固定収入

Highlights This week we elaborate on the issues that we believe will be critical to investors going into 2017: Feature 1. Is China beginning to export inflation? Not yet. As long as the RMB depreciates faster than the rate of domestic inflation, China will be exporting deflation to the rest of the world. 2. Is the selloff in so-called search-for-yield beneficiaries over? Most likely not. There is still meaningful upside in global bond yields as well as downside in prices of bond proxies and search-for-yield beneficiaries. 3. Will China recover or will it have another growth slump in 2017? China's industrial cycle will be topping out in the next couple of months and will relapse thereafter. 4. Will strong U.S./DM growth lift EM economies in 2017? Not really. EM will continue to be driven by its domestic credit cycle and commodities prices. If anything, higher U.S. interest rates and a strong U.S. dollar are bearish for both the EM credit cycle and commodities prices. Overall, we expect EM stocks, currencies, credit markets and domestic bonds to sell off and underperform their U.S./DM peers well into 2017. Is China Beginning To Export Inflation? With various inflation measures in China rising (Chart I-1A and Chart I-1B), the key question is whether China will soon export inflation rather than deflation to the rest of the world. Chart I-1AInflation In RMB Terms, ##br##Deflation In USD Terms Chart I-1BInflation In RMB Terms, ##br##Deflation In USD Terms Investors often confuse domestic inflation in China with China exporting inflation beyond its borders. The missing link is the exchange rate. Because of the yuan's depreciation, China is still exporting deflation, even though its domestic inflation rate is rising. Specifically: Chinese core consumer price inflation, consumer services inflation and ex-factory producer price inflation are all negative in U.S. dollar terms even though they are accelerating in local currency terms (Chart I-1A and Chart I-1B). Importantly, Chinese export prices and U.S. import prices from China are deflating in U.S. dollar terms but rising in RMB terms (Chart I-2). A rise in input costs in China has, so far, not translated into higher U.S. dollar prices of mainland goods shipped overseas. The reason is that the RMB's depreciation has allowed export companies to reduce U.S. dollar prices while receiving more RMBs per a unit. In China, labor compensation and unit labor costs are rising much faster in RMB terms than in U.S. dollar terms due to the currency's depreciation (Chart I-3). Chart I-2Chinese Export Prices ##br##Are Not Rising In USD Terms Chart I-3Chinese Unit Labor Costs ##br##Are Rising In RMB But Not In USD Income per capita (a proxy for employee compensation) is growing at an annual rate of 8% in nominal RMB terms, 6% in real (inflation-adjusted) terms and 2.5% in U.S. dollar terms (Chart I-4). Hence, the RMB's depreciation over the past year has reduced the pace of labor cost increases to Chinese producers in U.S. dollar terms. This has allowed producers to tolerate lower selling prices in U.S. dollars. Finally, there is thus far no evidence worldwide that tradable manufacturing goods (non-commodities) prices are rising. Specifically, Korean and Taiwanese export prices as well as manufactured export goods prices in Mexico have stabilized but are not yet rising (Chart I-5). Chart I-4Income Growth: ##br##Nominal, Real Terms & In USD Chart I-5Global Manufacturing ##br##Goods Prices: No Inflation Yet Bottom Line: Even though domestic price inflation has risen, China's export prices are still falling in U.S. dollar terms. The exchange rate is the key: As and if the RMB depreciates much further - and we expect it to depreciate 12% versus the greenback and to reach USD/CNH 7.8 by the end of 2017 - China will still be exporting deflation to the rest of the world. Is The Selloff In Search-For-Yield Beneficiaries Over? The selloff in so-called search-for-yield beneficiaries - trades that have in recent years benefited from a low interest rate environment globally - will likely persist in the first few months of 2017. Back in July,1 we argued that U.S./DM bond yields were set to rise considerably. Currently, we still expect bond yields to climb further. We believe there is still prevailing investor complacency about U.S./global bond yields as well as bond proxies elsewhere. U.S. bond yields in general, and inflation-adjusted (TIPS) yields in particular, are still very depressed and could rise meaningfully (Chart I-6). There is no reason why 5- and 10-year TIPS yields cannot reach their late 2015 levels - a move of about 30-50 basis points from current levels. At the moment, the market is pricing only 52 basis points in Federal Reserve rate hikes in 2017. This is not enough as animal spirits are rising in America at a time when the labor market is tight, and wages and unit labor costs are accelerating. All of this combined warrants meaningfully higher U.S. bond yields. Critically, in recent years a lot of money has flown into funds that invest in bonds and bond proxies. As U.S. bond yields rise, it is natural to expect some outflows from these funds. Odds are that these outflows could occur in January when many investors review their portfolios. Bond proxies such U.S. dividend aristocrat stocks, U.S. REITs, utilities and telecom share prices have barely corrected. EM local currency bond yield spreads over duration-matched U.S. Treasurys have not widened at all (Chart I-7, top panel). This does not make sense, as EM local bonds have benefited substantially from the so-called global search-for-yield of the past several years, and thereby should suffer meaningfully as U.S. bond yields are rising. Besides, EM currencies have weakened, and their outlook is worrisome.2 In fact, the EM local currency bond index has massively underperformed duration-matched U.S. Treasurys in common currency terms, and will likely continue to do so in the next six months (Chart I-7, bottom panel). Asian corporate spreads in general, and Chinese offshore corporate spreads in particular, have not widened yet (Chart I-8, top panel). More importantly, Chinese offshore corporate spreads over sovereigns have continued to narrow, and now stand at only 65 basis points (Chart I-8, bottom panel). In sum, there has so far been little setback in Asia/China credit markets. Chart I-6U.S. TIPS ##br##Yields Are Too Low Chart I-7EM Local Currency Bond ##br##Yields To Rise Much Further Chart I-8Asian And Chinese ##br##Corporate Spreads Are Too Low It would be strange if after years of blind search-for-yield there is no meaningful retrenchment in search-for-yield beneficiaries as U.S. bond yields shoot up. Finally, the S&P 500 is making new highs, indicating U.S. bond yields have not yet become restrictive. Odds are that U.S. bond yields will continue to rise until they hurt economic growth or the S&P 500. In other words, bond yields will likely overshoot before rolling over. Bottom Line: The path of least resistance for U.S. bond yields remains up. Hence, the current selloff in global bonds, bond proxies and search-for-yield beneficiaries will continue. China: Another Growth Slump In 2017? From our investor meetings on both the east and west coasts of the U.S. over the past month, we got a sense that investor sentiment toward China has improved considerably. While many U.S. investors are not upbeat about China's long-term outlook, the majority have seemingly become complacent on mainland growth for 2017. The common viewpoint is that ahead of Communist party leadership changes at the Party Congress next fall, the authorities will ensure that growth conditions remain very firm. As a result, the reasoning goes that China-related plays will do well in 2017. The missing point, however, is that Chinese policymakers have lately been marginally tightening liquidity/credit conditions amid the lingering credit bubble, and are no longer easing policy. On a rate-of-change basis, this policy stance no longer supports growth acceleration. On the contrary, it warrants a top-out in the nation's industrial cycle in early 2017 and probably a slowdown later in 2017. Chart I-9Interbank Liquidity Tightening In China Not only have Chinese corporate bond yields climbed alongside rising global bond yields, but the People's Bank of China (PBoC) has also tightened liquidity in the interbank market for non-bank financial institutions (Chart I-9). This is intended to limit speculative activities among non-bank financial organizations (shadow banking). This policy move is consistent with PBoC Governor Zhou Xiaochuan's statement this past October at the annual World Bank/IMF meetings in Washington, namely: "With the gradual recovery of the global economy, China will control its credit growth."3 As U.S. and European growth is firming up, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced in late October that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Macro Prudential Assessment ratios, starting from the third quarter.4 The clampdown on WMP accounting will reduce banks' capital adequacy ratios, curbing their ability to originate loans. Finally, property market tightening measures implemented of late are expected to lead to a slowdown in sales and renewed contraction in property starts. This will depress Chinese construction and demand for industrial commodities/materials as well as capital goods. Notably, both credit and fiscal impulses in China have already peaked over (Chart I-10). With no major new fiscal spending initiatives and credit growth gradually moderating, the credit and fiscal impulses will likely diminish. Chart I-11 illustrates that the recovery in industrial electricity consumption (a reliable proxy for industrial activity), industrial profits and manufacturing PMI since early this year has been largely due to combined credit and fiscal impulses. As these impulses wane, the industrial cycle will roll over. Chart I-10China: Credit And Fiscal ##br##Impulses Have Petered Out Chart I-11China: Industrial Sector ##br##Growth To Peter Out In Early 2017 Some clients may wonder why we are placing so much emphasis on the pending rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in early in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend/unwind of excesses. Similarly, moderate tightening in a healthy credit system should not be feared. While base metals prices have surged, tracking improvement in China's industrial sector, there is little evidence that the magnitude of this rally is justified by improvement in underlying demand. Chart I-12 demonstrates that China's imports of base metals have been flat since 2010, with all swings due to inventory cycles. The mainland's iron ore consumption has also been mediocre since late 2014 (Chart I-12, bottom panel). The recent rally in copper and other base metals prices is somewhat, though not entirely, due to financial demand. Chart I-13 reveals that commercial firms (producers) have been selling (shorting) copper while financial investors (non-commercial enterprises) have been buying according to data from Commodity Futures Trading Commission (CFTC). Copper prices are now sitting at their long-term moving average that often marks tops in bear market rallies and bottoms in bull market selloffs (Chart I-13, bottom panel). We expect copper prices to face a major resistance at their current levels, and relapse sooner than later. The U.S. consumes about seven times less copper and other industrial metals compared with China. Therefore, acceleration in U.S. growth and capital spending will be more than offset by a renewed slump in Chinese growth. Several Chinese and China-related financial markets are at a critical juncture (Chart I-14). Their breakdown from current levels will confirm our bias that China's industrial cycle will enter another slump in 2017. Chart I-12China: Net Imports Of Industrial ##br##Metals And Iron Ore Consumption Chart I-13Copper Rally Is Driven ##br##By Financial Demand Chart I-14China Related Plays ##br##Are At A Critical Juncture Bottom Line: China's industrial/capital spending cycle will peter out and will decelerate again in 2017. Will Strong DM Growth Lift EM Economies? Strengthening/robust growth in the U.S. and other developed economies will not be sufficient to lift EM growth. First, in the 1997-98 period, real GDP growth was 4.5% in the U.S. and 3.5% in Europe. In particular, U.S. import volume growth was booming at a double-digit pace (Chart I-15) yet it did not prevent widespread crises throughout the EM during this period. In a nutshell, these 1997-98 crises occurred amid plunging U.S./DM bond yields. Chart I-15The U.S. Growth/Import Boom In 1997-98 Did Not Preclude EM Crises Given the economic boom and falling bond yields in the U.S. and Europe did not prevent the 1997-98 EM financial crises, strong U.S./DM growth now is unlikely to help developing countries much. The importance of U.S. and European economies to EM has declined tremendously since the late 1990s, while the importance of China and intra-EM trade has grown. U.S. import volumes have been weak the past 12 months and will likely recover in 2017, yet this will not be enough to prevent an EM growth slump. The EM crises in 1997-98 were due to poor EM fundamentals and the latter are not much better now. Second, EM growth is primarily driven by the domestic credit cycle and commodities prices. We are bearish on both. Chart I-16 shows EM EPS growth and the aggregate EM credit impulse with projections. Assuming credit growth in each individual EM country converges with its nominal GDP growth in the next 12 months, and in China's case in the next 24 months, the 2017 projected EM credit impulse (equity market cap-weighted) will be negative. Historically, the credit impulse has been a good indicator for EPS (Chart I-16).5 Chart I-16EM EPS Growth To Relapse Again In 2017 In short, EM EPS will improve in the near-term but relapse later in 2017. Share prices are forward looking and their rally early this year is probably already discounting near-term EPS improvement. Thereby, EM share prices are at risk at the moment. Third, real capital spending (inflation-adjusted) in EM ex-China and China is as large as the U.S. and EU (Chart I-17). As the capital spending downturn in China and the rest of EM persists (Chart I-18), this will offset any capex recovery in DM and weigh on commodities, primarily industrial metals, as well as global machinery stocks. Chart I-17Capital Spending By Regions: ##br##EM/China As Large As U.S. And EU Chart I-18EM Ex-China Capex ##br##Has Been Contracting Bottom Line: EM growth will disappoint and EM listed companies' EPS will continue shrinking in 2017, despite the likely profit improvement in the very near term. 2017: The Beginning Of The End Of The EM Bear? Chart I-19 illustrates that this relative equity bear market in EM versus DM is getting late from a duration standpoint. That said, the magnitude of this bear market has been smaller compared with the previous one. Although we do not expect EM stocks to underperform as much as they did in the previous cycle, we still believe there is sizable downside in the months ahead. In short, EM share prices appear very vulnerable technically (Chart I-20), and will likely relapse in absolute terms and also underperform DM markets. Investors should stay short/underweight EM equities versus DM. Chart I-19The EM Bear Market Is Late But Not Over Chart I-20EM Stocks Are Technically Vulnerable For dedicated EM equity investors, our overweights are Korea, Taiwan, China, India, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. EM bank stocks hold the key, and their underperformance versus DM banks has further to run. Maintain the short EM banks / long U.S. banks equity position. EM currencies will depreciate further (odds of new lows are considerable for many of them) and local currency bonds will sell off. In our November 30 Weekly Report,6 we discussed the outlooks for EM local bond markets and exchange rates at great length, and offered asset allocation recommendations across EM local bond markets. EM sovereign and corporate credit spreads will widen versus U.S. corporate spreads. Stay underweight EM credit markets. Within EM sovereign credit, our overweights are Russia, Mexico and Argentina, Hungary, Peru and other defensive credit. In turn, our underweights are South Africa, Turkey, Brazil, Indonesia and Malaysia. As usual, the complete list of our equity, fixed-income and currency recommendations is available at the end of each week's report (please refer to pages 16 and 17). