don't need to slam on the brakes. The rise in unit labor costs in the U.S. suggests that core PCE inflation will gradually move up to 2% during the year (Chart 5). The latest FOMC minutes revealed that members want a further rate hike "fairly soon", and BCA expects the Fed to raise three times this year (to which the futures market ascribes only a 36% probability). But Fed policy remains very accommodative (Chart 6), the European Central Bank is unlikely to end its asset purchases soon on account of political and banking system concerns, and the Bank of Japan remains committed to its 0% yield target for 10-year government bonds until inflation is well above 2%. Absent a powerful fiscal stimulus in the U.S. or a move by the "hard money" advocates in the Trump administration to change the Fed's modus operandi, we think its unlikely that a tightening of monetary policy will drag down asset prices. Chart 5Labor Costs Putting Pressure On Prices Chart 6Fed Policy Still Accomodative Risks certainly abound. The Trump administration could start a trade war with China. Its proposals for corporate and personal tax cuts could disappoint both in terms of their details and the timing of Congress's passing them. European politics remain a concern, with the probability of Marine Le Pen becoming French President increasing recently (though it remains small). But risk markets tend to rise on a wall of worry. Investor sentiment is not particularly bullish at the moment, with the bull/bear ratio among individual investors barely above 1 (Chart 7) and flows into equity funds in recent months not reversing the outflows of last year (Chart 8). Chart 7Retail Investors Not So Bullish Chart 8Equity Flows Are Still Tepid After a year of a strong cyclical risk-on rally, progress from now on will get tougher. A short-term change of direction is quite possible (and has already happened in some assets, with the yen moving back to 112 and the 10-year Treasury yield to 2.3%). But we expect economic growth to remain robust this year - with U.S. real GDP growth likely to come in close to 3% on the back of surprises in capex - which will push the 10-year Treasury yield above 3% by year-end. In this environment, we continue to favor equities over bonds, and maintain our pro-risk tilt in equity sectors, credit and alternative assets. Equities: U.S. equities have outperformed Eurozone ones by 5% year-to-date, mainly because of worries about Europe's political risk and the fragility of its banking sector. Though we think the political risks are overstated (except perhaps in Italy), we continue to prefer the U.S. in common currency terms because of our expectations of further dollar appreciation and because the lower volatility of the U.S. helps reduce the beta of our recommended portfolio. Emerging markets have outperformed global equities by 3% YTD, mainly on the back of stronger commodities prices. But we remain underweight EM because of the risks from a stronger dollar and rising global rates, concerns about protectionism and debt refinancing, and because of the likelihood that China's rebound will run out of steam over the next 12 months (Chart 9). Fixed Income: Rates have pulled back recently: long-term institutional investors have begun to find attraction in the long end of the U.S. Treasury yield curve at 2-3%, though speculative investors remain short (Chart 10). With the Fed likely to raise rates three times this year, inflation expectations to pick up further, and nominal GDP growth in the U.S. to reach 4.5-5%, we expect the U.S. 10-year yield to rise above 3%. We therefore remain underweight duration and prefer inflation-linked over nominal bonds. In the improving economic environment, we continue to like credit, but find valuations more attractive for investment-grade bonds than for high-yield. Currencies: Dollar appreciation has been on hold since January but we think the long-term trend remains in place because of the probable direction of relative interest rates. Neither Japan nor the Eurozone is likely to move towards monetary tightening over the next 12 months. Even if the Trump administration were to want a weaker dollar, a few tweets would not be enough to offset monetary fundamentals. And, while it is true that sentiment towards the dollar is already bullish, this has historically not precluded further appreciation, for example in the late 1990s (Chart 11). Chart 9EM Equities Correlated With China PMIs Chart 10Divergent Views On U.S. Bonds Chart 11Optimism Need Not Stop USD's Rise Commodities: The oil price remains close to its equilibrium level at around $55 a barrel, with the OPEC agreement largely holding but being offset by a production increase from the U.S. shale drillers, whose rig count has doubled since last May. We are neutral on industrial commodities: Chinese demand resulting from last year's reflationary policy is likely to be offset by the stronger dollar. Gold remains a useful portfolio hedge in a world of elevated geopolitical worries and inflation tail-risk, but is also negatively correlated with the U.S. dollar. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see, for example, "The Sweetspot of a Hollow Baseball or Softball Bat", by Daniel A. Russell, Pennsylvania State University, available at www.acs.psu.edu/drussell/bats/sweetspot.html Recommended Asset Allocation Model Portfolio (USD Terms)

Data processing stocks have been in a consolidation phase, but this increasingly appears to be a trend change rather than a continuation pattern. The economic backdrop is no longer conducive to capital inflows. Data processing companies enjoy hefty recurring revenue but have lower economic leverage than much of the corporate sector. As such, when growth and inflation expectations climb, capital inflows tend to wane (inflation expectations shown inverted, middle panel). Meanwhile, top-line growth has been in a funk of late, even though companies have made a significant investment to boost marketing, as evidenced by the surge in SG&A, but so far, this has sapped margins more than stoked revenue. Importantly, Visa has recently provided a fee break to retailers, who are increasingly banding together to put pressure on the industry to lower fees. Amidst increased competition on the payments processing side, this trend is likely to be structural and put downward pressure on profit margins. We shifted from overweight to underweight in yesterday's Weekly Report. The ticker symbols for the stocks in this index are: V, MA, PYPL, ADP, FIS, FISV, PAYX, ADS, GPN, WU, TSS.

Since late last year, the market has adopted a more defensive than cyclically-oriented tenor. Defensive sectors have troughed at extremely attractive relative valuation levels, based on our models. Conversely, cyclical sectors have rolled over, meeting resistance at very demanding valuation levels of more than two standard deviations above normal. These nascent trend changes have developed even though economic data have generally surprised on the upside. Indeed, the global PMI has been strong, but any hint of a reversal would provide a catalyst for a full-fledged recovery in defensive vs. cyclical stocks. The contraction in U.S. bank lending growth may be heralding slippage in hard economic data (bottom panel), to the benefit of defensive vs. cyclical sectors. Keep in mind that the market is priced for non-inflationary growth nirvana, such that even modest economic disappointment could short circuit the buying binge. The yield curve has stopped widening and financial conditions are no longer easing, providing additional confirmation that the defensive vs. cyclical equity sector trough is more likely a budding trend change than a pause in a downtrend. The bottom line is that the character of the market advance is quietly changing, underscoring that investors should maintain a largely defensive portfolio structure. Please see yesterday's Weekly Report for more details.