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports, dated July 13 and July 27, 2016; available at ems.bcaresearch.com. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled " Will The Carnage In EM Local Bonds Persist?," dated November 30, 2016; a link is available on page 18. 3 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 5 For more details, please refer to the Emerging Markets Strategy Special Report, titled "Gauging EM/China Credit Impulses," dated August 31, 2016; a link is available on page 18. 6 Please refer to the Emerging Markets Strategy Weekly Report, titled " Will The Carnage In EM Local Bonds Persist?," dated November 30, 2016; a link is available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights ECB Policy: The European Central Bank (ECB) bought time for Euro Area inflation to sustainably move higher by extending the duration, and removing some of the self-imposed limits, on its bond buying program. The higher aggregate amount of monetary stimulus to be delivered in 2017 was an easing, not a taper. This should support a relative outperformance of core European bond markets next year. Treasury-Bund Spread: Growth and inflation divergences between the U.S. and Euro Area have pushed the spread between U.S. Treasuries and German Bunds to the highest levels since the late 1980s. Those divergences will begin to narrow later in 2017, but not before the Treasury-Bund spread widens further. Maintain an above-benchmark stance on core Europe versus the U.S. in hedged global bond portfolios. Italy: Global bond portfolio managers and traders should underweight Italian bonds versus hedged global benchmarks and Spanish Bonos. A risk premium will continue to build into Italian bonds over the course of 2017, as political gridlock and insufficient structural improvements will plague this economy for the next few years. Feature "Chart of the WeekA Taper? What Taper? We seem to be fairly far away from any such high-class problem." - Mario Draghi That comment was made after last week's European Central Bank (ECB) policy meeting in Frankfurt, when ECB President Draghi was asked if a tapering of the central bank's bond purchase program could occur in response to stronger European economic data. Draghi's pointed-yet-cynical response goes a long way in highlighting the ECB's current thinking. Conclusion: it is too soon to take away the morphine from the sick patient that is the Euro Area economy. The ECB decided to prolong its asset purchase program deep into 2017, and even longer if necessary. The decision was backed by the new set of ECB growth and inflation projections, which showed that Euro Area inflation is no longer expected to sustainably return to the ECB's 2% target by 2019 - a move that we had anticipated.1 Admittedly, we had also thought that there would be no change in the size of the monthly bond purchases, but the ECB did announce a reduction in the pace of bond buying back to €60bn per month. While some have called this a "taper", as fewer bonds will be bought each month, we take the opposite view, as the total aggregate amount of bonds to be purchased in 2017 was higher than market expectations. Last week's decision was an easing by the ECB that should allow core European bond yields to remain subdued relative to rising yields in the U.S. and elsewhere (Chart of the Week). Even Draghi himself stated that this move was not a taper, which he defined as a signal that bond purchases would eventually be lowered down to zero. The ECB's decision is a rare piece of bullish news in the current bear phase for developed market bonds. After all, by pushing out the earliest date when the tapering of asset purchases could begin, and by also not committing to a taper if European inflation continues to languish, the ECB can limit the damage to bonds from rising term premiums amid a worsening demand/supply balance for global fixed income. But with expectations for both global growth and inflation continuing to improve, the cyclical forces underpinning the recent bond rout remain in place. While we are currently recommending a tactical neutral duration stance while bond markets consolidate the latest rapid rise in yields, we continue to see core Europe outperforming during the next leg of the global bond bear phase in 2017. This is especially true versus U.S. Treasuries, which will continue to be battered by stronger growth expectations, rising inflation, Fed rate hikes and the ongoing threat of aggressive fiscal stimulus from the incoming Trump administration. "Low-Flation" Remains The ECB's Biggest Problem The consensus expectation was that the ECB bond buying program would be extended by six months to September 2017, but that the amount of purchases would be maintained at €80bn per month. The ECB delivered an extension of nine months to December 2017 but at a slower monthly pace of €60bn. The simple math suggests that the ECB delivered a bigger monetary stimulus than expected: €540bn (9 months times €60bn) vs €480bn (6 times €80bn). That may sound like an overly simplistic interpretation, but European financial markets certainly reacted as if the ECB decision was a monetary easing with a weaker Euro, higher equities and steeper government bond yield curves. The ECB is clearly puzzled as to why European inflation remains so stubbornly low. After all, a 50% rise in energy prices denominated in Euros over the past year should be enough to get headline Euro Area inflation back up to 2% (Chart 2). Draghi noted during the post-meeting press conference that the ECB was "not seeing yet any effect" of the rapid rise in oil prices in 2016 on underlying non-energy inflation - a point confirmed by the sideways move in core CPI and services inflation in the Euro Area (middle panel). The surge in oil, combined with the prolonged weakness of the Euro, has been enough to put a floor under inflation expectations. Draghi cited this as a key reason for the reduction in the monthly pace of bond purchases. With key measures of inflation expectations like the 5-year Euro Area CPI swap rate, 5-years forward no longer showing persistently low readings (bottom panel), the ECB can credibly decide to buy fewer bonds per month since, in Draghi's words, "the risk of deflation has largely disappeared." The other issue that the ECB addressed was the notion that it was "running out of bonds" to buy in the asset purchase program due to the rising share of the European bond market that is trading with a yield below the ECB's deposit rate of -0.4%. The backup in global yields since mid-year has helped mitigate that problem to some degree, given the 10% reduction in the share of European government bonds now trading with a negative yield (Chart 3). Chart 2Underwhelming European Inflation Chart 3Fewer Bonds With Negative Yields The ECB also addressed the bond shortage issue more directly by making two additional changes to the asset purchase program. First, it reduced the minimum remaining maturity of eligible bonds from 2 years to 1 year. Second, it agreed to buy bonds with yields below the previous -0.4% floor, if necessary. This yield floor was a completely self-imposed rule that was not necessary to maintain the ECB's credibility or the integrity of its monetary policy. By eliminating the floor, and by allowing bonds with shorter maturities to be included in the bond buying program, the ECB has freed up a significant share of the Euro Area bond market that could not be purchased previously. This is especially true in the larger core countries like Germany and the Netherlands where around 70% of bonds that had been ineligible can now be bought by the ECB (Chart 4). Chart 4ECB Removing A Self-Imposed Constraint Adding it all up, the ECB has successfully pushed out the bond market "cliff" where the pace of bond purchases was expected to peak out. As we show in Chart 5, the annual growth in the ECB's balance sheet is now expected to be maintained around the current pace for the next year. This implies additional downward pressure on core European bond yields via a narrower term premium. This should keep the spread between U.S. Treasuries and German Bunds at historically wide levels while the Fed continues on its rate hiking path. Bottom Line: The European Central Bank (ECB) bought time for Euro Area inflation to sustainably move higher by extending the duration, and removing some of the self-imposed limits, on its bond buying program. The higher aggregate amount of monetary stimulus to be delivered in 2017 was an easing, not a taper. This should support a relative outperformance of core European bond markets next year. Treasury-Bund Spreads Will Stay Wide In 2017 The steady widening in the yield gap between U.S. Treasuries (USTs) and German government debt has been one of the dominant themes in global fixed income over the past few years. The gap between the benchmark 10yr UST and German Bund now sits at 210bps, the highest level since the late 1980s. Do not look for the spread to narrow anytime soon. The combination of a Fed exiting the quantitative easing business, as the ECB was ramping up its bond buying, goes a long way to explain the steady widening of the UST-Bund spread. From a more fundamental perspective, wider spreads are a product of the persistently expanding gap between inflation and unemployment in the U.S. versus Europe, which has created a growing monetary policy divergence between a tightening Fed and an easing ECB (Chart 6). Chart 5Pushing Out The Monetary Peak Chart 6Big Divergences Between Europe & The U.S. The Euro Area remains in a state of excess capacity, as indicated by the negative output gap and an unemployment rate that remains above estimates of NAIRU.2 The opposite exists in the U.S. where the economy is close to, if not beyond, full employment. Both the ECB and Fed are projecting tighter labor markets over the next three years, although the decline in Europe will not be enough to push the unemployment rate below NAIRU (Chart 7). If the central banks' forecasts for both unemployment and inflation come to fruition, then the underlying gaps that have driven the UST-Bund spread widening in recent years will begin narrowing to levels less favorable for Bunds over Treasuries in the years ahead (Chart 8). This implies that the peak level of the UST-Bund spread should be reached sometime in the latter half of 2017. Chart 7Fed & ECB See Unemployment Moving Lower Chart 8UST-Bund Spreads: Widening Now, Narrowing Later A shift in relative monetary policies will be required for that peak to occur, led by a move by the ECB towards tapering its bond purchases and the Fed to signal an end to the current slow-motion tightening cycle. As discussed earlier, the former is unlikely to happen until the ECB can be comfortable in projecting Euro Area inflation will rise sustainably towards the 2% central bank target. That is likely to happen later in 2017 when the ECB is forced, once again, to make a decision on the future of its asset purchase program and when Euro Area inflation expectations are more likely to be closer to the ECB target. From the Fed's perspective, some signs that the U.S. labor market is cooling off would likely be necessary for the FOMC to ease off the monetary brakes. However, given our expectation that U.S. inflation will continue to grind higher over the course of 2017, amid a period of accelerating U.S. growth and a potential fiscal boost from the new Tweeter-in-Chief in the White House, we do not see the Fed backing off from its planned rate hikes next year. In sum, we see the transition period from UST-Bund spread widening to narrowing beginning in the latter half of 2017, led more by rising Bund yields than declining UST yields. In the meantime, with no move in the bond spread currently priced into the forward curves of the two markets, there is room to profitably play the spread from both directions - wider first, narrower later. (Chart 9). The spread widening is currently stretched, however, both in terms of the level (middle panel) and price momentum (bottom panel). Thus, some consolidation of the recent rapid move higher in the spread is likely before the next phase of widening can begin. Bottom Line: Growth and inflation divergences between the U.S. and Euro Area have pushed the spread between U.S. Treasuries and German Bunds to the highest levels in 30 years. Those divergences will begin to narrow over the course of 2017, but not before the Treasury-Bund spread widens further. Maintain an above-benchmark stance on core Europe versus the U.S. in hedged global bond portfolios. Renzi's Vacuum Effect On June 28th of this year, we moved to a below-benchmark stance on the Peripheral bond markets of Italy and Spain. Our concern was that, with cyclical economic momentum starting to slow in those economies, at a time of increased European political uncertainty and renewed pressure on the weakest parts of the European banking system, the risks of owning Peripheral Euro Area sovereign debt had become more elevated. This portfolio allocation recommendation has paid off so far, generating 64bps of excess return versus the Barclays Global Treasury hedged index. Today, we reiterate this stance and add a new trade, shorting 5-year Italian BTPs versus Spanish Bonos, to our Overlay Trade Portfolio (Chart 10). Chart 9Spreads Must Consolidate Before Moving Higher Chart 10Underweight Italian Bonds A lost opportunity The latest developments in Italy have not been friendly to bond investors. Prime Minister Matteo Renzi's defeat in the referendum earlier this month, and his subsequent resignation, has made the Italian political scene more uncertain. The vacuum created by his departure will lead to a period of delay on badly needed structural reforms. Moreover, the odds have increased that new elections will happen in 2017, with a chance that anti-Euro populist parties like the Five-Star Movement could gain greater influence. Against such a backdrop of renewed political instability, investors will likely require a larger risk premium to hold Italian bonds. The "no" result in the constitutional referendum came as no real surprise. Polls had already been pointing in that direction in the weeks leading up to the vote, as voters were becoming increasingly concerned about the proposed reforms that would eliminate many of the embedded checks & balances in Italy's multi-party political system. However, the magnitude of the "No" victory leaves one to wonder if Italians have the appetite for difficult reforms. More likely, the country will be content to simply try to muddle through, yet again. Although, this strategy could work in the short term, at some point Italy's structural fragilities will re-emerge. This would be unfortunate, since Italy's reform momentum has been decent of late. According to the European Commission, substantial progress has been made in reforming the banking sector, the labor market and the educational system. Yet, Italy still has massive work to do in order to become competitive: Italy has a horrible demographic outlook, with a labor force that is projected to suffer steep declines in the years ahead and a participation rate that remains low. Italian productivity growth has been anemic, underperforming all developed markets and most emerging markets before and after the 2008 crisis.3 Italy scores very poorly in terms of generational earnings elasticity. This means that the future earnings of Italian children are highly dependent on their parents, implying low social mobility. The quality of Italy's institutions - according to the annual rankings from the World Economic Forum - and its labor market efficiency are underwhelming compared to its peers. Unfortunately, Italy cannot really afford to maintain the status quo. Despite a strained infrastructure, growth in Italian investment spending has lagged that of the rest of the developed world by a wide margin since 2008 (Chart 11). Political gridlock will only postpone the necessary productivity-enhancing adjustments that could boost Italy's long-term economic potential and help reduce the low-growth risk premium on Italian financial assets. Investment spending is also being restrained by Italy's other major structural problem - an undercapitalized banking system clogged with non-performing loans. Until this issue is resolved, credit growth, investment spending and overall economic growth will remain feeble. Hence, a resolution of the banking impasse is paramount. Unfortunately, there is no clarity as to how this situation could be quickly resolved in an investor-friendly fashion. As our colleagues at BCA European Investment Strategy have highlighted, the mechanisms used for public bailouts of the troubled banks in Spain & Ireland after the 2011-12 European banking crisis are unavailable to Italy after the advent of the European Union Bank Recovery and Resolution Directive (BRRD). The BRRD allows state intervention in a banking crisis, but only after creditors like senior bondholders and large-value depositors have taken significant writedowns of their exposures to the troubled banks.4 It is highly unlikely that Italian banks would seek a government bailout if it were to hurt senior creditors, many of which are individual Italian citizens who were sold the senior debt of banks as high-interest investment vehicles. The only alternative for the banks is to pursue an injection of capital from financial markets, but investors have shown little appetite to participate in recent capital raising exercises for some of Italy's most troubled banks. Without healthier banks, Italy's economy will struggle to grow. Already, the Italian business cycle expansion is exhibiting signs of exhaustion. After a few years of rapid increases, consumer confidence has rolled over; much lower wage-growth partly explains this trend. As a result of lower confidence and income, consumption growth is decreasing anew (Chart 12). Chart 11Lagging Investments Chart 12Consumption Will Recede Against this backdrop, Italian growth will disappoint expectations (Chart 13). While ECB asset purchases of Italian debt have helped reduce the risk premium on Italian debt in the past couple of years, the increasing odds of an Italian economic downturn remain a significant negative for Italian bonds. Increased risks, but no crisis Some market participants fear that Italy could succumb to a debt sustainability crisis, potentially triggering a Euro break up. This scenario remains remote, in our view. In the last few years, Italy has extricated itself from its debt trap. With the federal government running a primary budget surplus, and with the nation as a whole running a current account surplus, the Italian debt arithmetic has become much less problematic. It would now take a deep domestic recession or a global deflationary shock to push Italy back into a fiscal crisis. We do not expect either to occur in 2017, so the longer-term debt sustainability risk will probably not resurface during the year. Moreover, a full blown political crisis driving a euro collapse is unlikely. Surveys show that Italians overwhelmingly support the Euro Area (Chart 14). Moreover, our colleagues at BCA Geopolitical Strategy believe that Euro-skepticism in Italy is not a long-term, strategic interest but a short-term, tactical gambit. Italian policymakers are using it as a "negotiating tactic" against austerity-minded Berlin and Brussels.5 Chart 13Economic Growth To Moderate Chart 14Italians Support The Euro Area From the bond market's perspective, there should only be a modest political risk premium priced into Italian bond yields, in response to rising odds of a Brexit-like anti-EU stance becoming a reality in Italy. However, in practice, odds are that the market won't reach that logic immediately during the transition period to a new caretaker Italian government and eventual fresh elections later next year. A spread widening phase will likely happen before the bigger picture is fully understood. Investment implications If the ECB starts hinting at tapering its bond purchases later this year, as we discussed earlier, most European bond yields will move higher, but more dramatically so in countries that have benefitted the most from loose monetary policies. Italy is near the top of that list. As much as the market has been able to front-run ECB purchases, as the ECB described in a recent research paper, the market will also try and front-run the taper phase.6 This won't happen in the first half of 2017, but it could definitely be the case in the second half. More importantly, our underweight stance on Italian sovereign debt hinges on Italy's slow structural decay, rather than a view on future ECB tapering. As they lift a monetary policy that has, by design, distorted asset prices, the true value of Italian debt (i.e. yield) will re-surface, definitely at higher yields and most likely at wider spreads to Germany. Stay underweight Italian bonds versus both core Europe and hedged global benchmarks. For a less directional exposure, traders should short 5-year Italian bonds versus Spanish Bonos. Spain's structural backdrop has become much more solid in recent years: Labor productivity and wages have improved (Chart 15). Spain's real estate market has been healed after the bursting of the mid-2000s bubble; house price and transactions are growing at a healthy pace again (Chart 16). Spain's employment elasticities have increased much more drastically than those of Italy since the crisis, meaning this economy can better shift its human capital towards growing sectors. Spain's banking sector appears in much better shape than Italy's; Spanish Bank non-performing loans (NPLs) now stand at 30% of tangible common equity, versus 100% for Italy. Chart 15Italy Has Productivity Problems Chart 16Spanish Housing: Not a Drag Anymore In sum, Spain's economy has become better equipped to handle any financial turmoil, making Spanish bonds a less risky asset to own versus Italian equivalents. This might transpire when the ECB does finally begin to taper its asset purchases. We recommend implementing this short Italy/long Spain trade at the 5-year maturity point, where a 67bps yield increase is priced into the Italian forwards, versus 60bps for Spanish bonds, on a one-year horizon. A 7bp widening is a low hurdle for making our trade profitable, given the growing risks in Italy. Bottom Line: Global bond portfolio managers and traders should underweight Italian bonds, both versus global hedged benchmarks and Spanish Bonos. A risk premium will continue to build into Italian bonds over the course of 2017, as political gridlock and insufficient structural improvements will plague this economy over the next few years. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com 2 The Non-Accelerating Inflation Rate of Unemployment 3 Using date from the U.S. Conference Board on global labor productivity 4 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question", dated December 1, 2016, available at eis.bcaresearch.com 5 Please see Section II of the BCA Geopolitical Strategy Monthly Report, "Europe's Divine Comedy: Italian Inferno", dated September 2016, available at gps.bcaresearch.com 6 https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1939.en.pdf?712abb4a54132af89260d47385ade9ef The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. Corporate Bonds: The macro back-drop is turning marginally more positive for corporate spreads. C&I lending standards are no longer tightening and bank stocks have rallied significantly. Corporate Bonds: Spreads are too tight at the moment, even for an improving economic environment. Remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now. We are actively looking to add exposure to corporate credit from more attractive levels. Feature There is no question that the U.S. economy is on a firm footing heading into the New Year. Third quarter real GDP growth came in at a robust 3.2%, and the Atlanta and New York Fed tracking models currently forecast fourth quarter growth of 2.6% and 2.7%, respectively. This represents a marked acceleration from the average growth rate of 1.1% witnessed during the first two quarters of 2016. Forward-looking survey data are also pointing in the right direction. The ISM non-manufacturing survey reached 57.2 in November, its highest level since October 2015, while the expectations component of the University of Michigan Consumer Sentiment survey reached 88.9 in December, its highest level since January 2015 (Chart 1). The question for bond investors is how much of this good news is already reflected in Treasury yields. Higher Treasury yields and a stronger dollar have already led to a material tightening in some broad indexes of financial conditions, enough to exert a meaningful drag on U.S. growth (Chart 2). In fact, according to the Fed's FRB/US model, the recent interest rate and dollar moves could be expected to shave 1% from GDP over the next eight quarters. Chart 1Economic Tailwinds Chart 2Financial Conditions Must Ease The natural conclusion is that while some upside in Treasury yields is justified by an improving economic outlook, the bond selloff has proceeded too quickly and must pause in the near-term to prevent financial conditions from exerting an excessive drag on growth. Sentiment and positioning indicators also confirm that the uptrend in yields appears stretched (Chart 2, bottom two panels). As such, last week we tactically shifted our recommended portfolio duration allocation from 'below benchmark' to 'at benchmark'.1 We expect Treasury yields will grind higher next year, reaching a range of 2.8% to 3% by the end of 2017, but the selloff will proceed more gradually, in line with the acceleration in economic growth. A More Uncertain World The premise that the bond selloff has proceeded too quickly is confirmed by our Global PMI models of the 10-year Treasury yield. We track two versions of our Global PMI model. One is a 2-factor model based only on the Global PMI index and a survey of bullish sentiment toward the U.S. dollar. The intuition behind this model is that improving global growth contributes to a higher fair value Treasury yield. However, for a given level of global growth, increasingly bullish dollar sentiment applies downward pressure to yields. This is because a stronger dollar represents a tightening of monetary conditions, so that all else equal, a stronger dollar means we should expect fewer Fed rate hikes. The current fair value reading from this 2-factor model is 2.26%, meaning that the 10-year Treasury yield at 2.49% appears somewhat cheap (Chart 3). The second version of our Global PMI model is a 3-factor model which adds the Global Economic Policy Uncertainty Index (EPUI) as a third independent variable. All else equal, an increase in uncertainty about the economic outlook should depress the term premium in long-dated Treasury yields. The data appear to back-up this assertion, as the EPUI is negatively correlated with the 10-year Treasury yield over time. With the addition of the EPUI, our 3-factor model explains 84% of the variation in the 10-year Treasury yield since 2010, compared to 80% from our 2-factor model. The EPUI spiked last month, and as such, this version of the model suggests that fair value for the 10-year Treasury yield is only 1.82% (Chart 4). Chart 32-Factor Global PMI Model Chart 43-Factor Global PMI Model There are probably good reasons to overlook last month's spike in policy uncertainty. For one, the EPUI, created by Baker, Bloom and Davis,2 is largely constructed from algorithms that scan newspaper articles for keywords. They do not attempt to distinguish between economic news with bond-bearish or bond-bullish implications. Second, we have found that large spikes in uncertainty that do not coincide with deterioration in economic growth tend to mean-revert fairly quickly. This past summer's Brexit vote being a prime example. As a counterpoint, however, the negative correlation between the EPUI and the 10-year Treasury yield is quite robust (Chart 5), and historically, incidents of spiking policy uncertainty and rising Treasury yields have been few and far between. Since 1991, there have been 42 instances when the monthly increase in the EPUI exceeded one standard deviation. In those 42 months, the 10-year Treasury yield increased only 36% of the time, with last month's 53 basis point rise being by far the largest on record. We tend to view the reading from the 2-factor model as the more reasonable assessment of fair value in the current environment. But the spike in policy uncertainty does underscore why we should view the recent bond selloff skeptically. The recent selloff has, to a large extent, been predicated upon promises of fiscal stimulus that have yet to be delivered, from a President-elect who has shown himself to be highly unpredictable. In this environment, near-term caution is clearly warranted. Of course, this week the market's focus will at least temporarily turn away from fiscal policy and toward the Fed. We expect that the Fed will announce a 25 basis point increase in the fed funds rate tomorrow, but also that participants' interest rate projections will not change meaningfully. The FOMC will likely be much slower to react to promises of fiscal stimulus than the market. With the Fed's projected near-term path for interest rates already mostly discounted by the market (Chart 6), we could see a "dovish hike" from the Fed tomorrow coinciding with the near-term top in Treasury yields. Chart 5Economic Policy Uncertainty & Treasury Yields Chart 6A "Dovish Hike" Is In The Price Bottom Line: An easing of financial conditions is likely necessary for recent improvements in U.S. economic growth to continue. As such, the uptrend in Treasury yields will pause in the near-term before resuming early next year. A More Favorable Environment For Credit We frequently point to three main indicators that we use to assess the current stage of the credit cycle: Our Corporate Health Monitor (CHM) Monetary conditions relative to equilibrium C&I bank lending standards In a report3 published earlier this year we found that the performance of bank stocks relative to the overall market is another useful indicator (Chart 7). While the credit cycle is still very much in its late stages, recently, our indicators have been sending marginally more positive signals. The CHM remains deep in 'deteriorating health' territory and non-financial corporate balance sheets continue to lever-up aggressively. However, the indicator did inch slightly closer to 'improving health' territory in the third quarter due to an improvement in all six of its components (Chart 8). Make no mistake, trends in corporate balance sheet leverage are not supportive for corporate spreads. In fact, as we will explore in a future report, the recent divergence between rising leverage and tightening spreads is nearly unprecedented during the past 40 years. But at the margin, recent trends are less worrisome. Chart 7Credit Cycle Indicators Chart 8Corporate Health Monitor Components Box1: Corporate Health Monitor Components The BCA Corporate Health Monitor is a normalized composite of six financial ratios, calculated for the non-financial corporate sector as a whole. These six ratios are defined as follows: Profit Margins: After-tax cash flow as a percent of corporate sales Return on Capital: After-tax earnings plus interest expense, as a percent of capital stock Debt Coverage: After-tax cash flow less capital expenditures, as a percent of all interest bearing debt Interest Coverage: EBITDA (Earnings before interest, taxes, depreciation & amortization) divided by the sum of interest expense and dividends Leverage: Total debt as a percent of market value of equity Liquidity: Working Capital, excluding inventories, as a percent of market value of assets Second, although monetary conditions appear very close to our estimate of equilibrium, the recent steepening of the yield curve suggests that the market is revising its estimate of monetary equilibrium higher, leading to a de-facto easing of monetary conditions. In the long-run, with the Fed in the midst of a hiking cycle, this sort of easing is unlikely to persist. But, as we argued in a recent report,4 the bear steepening curve environment could continue in the first half of next year as the Fed is slow to respond to an improving economy. Third, C&I bank lending standards have fallen back to unchanged after having tightened for four consecutive quarters. This likely reflects less stress in the energy sector now that oil prices have rebounded. Fourth, bank stocks have rallied strongly alongside the steepening yield curve. To the extent that higher bank stock prices reflect lower future commercial loan delinquencies, then this trend should be viewed positively from the perspective of credit investors. To test the idea that bank stock performance might help us trade the corporate bond market, we take a look at the past six credit cycles, going back to 1975 (Chart 9). The bottom panel of Chart 9 shows the percent drawdown in relative bank equity performance from its peak during the most recent credit cycle. We define credit cycles as the periods between when the CHM crosses into 'improving health' territory. For example, we define the most recent credit cycle as beginning when the CHM fell into 'improving health' territory in 2002 and ending when it fell into 'improving health' territory in 2009. Shaded regions in Chart 9 show periods when the CHM is in 'deteriorating health' territory. Chart 9Bank Equity Drawdown & Corporate Bond Performance If we construct a trading strategy using the CHM alone, we can get fairly good results. We find that investment grade corporate bonds underperform duration-equivalent Treasury securities in 3 out of 6 instances, over a 12-month investment horizon, following the time when the CHM first crosses into deteriorating health territory, for an average excess return of -1.2% (Table 1). Table 1Corporate Bond Trading Rules: 12-Month Investment Horizon However, we find that this result can be improved if we also incorporate bank stock price performance. If we were to only reduce corporate bond exposure when the CHM was in deteriorating health territory and after the drawdown in bank equities exceeded 20%, then the position is still profitable in 3 out of 6 instances, but for a more negative average return of -1.9%. Further, if we were to wait for the drawdown in bank equities to surpass 30%, then the hit rate on our position improves to 3 out of 5 and the average return falls to -4.6%. We find similar results if we use a 6-month investment horizon (Table 2). In the current cycle, the drawdown in bank stocks breached 25% in February but has since reversed course, and it has not yet reached the 30% threshold. Our analysis suggests that corporate bond underperformance tends to persist for some time even after the drawdown in bank stocks exceeds 30%. Table 2Corporate Bond Trading Rules: 6-Month Investment Horizon Chart 10Corporate Spreads Are Too Low Bottom Line: The macro back-drop is turning marginally more positive for corporate spreads. We remain neutral (3 out of 5) on investment grade and underweight (2 out of 5) on high-yield for now, due to poor starting valuation (Chart 10). But we are looking for an opportunity to upgrade from more attractive spread levels in the next couple of months. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Portfolio Allocation Summary, "Too Far Too Fast, But The Bond Bear Is Still Intact", dated December 6, 2016, available at usbs.bcaresearch.com 2 For further details on the construction of this index please see www.policyuncertainty.com 3 Please see U.S. Bond Strategy Weekly Report, "Lighten Up On Duration", dated February 16, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Investors' justification for owning stocks has shifted from TINA - There Is No Alternative, to LISA - Let's Invest Somewhere, Anywhere. Long-term earnings expectations have broken out, suggesting that investors have greatly improved confidence about the health and longevity of the business cycle. Economic conditions are improving, but equity prices have overshot. The recent tightening in monetary conditions means that a payback period is ahead. OPEC has put a floor under oil prices; we expect WTI oil prices to average $55/bbl in 2017. Feature Equity market behavior since early November has been both incredible and incredulous. Instead of dropping spectacularly, as most pundits forecast ahead of a Trump win, the S&P 500 has gained 5.2% since November 8. The rally has occurred on the back of a modest improvement in recent economic data, and a lot on the back of hope. As we outlined in our November 21 report,1 there are as many market-negative proposals in Trump's plans as there are equity market-friendly ones. Indeed, it is incredulous that prices have rallied on so little good news. Not only have prices rallied, but there appears to be a fundamental shift in investors' expectations about long-term earnings prospects. Chart 1 shows five-year earnings for S&P 500 companies. Expectations have broken out of the low range that has reigned since the beginning of the Great Recession. It appears that investors' justification for owning stocks has shifted from TINA (There Is No Alternative) to LISA (Let's Invest Somewhere, Anywhere). Chart 1Sudden Optimism In The Long-Term Outlook! From 2010 until last year when the Fed started raising interest rates, "There Is No Alternative," or TINA, was the adage that best described the behavior of investors in a ZIRP/QE world, where cash earned nothing and there was a shortage of risk-free bonds. As central banks across the globe initiated quantitative easing by buying the safest assets and compressing their yields, investors were forced further out on the risk spectrum. This portfolio balance effect from QE first bid up non-Treasury fixed income products and then spilled over to fixed income equity proxies, such as REITs and higher dividend stocks. For instance, the S&P Dividend Aristocrats index, an aggregate of stable dividend-growing stocks, historically only ever outperformed the S&P 500 in recessions, when investors prefer to hide in relatively high-quality companies that consistently grow their dividends (Chart 2). But during this cycle, Dividend Aristocrats have handily outperformed the S&P 500 each year since 2009, as the index was an important TINA beneficiary. Now that the Fed is finally finding its groove in a new rate cycle (please see the section on page 5), cash is no longer earning zero (albeit it is still not particularly appealing), and Treasury yields are finally comfortably off their multi-decade lows. In other words, investors are beginning to once again have alternatives. Does this mean that investors are giving up on TINA? We think so, but what comes next is difficult to gauge. We have long argued that ending the dance with TINA would require one of two scenarios: 1) A drastic economic shock such as a recession that sends investors into cash and other safe havens, or 2) A significant change in the price of bonds that makes dividend yielding equities less attractive. The former is very unlikely given that a non-inflationary backdrop means that the Fed will not need to raise interest rates at a pace that will meaningfully impact growth. The second scenario is now underway, although the sustainability and magnitude of this trend is unclear. As we highlighted last week, bond yields have shot to undervalued territory, based on our indicators and assumptions about growth over the next year. True, it is encouraging that economic indicators have perked up in recent weeks. In particular, it is positive that there has been a noticeable uptick in consumer confidence over the past couple of months, particularly as job security is improving. Chart 3 summarizes a wide range of economic indicators that are showing recent strength: Global LEI, core PCE inflation, and the Global Manufacturing PMI are among those that have increased. Still, as the chart highlights, these improvements remain subdued and in some cases, recent data points have been too choppy to give a reliable signal. The ISM manufacturing survey is a case in point. Meanwhile, the ISM non-manufacturing survey headline index has jumped higher, as did the employment index. However, the forward-looking component, new orders, dropped. Chart 2TINA Pushed Investors##br## Into Yield Chart 3Momentum Strong Enough ##br##To Bid Up Equity Prices? This economic performance is at odds with the investor optimism captured in Chart 1: there is considerable discrepancy between market expectations and economic data. Granted, financial markets tend to be forward-looking, but the current message is that investors have drastically changed their view about the trajectory of growth and earnings. We do expect economic growth to improve in 2017, as consumers begin to spend more of their wage gains than over the past five years. But the headwinds to profit growth, notably a weak pricing backdrop, and a strong currency are still in place. We believe that market moves and investor sentiment has moved too far, too fast. This swing to optimism appears to be ushered in by LISA, Let's Invest Somewhere, Anywhere. With LISA, investors have traded in their forced justifications (i.e. the lack of alternatives) for unfounded ones (drastically improved long-term earnings outlook). In this environment, the likelihood of profit disappointments runs high. For now, LISA's disregard for fundamentals can prop up equity prices, but with monetary conditions tightening via a simultaneous rise in the dollar and bond yields, investor optimism is likely to be curtailed. Indeed, if bond investors begin to forecast the same rosy growth scenario as equity investors, then there is a danger that an overly aggressive re-pricing of the Fed rate path transpires (Chart 4). This after years of bond market expectations remaining lower than the Fed's dot-plot projections. Chart 4Bond Market Risk: From Underpricing To Overpricing The Fed? Fed Preview Bond market expectations for a rate hike on Wednesday are nearing 100%, which is consistent with our expectations. The Fed will raise interest rates and the only uncertainty is the extent of hawkishness in the accompanying FOMC statement and post-meeting press conference. Chart 5Inflation And Stimulus: Canadian Case Study At this point in the economic cycle, the pace of future rate hikes will depend much more on the Fed's outlook for inflation than for the labor market. As we wrote in a Special Report on November 28,2 the labor market is likely now nearing full employment, i.e. is tight enough to create modest upward pressure on wages. In other words, the Fed's objective of full employment has been - or is at least very close to - being met. Nonetheless, we are not worried about an imminent aggressive turn higher in inflation. True, if our economic forecast for next year pans out, then growth will run somewhat hotter than underlying trend growth (estimated by the Fed to be at 1.8%). That said, there are several headwinds that will keep inflation contained: The U.S. continues to import deflation from overseas. About one-third of the core PCE basket is core goods and prices continue to deflate. Recall that in the early 2000s business cycle recovery, even with a falling U.S. dollar, goods prices could not escape deflation. Retail prices, which represent about 30% of the total core PCE index, continue to deflate at a faster rate than at any point in the past fifteen years. Bond market inflation expectations have surged on the expected inflationary impact of Trump's political agenda. We concede that aggressive fiscal spending and larger budget deficits have the potential to spur inflation, but this is not yet a foregone conclusion. Investors looking for a roadmap for the impact of fiscal spending may turn to Canada. The Trudeau government was elected in October 2015 on a platform of fiscal spending and middle-income family tax cuts. According to the Bank of Canada this week, "the effects of federal infrastructure spending are not yet evident in the GDP data... business investment and non-energy goods exports continue to disappoint". Fourteen months after the election, inflation is still at 2% (Chart 5). A final point is that multiple statistical models refute the notion that a sustainable breach of the 2% inflation target is imminent. Last month, the Cleveland Fed published a report that showed that 5 out of 6 of the top Fed inflation models assign a less than 50% probability to inflation's being 2% or higher over the next three years!3 Our takeaway from their research is a reminder that even once the output gap closes, it can take a long time for inflation pressures to build and for inflation expectations to move higher. The bottom line is that it is too early to expect a shift in the message from the Fed. After the December rate hike, the Fed will maintain its policy of responding to incoming data. We expect minimal revisions to the Fed's economic and inflation forecasts and therefore to their expected rate path. An Update On Oil Two weeks ago, OPEC members agreed to cut 1.2 million barrels of its daily oil output, starting in January. After the initial knee-jerk reaction to a potentially tighter oil market next year (oil prices jumped 10%), prices have started to reverse. Doubts about OPEC's ability to stick to the quota are beginning to set in. According to a Reuters poll,4 most analysts expect cheating, and have doubts about whether quota cuts will be enough to rebalance markets. Our commodity strategists believe that OPEC will by and large respect the new quotas, primarily because both Russia and Saudi Arabia need higher prices. Both countries have consumed considerable foreign reserves to fund government expenditures following the price collapse. BCA estimates that Saudi Arabia will have burned through $220 billion in reserves between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, equivalent to 30% of foreign reserves. Russia will have drawn down its official reserves by $77 billion over the same period, or 16% of its total holdings. Our commodity team expects to see evidence of the cuts begin to show up in February-March, in the form of falling commercial inventory levels. Even if actual cuts only amount to 60-70% of the volumes agreed at OPEC's November 30 meeting, OECD storage levels - combined commercial inventories of both crude oil and refined products - could fall by 10%, i.e. to about 2.75 billion barrels by the end of 2017Q3. This would put stocks roughly at their five-year average levels, the stated goal of OPEC, and its reason for negotiating the production cut (Chart 6). Chart 6Oil Inventories Normalizing Chart 7OPEC Putting A Floor At /bbl For WTI In sum, we believe that the OPEC agreement will at the very least put a floor under oil prices at around $45/bbl for WTI (Chart 7). We expect prices to average at $55/bbl in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com David Boucher, Editor/Strategist U.S. Investment Strategy davidb@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten," dated November 21, 2016, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com. 3 "The Likelihood of 2 Percent Inflation in the Next Three Years," Federal Reserve Bank Of Cleveland, November 29, 2016. 4 Please see "OPEC expected to deliver only half of target production cut: Kemp," published online by reuters.com on December 6, 2016. OPEC has invited Russia, Colombia, Congo, Egypt, Kazakhstan, Mexico, Oman, Trinidad and Tobago, Turkmenistan, Uzbekistan, Bolivia, Azerbaijan, Bahrain and Brunei to meet in Vienna Dec. 10, according to Reuters.

Highlights Investors are understating the risks that the Trump administration will enact protectionist trade policies. Contrary to popular belief, the economic costs to the U.S. of a protracted "trade war" would be low. The geopolitical impact, however, would be much more sizeable, as would the impact on S&P 500 profits. The near-term risks to global equities are on the downside, although firmer growth in developed economies should provide support to stocks over a 12-month horizon. Global bond yields will be higher this time next year, as will the dollar. The yen is especially vulnerable. We are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. Feature They come over here, they sell their cars, their VCRs. They knock the hell out of our companies. - Donald Trump in an interview with Oprah Winfrey discussing trade with Japan, 1988 Making Tariffs Great Again Donald Trump has flip-flopped on many issues. On trade, however, he has been perfectly consistent. As the quote above demonstrates, Trump has been advocating mercantilist policies ever since he entered the public spotlight in the 1980s. Even in the unlikely event that he wanted to pivot on this issue, he would be hard-pressed to do so. The Republican establishment and most Democrats will hate him no matter what he does. If Trump backpedals from his hardline stance on trade and immigration, he will lose a large chunk of his white, working-class base (Chart 1). One might argue that Trump would have no choice but to adopt a more conciliatory tone if the imposition of protectionist trade policies were to push the U.S. into a recession. However, contrary to widespread opinion, it is far from obvious that this would happen. While rising protectionism would have a major negative effect on many other economies, the impact on the U.S. would be modest, even if other countries were to match higher U.S. tariffs with retaliatory measures. Keep in mind that the U.S. is a relatively closed economy, with exports totaling only 12% of GDP. Exports to China and Mexico amount to 0.9% and 1.4% of GDP, respectively. And much of these exports are intermediate goods that are processed and reshipped back to the U.S. or some other third market. It would not make sense for China or Mexico to put up import barriers on these intermediate goods because this would just reduce domestic employment, without giving domestic firms much of a leg up. One should also remember that an appreciation of the dollar reduces U.S. export competitiveness in much the same way as higher tariffs placed by foreign governments on U.S.-made goods. The real trade-weighted dollar has appreciated by 20% since mid-2014 (Chart 2). While this obviously has been unpleasant for U.S. exporters, it has not pushed the economy into recession. Neither will retaliatory foreign tariffs. Chart 1Trump's Supporters Are Not ##br##Free Trade Enthusiasts Chart 2The Dollar Has Been ##br##Appreciating Since Mid-2014 Why The Consensus On Trade Is Misleading The view expressed above is far outside the consensus and clashes strongly with the large number of studies arguing that the implementation of Trump's trade agenda would have grave consequences for the U.S. economy. Let me first enumerate the ways these studies fall short on strictly economic grounds, and then discuss why they may still ring true if one takes a broader perspective. As far as the pure economics are concerned, these studies all suffer from some combination of the following deficiencies: They assume that foreign producers can fully or almost fully pass on the cost of U.S. tariffs to their customers. In reality, the evidence suggests that foreign producers will absorb about half of the increase in tariffs through lower profit margins. In other words, the imposition of a 20% tariff would only raise U.S. import prices by around 10%. Granted, retaliatory tariffs would squeeze the profit margins of U.S. exporters. However, this effect would be mitigated by the fact that the U.S. runs large bilateral trade deficits with China and Mexico (Chart 3), as well as the fact that foreign producers have less pricing power in the relatively large U.S. market than American producers have abroad. On net, this implies that higher trade barriers could actually make the U.S. better off by shifting the terms of trade in its favor. Chart 3The U.S. Runs Large Bilateral Trade Deficits With China And Mexico These studies treat tariffs like regular old taxes. To the extent that tariffs are taxes whose burden is partly borne by domestic consumers, their imposition has a dampening effect on activity. However, to model the impact of higher tariffs simply as a tightening of fiscal policy implicitly assumes that any tariff revenue will be used to pay down debt, rather than being used to finance tax cuts and spending increases. Given that Trump is touting a program of fiscal stimulus, that is not a sensible assumption. Moreover, unlike, say, a sales tax hike, higher tariffs divert demand towards domestically-produced goods. This tends to boost employment. These studies overstate the adverse effect of tariffs on domestic investment. More than half of global trade consists of capital equipment and intermediate goods (Chart 4). To the extent that higher tariffs raise the cost of production, this can lower investment. Moreover, trade barriers tend to increase economic inefficiencies. This can lead to slower productivity growth, causing firms to reduce capital spending. In practice, however, neither effect is particularly significant. As we discussed two weeks ago, the negative impact of trade barriers on productivity growth is generally overstated, especially for large economies like the United States.1 Chart 5 shows that productivity growth was actually faster in the three decades following the Second World War than in the hyper-globalization era that began in the early 1980s. Chart 4Intermediate And Capital Goods ##br##Make Up Over Half Of Global Trade Chart 5Rising Trade Has Not ##br##Boosted Productivity Growth While the price of capital goods does influence investment spending, for the most part, firms tend to base their investment decisions on the expected demand for their products. Since the U.S. runs a trade deficit, an equal percentage-point decline in both exports and imports would increase final demand through the familiar Y=C+I+G+X-M identity. This should lead to higher investment. Moreover, even if higher trade barriers leave final demand unaffected, there are reasons to think that investment would still rise. Think about a closed economy where most households decide all of a sudden that they prefer strawberry ice cream over vanilla ice cream. Let us assume, just for the sake of argument, that shifting production from vanilla to strawberry ice cream is very difficult and requires a lot of new investment. What do you expect would happen to overall investment in this economy? The answer is that it would likely rise, as companies scramble to build out new strawberry ice cream-making capacity. Now extend the analogy to trade. If the U.S. slaps tariffs on manufacturing imports, this will lead to a wave of new domestic investment in industries that benefit from tariff protection. This is bad news for companies that must incur the cost of relocating production back onshore, but it is good news for American workers who can now find gainful employment. The Bigger Picture Our guess is that in purely economic terms, the U.S. would not suffer much if the Trump administration were to forge ahead with its protectionist trade agenda, and could actually benefit if America's trading partners felt restrained in how they could retaliate. Yet, focusing only on the economics misses the bigger picture. Trade agreements are also about politics - they help form the geopolitical glue that holds the global community together. As we noted two weeks ago, the real reason the 1930 Smoot-Hawley Tariff Act was so disastrous was not because it contributed to the Great Depression, but because it led to a breakdown of international relations among democratic governments at a time when fascism was on the rise.2 Donald Trump's threat to pull out of trade deals and unilaterally impose tariffs on countries that he feels are engaging in unfair trade practices is likely to accelerate the shift to a multipolar geopolitical order where competing countries strive to carve out their own spheres of influence. As Chart 6 shows, such geopolitical orders have often contributed to the breakdown of globalization, and at times, have even led to military conflict. Chart 6AIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand Chart 6BIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand The fact that rising protectionism could benefit the U.S. at the expense of other countries is bound to stoke anger abroad. China, the focus of much of Trump's rhetoric, is especially vulnerable. Trump has threatened to declare the country a "currency manipulator," even though it meets only one of the three criteria for such a designation as set out by the Treasury Department.3 Other countries should not breathe a sigh of relief, however. There is a certain logic about protectionism that makes it difficult to hike tariffs on just one or two countries. For example, if the U.S. raises tariffs on China, some of the existing demand for Chinese goods will be diverted to countries such as Korea or Vietnam, rather than back to the U.S. This creates an incentive to raise tariffs on those countries as well. It is easy to see how the whole global trading system can break down under such circumstances. Investment Conclusions Donald Trump's threat of across-the-border tariffs of 35% on Mexican goods and 45% on Chinese goods will likely turn out to be a negotiating ploy. That said, some increase in trade barriers seems inevitable. These need not even be explicit barriers. Trump's success in browbeating Carrier into keeping its plant open in Indiana is an example of things to come. Corporate America does a lot of business with the government, and the subtle threat of cancelled government contracts will make any CEO take notice. Good news for Main Street perhaps, but definitely bad news for Wall Street. For now, investors are focusing on the positive elements of Trump's agenda. That may change soon. Yes, increased infrastructure spending and corporate tax cuts are both bullish for stocks. However, effective U.S. corporate tax rates are already quite low thanks to numerous loopholes. Thus, any cuts to statutory rates may not boost S&P 500 profits by as much as investors are hoping (Chart 7). And while more infrastructure investment is welcome, there simply are not enough "shovel ready" projects around. Chart 7U.S. Effective Corporate Tax Rate Is Already Quite Low Moreover, Trump's plan to finance infrastructure spending through private-public partnerships greatly narrows the universe of possible projects. The U.S. Society Of Civil Engineers estimates that most of the "infrastructure gap" consists of deferred maintenance (i.e., potholes to fix, bridges to repair).4 It is difficult to get investors interested in such work, which is why it is typically financed directly through government budgets. Meanwhile, financial conditions have tightened via a stronger dollar and higher bond yields (Chart 8). Historically, such a tightening has been bearish for stocks (Table 1). We are tactically cautious on a three-month horizon, and are positioned for this by being short the NASDAQ 100 futures. Our guess is that global equities will correct by about 5%-to-10% from current levels, setting the stage for positive returns down the road. U.S. high-yield spreads, which are near post-crisis lows, are also likely to widen (Chart 9). Chart 8U.S. Financial Conditions Have Eased Chart 9U.S. High-Yield Spreads Likely To Widen Table 1Stocks Tend To Suffer When Bond Yields Spike A correction in risk assets could temporarily knock down Treasury yields. Nevertheless, the long-term path for global bond yields is to the upside. The three key features of Trump's platform - fiscal stimulus, tighter immigration controls, and trade protectionism - are all inflationary. Only JGB yields are likely to stay put for the foreseeable future due to the BOJ's well-timed decision to peg the 10-year yield at zero. As bond yields elsewhere rise, the yen will come under further downward pressure. We see USD/JPY reaching 125 in 12 months' time. Chart 10Global Growth Is Accelerating A weaker yen should boost Japanese stocks, at least in local-currency terms. European equities will also benefit from a somewhat cheaper euro and firming global growth (Chart 10). Steeper yield curves are helping to boost European bank shares, despite ongoing concerns about the health of the Italian financial sector. As we have discussed in the past, systemic risks around the Italian banks are overstated.5 With that in mind, we are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. The recent rally in commodity markets and the uptick in global activity indicators are welcome developments for emerging markets. Still, it will be hard for EM equities to muster a sustainable rally as long as the dollar remains in an uptrend and protectionist sentiment is on the rise. For now, a modest underweight in EM stocks is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1,2 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 3 The U.S. Treasury is allowed to define a country as a currency manipulator if: i) it runs a large trade surplus with the U.S.; ii) it has an excessively large current account surplus with the rest of the world; and iii) it is engaging in direct foreign exchange intervention in order to weaken its currency. While the first criterion arguably holds, the other two do not, given that China's overall current account surplus currently stands at 2.4% of GDP and recent currency intervention has been designed to prevent the yuan from depreciating more than it would have otherwise. 4 Please see "Failure to Act: Closing the Infrastructure Investment Gap for America's Economic Future," American Society of Civil Engineers (2016). 5 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

特別レポート

Highlights The brief history of our model portfolios is a tale of two regions: our global portfolios are beating their benchmarks by an aggregate 350 basis points ("bps"), while our U.S. portfolios lag by 55 bps. Defensive sector tilts weighed on all four portfolios, but market-cap tilts gave the U.S. portfolios a big boost, and currency-hedged country and fixed-income positions turbocharged global portfolio performance. We expect to see bond yields, the dollar and DM equity prices higher at year-end 2017 and our portfolio positioning will continue to reflect these broad themes. True inflection points are few and far between, but the U.S. will at least experience a sugar rush, and we are adding some credit risk while walking back some of our defensive equity positioning to prepare for it. Table 1Summary Portfolio Performance Feature This report presents the first review of our model portfolios, which have now been live for seven weeks. Going forward, we will review them in our first publication of every month. The reviews will have two components: an ex-post examination of portfolio performance and an ex-ante discussion of our outlook. Both components are meant to foster transparency, with the ex-post component opening a window on our ongoing efforts to improve our process, and the ex-ante component shining a light on how our views are evolving in real time. Results To Date Our model portfolios have outperformed, on balance, over their first two months, but the aggregate results cover over a fault line between U.S. and global portfolio performance. The U.S. Long-Only portfolio is just even with its benchmark and the Long/Short lags by 55 bps, (Table 1). The disparity highlights the way dollar moves can create international opportunities. Being on the right side of the greenback helped us generate alpha despite dreadful sector positioning. Portfolio Performance Attribution We track portfolio attribution on up to six applicable dimensions. For all the portfolios, we consider Asset Allocation, Equity Sector Allocation and Fixed Income Category Allocation. If the Equity portion of the portfolios has any mid- or small-cap exposures, we track Market Cap Allocation; if it has multi-country exposures, we track Country Allocation; and if it has short positions, we track Long/Short Allocation based on the contribution from its long/short pairs. Since all of the portfolios were initially set to match our benchmark asset allocations (60% Equity/37.5% Fixed Income/2.5% Cash), we have no Asset Allocation attribution to report in this update (Table 2). Table 2Applicable Attribution Sources U.S. Long-Only Our U.S. Long-Only portfolio (Table 3) outperformed its benchmark by 1 basis point through November 30.1 Market cap allocation paved the way to the outperformance, as small- and mid-cap stocks zoomed higher following the election (Table 4). Our fixed-income category allocations helped, as well, with the outperformance of our income hybrids bucket and our sizable underweight in lagging investment-grade corporates more than making up for our zero weight in outperforming high yield (Table 5, bottom panel). The gains were consumed by equity sector underperformance, which labored mightily under an inopportune defensive bias (Table 5, top panel). Table 3U.S. Long-Only Model Portfolio: Absolute Performance By Position Table 4U.S. Relative Performance Contribution From Market-Cap PositioningTable 5U.S. Relative Performance Contribution From Sector Positioning U.S. Long/Short Our U.S. Long/Short portfolio (Table 6) underperformed its benchmark by 55 basis points through November 30.2 Larger defensive sector tilts weighed on the long/short portfolio relative to its long-only counterpart, compounded by short positions in cyclical sectors (Table 7, bottom panel). Our fixed-income pairs fared better: while the HYG short/LQD long detracted from performance, the IEF short/TIP long was able to offset it (Table 7, top panel). The former, an anti-credit risk (and duration-extending) play, was poorly positioned on both counts, but the latter was well positioned to reap the benefit of the pickup in inflation expectations. Table 6U.S. Long/Short Model Portfolio: Absolute Performance By Position Table 7U.S. Relative Performance Contribution From Long/Short Pairs Global Long-Only Our Global Long-Only portfolio (Table 8) outperformed its benchmark by 188 basis points through November 30.3 Successful country positioning contributed to the sizable outperformance, as the (currency-hedged) Japan overweight was a rousing success (Table 9). Fixed-income category allocations were also big winners, driven by the currency-hedged non-U.S. aggregate exposure (BNDX) and the U.S. aggregate (AGG) and corporate holdings (LQD), which more than offset the drag from the unhedged international sovereign exposure (BWX) (Table 10, bottom panel). Only equity sector allocations weighed on the portfolio, as both Staples and Health Care were drubbed by the benchmark index (Table 10, top panel). Table 8Global Long-Only Model Portfolio: Absolute Performance By Position Table 9Global Relative Performance Contribution From Country PositioningTable 10Global Relative Performance Contribution From Sector Positioning Global Long/Short Our Global Long/Short portfolio (Table 11) outperformed its benchmark by 166 basis points through November 30.4 Just like its U.S. counterpart, the global Long/Short portfolio was weighed down by its wrong-footed long defensives/short cyclicals pairs (Table 12). Country long/short pairs paid off nicely, however, especially in November, as emerging markets with sizable current account deficits, like Turkey and Brazil, underperformed their less dollar-vulnerable peers. Our fixed-income long/short pairs also outperformed, albeit by a smaller margin. Table 11Global Long/Short Model Portfolio: Absolute Performance By Position Table 12Global Relative Performance Contribution From Long/Short Pairs How Our Views Fared Rates, Inflation And Credit Markets rewarded two of the four components of our fixed-income view. U.S. inflation expectations surged (Chart 1) and developed-world sovereigns proved to be an especially poor value, as the aggregate G7 economies' 10-year bond yield spiked faster than at any point since the taper tantrum in 2013 (Chart 2). These views, expressed as portfolio tilts - underweight fixed income, own TIPS and hold duration at or below benchmark duration - worked well when translated to portfolio positions, as noted above. Chart 1Inflation Expectations Spiked... Chart 2...And So Did Nominal Yields The bear-flattening call turned out to be a dud, as the Treasury yield curve steepened despite the looming Fed tightening cycle. Overwhelmed by our anti-duration call, though, it had no meaningful portfolio impact. Our credit-bearish call was a central fixed-income pillar in all four of our portfolios, and it did constrain performance as high yield outperformed at home and abroad. Yields may well be due to pull back following their November surge, but we see them ending 2017 higher, making credit's positive carry an attractive buffer against rising rates. Economic Growth And Corporate Earnings Our concerns that the equity rally has become uncomfortably stretched, and that U.S. corporate margins face downward pressure, did not amount to anything over the last two months. Since we maintained benchmark equity weightings across all of our portfolios, however, our too-early views did not affect performance. We expressed our defensives-over-cyclicals view in every portfolio's sector allocations to the detriment of performance across the board. Thanks to currency-hedged Japanese equities' surge, the global portfolios benefitted slightly from our view that European and Japanese multinationals would find the going easier than their U.S. counterparts, and we remain optimistic about the potential for a relative European profit inflection. New And Revised Views Rates, Inflation And Credit There are still too many unknowns about the details of policy proposals to assess whether or not the U.S. is on the cusp of sustained growth acceleration, but the incoming administration, supported by a compliant Congress, can unquestionably bestow a sugar rush. The credit upshot is that it will be harder to default if both growth and inflation get a fillip in 2017. The curve is likely to steepen on the grounds that our bond strategists expect the Fed to allow inflation expectations to gather momentum before it signals an increased pace of hikes and a higher terminal rate. The bond vigilantes could add to the upward pressure on long rates if they ever stir from their long hibernation. It would be entirely reasonable for yields to retrace at least a portion of their sudden and sizable move, and our U.S. Bond Strategy service has moved to benchmark duration to position for near-term consolidation. It still sees long rates higher a year from now, though, and we are not going to wait to add some carry to the portfolio. We are replacing our U.S. REIT exposure with business development company exposure via the BIZD ETF, which will add some beta along with credit exposure. We are going to add bank loans in the form of the BKLN ETF, providing some rate protection (bank loans carry floating rates) and allowing us to dip our toe into the most senior tranche of the high-yield space. BKLN will push our Treasuries exposure to below benchmark,5 but we will maintain Treasury duration near benchmark in line with our bond strategists' tactical guidance. We will look to exit our TLT position on a 10-year rally back to the 2-2.2% range. Chart 3Pigs Get Slaughtered Cyclicals Versus Defensives The uncertainty around the impact of the incoming administration's proposed policies keeps us from fully reversing course on our cyclicals/defensives positioning. But our conviction about higher rates increases our remorse at overstaying our welcome in Staples and Telcos (Chart 3). As an analogue to positioning for near-term economic acceleration by taking on some credit risk, we're shifting capital away from rate-driven Staples and Telecom to Discretionaries and Energy. Our exit from Swiss equities in the global portfolios furthers our move to more neutral intra-equity settings. We are adding Energy exposure to all of the portfolios to reflect our strategists' bullish take on crude oil. The recently agreed OPEC-Russia production cuts will fuel inventory drawdowns that will keep crude prices from falling below $50. Our Energy Sector Strategy service argues that U.S. shale producers will reap the greatest benefits, as $50+ crude will allow them to accelerate oilfield reinvestment and grow production in 2017. We are therefore adding FRAK, an ETF dominated by U.S. shale oil and natural gas producers, to our U.S. portfolios.6 Other Portfolio Changes Aside from dialing back our defensive equity positioning and embracing some credit risk, our biggest change has been to pull in our horns on the sector tilts across all of our portfolios. We are chastened by being off-sides with our sector calls and are pulling back until we have a better sense of direction. We are waiting in all portfolios for an opportune time to shorten duration. We expect to maintain our sizable income hybrids sleeve as the nascent bond bear market grinds along. Table 13 shows our revised U.S. Long-Only portfolio. As mentioned above, it no longer shuns cyclical sector or credit exposures and will continue to evolve with the anticipated direction of the economy. We have chosen not to rebalance our mid- and small-cap exposures and we would be happy to increase them if they retrace some of their relative gains in the near term. The U.S. Long/Short portfolio (Table 14) is effectively an amplified version of the Long-Only portfolio but its sector tilts are being trimmed considerably as well. Table 13Revised U.S. Long-Only Model Portfolio Table 14Revised U.S. Long/Short Model Portfolio The changes to our Global Long-Only portfolio mute its defensive bias and attempt to simplify it by removing standalone currency-hedging positions (Table 15). We substitute HEWU, the currency-hedged version of EWU, for our existing EWU/FXB pair, giving up some liquidity to save on ETF and borrow fees. We clean up the other currency short by exiting our Swiss equity position, which is no longer needed now that we are dialing back the portfolio's defensive cast. We exit BWX and reallocate its proceeds to BNDX and AGG to simplify the portfolio and remove incremental sovereign and currency exposure. We replace LQD with JNK to introduce a modest high-yield exposure to the portfolio. Table 15Revised Global Long-Only Model Portfolio Like its U.S. counterpart, our Global Long/Short portfolio is significantly dialing back its sector tilts (Table 16). The Staples, Telco and Utilities overweights are being eliminated, along with the Financials short. The Health Care overweight and the corresponding Industrials and Tech shorts have been reduced. As in the Long-Only portfolio, we are exiting Switzerland and redeploying the proceeds in Energy, Discretionaries and a slightly reduced U.S. underweight. We are replacing the incremental exposure to U.S. Investment Grade (LQD) with High Yield (JNK), reflecting our U.S. rates and credit view. With the addition of JNK, we are taking the opportunity to do a little housecleaning by replacing the U.S. leg of our EM junk spread-widening pair, formerly HYG, with JNK, which better aligns with our portfolio benchmark and is 10 bps cheaper per annum. Table 16Revised Global Long/Short Model Portfolio Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 Through December 5th, the U.S. Long-Only portfolio is in line with its benchmark. 2 Through December 5th, the U.S. Long/Short portfolio has underperformed by 65 basis points. 3 Through December 5th, the Global Long-Only portfolio has outperformed by 184 basis points. 4 Through December 5th, the Global Long/Short portfolio has outperformed by 160 basis points. 5 In our October 12th Special Report introducing the model portfolios, we referred to outdated Aggregate/High Yield proportions in our U.S. and global fixed income benchmarks. Based on the outstanding value of the bonds in the indexes, the correct U.S. breakdown is 90/10 AGG/HY and the correct global breakdown is 93/7 AGG/HY, not 95/5 as originally stated. Our performance attribution calculations reflect the correct benchmarks. 6 For more information on the shale producers and the effects of the OPEC cuts, please see the following Energy Sector Strategy reports, available at nrg.bcaresearch.com: Constructive On U.S. Shale Producers And Select Service Companies, published July 6, 2016; The OPEC Debate, published November 23, 2016; and Recommendation Additions & Changes Following OPEC's Cut, published December 7, 2016.

Highlights ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment Chart I-3Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... Chart I-7...Italy May Ultimately##br## Do The Same The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Global Duration: Global bond yields, pushed higher since July on the back of improving global growth and rising inflation, have now overshot to the upside on excessive expectations of U.S. fiscal stimulus. Take profits on bearish bond positions and increase portfolio duration exposure to at-benchmark on a tactical basis until the oversold conditions unwind. 2017 Global Yield Curve Expectations: The recent steepening of government bond yield curves across the developed markets should soon begin to fade, leading to a more diverse evolution of curves during the course of 2017: steeper in the U.S., core Europe and in Japan (at the long end), flatter in the U.K., Canada, Australia and New Zealand. U.K. Inflation Protection: Take profits on our recommended U.K. inflation trades (overweight inflation-linked bonds and CPI swaps), in response to the recent stability of the Pound and signs that the Bank of England is shifting in a more hawkish direction. Feature Time To Tactically Take Profits On Short Duration Positions Investors have been reminded over the past few months that boring old bonds, just like equities, can generate painful losses when prices disconnect from fundamentals. Back on July 19, we moved to a below-benchmark stance on overall portfolio duration, as we noted that government bonds across the developed markets had reached an overbought extreme despite improving trends in global growth and inflation (Chart of the Week).1 Bonds have sold off smartly since, with benchmark 10-year government yields in the U.S., U.K., Germany and Japan rising +88bps, +60bps, +36bps, +27bps respectively. The popular market narrative is that the latest leg of the bond selloff is a direct result of Donald Trump winning the White House. This raised investor awareness to the bond-bearish implications of a protectionist U.S. president looking to provide a fiscal kick to an economy already at full employment. The reality, however, is that global bond yields troughed a full four months before the U.S. elections on the back of a better global growth picture. It is quite possible that the latest bump in yields would have happened even if Trump did not win the election. Rising industrial commodity prices, happening in the face of a strengthening U.S. dollar that typically dampens prices, also suggest that bond yields have been responding more to faster realized growth and inflation and less to future expected fiscal stimulus (Chart 2). Chart of the WeekGlobal Bonds##br## Are Oversold Chart 2Stronger Growth Has ##br## Pushed Yields Higher Looking ahead, if the global economy evolves as we expect, with growth continuing to look relatively robust and inflation continuing to grind higher, then yields have even more upside in 2017. However, bonds now appear deeply oversold amid highly bearish sentiment. U.S. Treasury yields, in particular, have overshot the fair value estimates from our models (Chart 3). Also, this week's ECB meeting is unlikely to provide any bearish surprises for bond investors, as the ECB will likely extend the current QE program (at the current pace of buying) until at least next September. This should act to cap the recent widening of global bond term premia (Chart 4) and prevent a "Fifth Tantrum" from unfolding in global bond markets, as we discussed last week.2 Therefore, we are taking profits today on our bearish bond call and moving back to a tactical at-benchmark portfolio duration stance. However, we still expect yields to rise over the next year to levels beyond current forward rates.3 Thus, we would look to reinstate a below-benchmark duration posture if the 10-year U.S. Treasury yield were to fall to the 2-2.2% range. We will also look for signs of oversold momentum fading and a reduction in short positioning in U.S. Treasuries before re-establishing a below-benchmark duration tilt (Chart 5). The next leg of pressure on global bond yields should come from the U.S., given our optimistic view on U.S. growth and inflation for next year (see below). Chart 3UST Yields Are##br## A Bit Too High Chart 4A Big Adjustment In##br## Term Premia & Expectations Chart 5Taking Profits On##br## Our Bearish Bond Call Bottom Line: Global bond yields, pushed higher since July on the back of improving global growth and rising inflation, have now overshot to the upside on excessive expectations of U.S. fiscal stimulus. Take profits on bearish bond positions and increase portfolio duration exposure to at-benchmark on a tactical basis until the oversold conditions unwind. Some Initial Thoughts On Developed Market Yield Curves In 2017 With only a handful of trading days remaining in 2016, it is time to peer ahead to how markets could perform in the New Year. We will be publishing our full 2017 Outlook report on December 20th, but this week we are presenting some preliminary ideas on how government bond yield curves could evolve over the course of next year. United States - Eventual Bear Steepening In Excess Of The Forwards We see U.S. growth accelerating to a 2.8% pace next year, an above-potential pace that is stronger than current consensus forecasts.4 Combined with a steady grind higher in realized inflation (both headline and core), this will generate a nominal growth outcome over 5% in 2017. This will help push the 10-year U.S. Treasury yield to the 2.8-3.0% area by the end of 2017 as the Fed will likely continue to raise rates but not as fast as nominal growth will accelerate (i.e. will remain accommodative). This move will be led by rising inflation expectations, which we see rising to a level consistent with the Fed's inflation target.5 This will put steepening pressure on the U.S. Treasury curve, at a pace that will easily exceed the flattening currently priced into the forwards (Chart 6, top panel). We see the potential for curve steepening pressure to come both from growth, which will push up longer-dated real yields and steepen the "real" yield curve, and from inflation, with a tight labor market putting upward pressure on wage and price inflation even with a stronger U.S. dollar (Chart 7). Chart 6A Steeper UST Curve,##br## Led By Rising Real Yields Chart 7Will UST Yields Pause##br## After A Rate Hike Next Week? For now, however, we are keeping a "neutral" stance on U.S. yield curve exposure until we see signs that oversold conditions in the Treasury market have corrected. One final point: the Treasury market likely moved too quickly in recent weeks to discount a fiscal ease under the new Trump administration. However, any impetus to growth from the government sector, coming at a time when the U.S. economy is running near full employment, will be another structural factor putting steepening pressure on the yield curve in the next year through more Treasury issuance and stronger inflation pressures. Core Euro Area - Very Modest Steepening In Line With The Forwards As we discussed in a recent Weekly Report, the ECB will most likely continue with its current bond-buying program, with no tapering of the size of the purchases, until at least September 2017.6 European inflation remains too low relative to the ECB's target (Chart 8) and the central bank will be wary about reducing monetary stimulus anytime soon. The overriding presence of ECB buying will act to limit the upside in longer-dated European bond yields, even in an environment where U.S. Treasury yields rise over the course of 2017. The core European government bond yield curves (Germany, France) will likely still see some modest steepening pressure, led by upward pressure on real yields, as global growth continues to improve. Combined with the lagged impact of the weakening Euro and the rise in commodity prices, there should be some mild additional steepening pressure coming from inflation expectations, as well. The forward curves are currently pricing in a very modest steepening over the next year, and we do not see a case for the curve to steepen much beyond the forwards (Chart 9). We continue to favor core Europe as a recommended overweight in our global Developed Market bond allocation. Favoring the longer-end of the curve (10 years and longer) in Germany and France - the higher yielding parts of these low-yielding bond markets - makes the most sense against the backdrop of subdued Euro Area inflation. Chart 8No Threat To Global Bonds##br## From The ECB This Week Chart 9ECB QE Will Limit##br## Any Curve Moves In Europe Japan - Expect Long-End Steepening, Even With Bank Of Japan Curve Targeting The Japanese yield curve is now fairly straightforward to predict, with the Bank of Japan (BoJ) now explicitly targeting the level of JGB yields. The BoJ has committed to keep the 10yr JGB yield at 0% until Japanese inflation expectations overshoot the 2% BoJ target. With inflation expectations currently sitting just above 0%, that goal is now far from being realized. We see very little movement in the 2-10 year part of the JGB curve next year, but we expect the curve beyond 10 years to be more influenced by trends in global bond yields, with the BoJ providing no guidance on the desired level of longer-dated JGB yields. Given our views on a potential bear-steepening of the U.S. Treasury curve in 2017, we expect that the 10/30 JGB curve will also steepen (Chart 10). Focusing Japanese bond exposure on the 10-year point makes the most sense in this environment, although at a yield of 0% the return prospects are hardly inviting. U.K. - Steepening Will Turn To Flattening The Bank of England (BoE) took out a very large insurance policy on the U.K. economy by cutting interest rates and re-starting quantitative easing (QE) after the shocking Brexit vote. This has appeared to work, as U.K. economic growth has been surprisingly strong in the months since the June referendum. But the ramifications of the BoE's aggressive easing was a massive depreciation of the Pound and a subsequent rise in U.K. inflation (Chart 11). Chart 10BoJ Is Not Worrying About##br## The Long End For JGBs Chart 11The Post-Brexit ##br## Adjustment Is Nearly Complete This has set up a situation where the Gilt market is behaving much like the U.S. Treasury market did after the Fed introduced its own QE programs between 2008 & 2012. The result was as rise in nominal bond yields led by rising inflation expectations and stronger economic growth, both of which were a function of a weaker currency. In the case of the U.K. now, the rise in inflation has been strong enough to force the BoE to back off its promise to deliver an additional rate cut before the end of 2016. The BoE will likely not extend the latest QE program beyond the March 2017 expiry, as well. There is even a chance that the BoE could be forced to hike rates sometime in the first half of 2017. Against this backdrop where the BoE has to play a bit of monetary catchup to rising nominal growth, the Gilt curve is likely to see some flattening pressure after the recent steepening. With the forwards pricing in no change in the slope of the curve next year (Chart 12), curve flattening positions that limit exposure to the front-end of the Gilt curve could offer opportunities in 2017 after global bond yields consolidate the recent rise in yields. While we believe it is too early to reposition our Gilt curve allocation this week, we are taking profits on our recommended U.K. inflation protection trades given the recent stability of the Pound and growing evidence that the Bank of England is turning more hawkish (Chart 13). Specifically, we are closing our Overlay Trade favoring index-linked Gilts versus nominals at a profit of +59bps. We also advise closing our "Brexit hedge" trade suggested in June before the referendum, which was a long position in U.K. CPI swaps versus U.S. equivalents. Chart 12Nearing The End Of ##br## Gilt Curve Steepening? Chart 13Take Profit On U.K.##br## Inflation Protection Trades Canada - The Steepening Is Over A modest steepening of the Canadian government bond yield curve in 2017 is currently priced into the forwards. We think even this small move is unlikely to be realized. The short-end of the yield curve should stay well-anchored around current levels. Probabilities extracted from the Canadian Overnight Index Swap (OIS) curve currently show a 4% market-implied chance of a rate cut, and 40% odds of a rate hike, by December 6th 2017. Of the two, the probability of a rate hike looks too high. The Bank of Canada (BoC) has rarely increased policy rates when our BCA Canadian Central Bank Monitor was in "easy money required" territory (Chart 14). More likely, the Bank of Canada will stay on hold throughout 2017 due to a lack of inflationary pressures. The Canadian unemployment rate remains far higher than the full employment level, while a wide gap has developed between the growth rates of core CPI and weekly earnings; low wage inflation usually drags core CPI inflation lower. Already, the Canadian CPI less the most volatile components - one of the core inflation measures monitored by the BoC - has rolled over. In the longer part of the curve, the weakening economic cycle will keep yields well contained. While the rebound in energy prices seen this year is a positive for the beaten-up Alberta economy, even higher prices will be needed for Canadian energy producers to rekindle investments in that sector given the high cost of oil extraction in Western Canada. Without a meaningful recovery in Alberta, the Canadian economy will be unable to expand at an above-trend pace; growth will be slower than the general consensus forecast of 2.0% in 2017.7 To profit from that view, we are opening a new butterfly spread trade on the Canadian curve: going long the 2-year/10-year barbell versus a short position in the 5-year bullet. This trade should generate positive excess returns if the 2-year/10-year slope of the Canadian curve flattens, as we expect (Chart 15). Chart 14Canadian Short Rates##br## To Remain Well-Anchored Chart 15Go Long A Canadian 2/10 ##br## Barbell Vs. The 5yr Bullet Australia - Flattening Phase Ahead A small flattening of the Australian yield curve over the next 12 months is currently priced into the forwards. This expectation seems reasonable to us, but the bulk of the flattening should come from the short end where yields will drift higher over the course of the year. Australian inflation prospects are improving, with the Melbourne Institute Inflation Gauge having stabilized of late. As the negative impact of imported goods price deflation recedes going forward, domestic inflation should rise. In addition, our model is calling for core CPI inflation to grind higher in 2017 (Chart 16). Chart 16Australian Inflation Is Bottoming... Chart 17...Even As Australian Growth Is Starting To Cool Because of this, the Reserve Bank of Australia (RBA) will progressively become less dovish and greater odds of a rate hike will be priced into the yield curve. This is already starting to happen, on the margin; since October, the probability of a rate cut by December 5th, 2017 has decreased substantially, from 65% to 5%. As we have been pointing out over the past several months, the Australian economy has been humming along. China's policy reflation seen earlier in 2016 had a direct positive impact on Australian export demand, while a rising terms of trade fueled by higher base metals prices has provided a boost to domestic income. However, the upward pressure on yields from accelerating domestic growth has become milder of late. Employment growth, motor vehicle sales and aggregate private sector credit growth are now all trending to the downside (Chart 17). This might be an indication that the boom from the first half of this year is starting to dissipate. This tames, to some extent, our optimism over the Australian economy. If economic activity continues to slow modestly, corporate bond supply, i.e. demand for credit and liquidity, should ease. In turn, this should also alleviate the recent upside pressure on the longer part of the Australian government bond yield curve. Chart 18The NZ Curve Will Follow##br## The Forwards In 2017 In sum, on a 3-6 month horizon, the short end of the Aussie curve could edge higher as the market prices in a less dovish RBA that will need to begin worrying about rising inflation once again. While at the same time, longer-term bond yields might have seen their highs given some cooling of economic growth. We already have a recommended position on the Australian curve to benefit from these trends, as we are short the 4-year government bond bullet versus a long position in the 2-year/6-year barbell. This trade was initiated earlier this year, has generated +13bps of profits so far, and remains valid.8 As an exit strategy, we will re-evaluate this trade if high-frequency cyclical Australian data disappoint further or the current expansion of Australia's terms of trade starts to reverse. New Zealand - Following The Forwards The New Zealand forward yield curve is currently pricing a 12bps flattening over the next 12 months, with the 2-year/10-year slope expected to move from 107bps to 95bps (Chart 18). This move seems reasonable to us. As we discussed in a recent report, inflation will re-surface in New Zealand in 2017.9 The upside surprise will be due to those factors: Narrowing global output gaps that will bring about a more inflationary global backdrop. A boost from China, most notably through higher producer prices. A weakening of the Kiwi dollar in response to a more hawkish Fed. A stronger dairy sector, which should help New Zealand's exports and reflate domestic wages. A potential reversal of migration inflows, which should shrink the supply of workers and tighten the labor market, boosting wage growth and pressuring price inflation higher. If this view materializes, the Reserve Bank of New Zealand (RBNZ) will become more hawkish. This should push short term yields higher and flatten the New Zealand government bond yield curve. Like everywhere else, the New Zealand yield curve has steepened over the last month as global bond markets have priced in faster growth and the potential impact of Trump-ian fiscal stimulus in the U.S. As this external impact dissipates in the next few months, the main factor driving the shape of the New Zealand curve will swing back to expectations of future RBNZ policy. Bottom Line: The recent consistent steepening of government bond yield curves across the developed markets should soon begin to fade, leading to a more diverse evolution of curves during the course of 2017: steeper in the U.S., core Europe and in the long end in Japan; flatter in the U.K., Canada, Australia and New Zealand. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at gfis.bcaresearch.com & usbs.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy/U.S. Bond Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at gfis.bcaresearch.com & usbs.bcaresearch.com 3 The current 1-year forward rate for the benchmark 10-year U.S. Treasury is 2.67% 4 Please see BCA Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen", dated October 14, 2016, available at gis.bcaresearch.com 5 The Fed targets headline PCE inflation, while inflation compensation in U.S. TIPS is priced off headline CPI inflation. The historical gap between the two measures is about 40bps, thus a level of breakeven inflation in TIPS that is consistent with the Fed's 2% inflation target is 2.4% (2% PCE inflation + 0.4%). 6 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com 7 Both the Bank of Canada and the median economist surveyed by Bloomberg forecast 2.0% real GDP growth in 2017. For further details, please http://www.bankofcanada.ca/2016/10/mpr-2016-10-19/ 8 Please see BCA Global Fixed Income Strategy Weekly Report, "Five Yield Curve Trades For The Rest Of The Year", dated May 24, 2016, available at gfis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Weekly Report, "A Post-Trump Update Of Our Overlay Trades", dated November 22, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1More Upside From Inflation We moved to below benchmark duration on July 19, when the 10-year Treasury yield was 1.56%. As of last Friday's close, the 10-year Treasury yield was 2.4% and above the fair value reading from our global PMI model. While our economic outlook still justifies higher Treasury yields on a 12-month horizon, the selloff in bonds has moved too far, too quickly. We recommend tactically shifting to a benchmark duration stance. Longer run, the upside in Treasury yields will be concentrated in the inflation component. The cost of 10-year inflation compensation can rise another 49 bps before it is consistent with the Fed's target. But that adjustment will proceed gradually next year, alongside a shallow uptrend in realized inflation (Chart 1). Higher inflation compensation can occasionally be offset by lower real yields, but this only occurs when the increase in inflation compensation results from an easing of Fed policy, as in 2011-2012. With the Fed in the midst of a hiking cycle, the downside in real yields is limited. We would not be surprised to see the 10-year Treasury yield re-visit the 2%-2.2% range during the next month or two. At that point we would re-initiate a below benchmark duration stance, on the view that the 10-year yield will reach 2.80%-3% by the end of 2017. Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 52 basis points in November. The index option-adjusted spread tightened 3 bps on the month and, at 129 bps, it is now slightly below its historical average (134 bps). Spread per unit of gross leverage1 for the nonfinancial corporate sector is slightly above its historical average (Chart 2). But unusually, spreads have been tightening this year despite sharply rising gross leverage. Since 1973, there has only been one other period when spreads tightened despite rising gross leverage. That was in 1986-88 when, similar to today, spreads were tightening from extremely oversold levels. Much like today, elevated spreads in 1986 resulted from distress in the energy sector that dissipated as oil prices recovered. This caused corporate spreads to widen dramatically and then tighten, while in the background gross leverage persistently climbed higher. The current recovery in oil prices could lead to further corporate spread tightening early next year. Indeed, energy sector credits still appear cheap on our model and we continue to recommend overweighting those sectors. This month we also upgrade Paper from neutral to overweight (Table 3). Table 3Corporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* However, corporate credit fundamentals are deteriorating rapidly and spreads will be at risk when the Fed adopts a more hawkish policy stance, possibly as early as the second half of next year.2 High-Yield: Maximum Underweight Chart 3High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 128 basis points in November. The index option-adjusted spread tightened 23 bps on the month and, at 450 bps, it is 71 bps below its historical average. A model based on lagged spreads and default losses explains more than 50% of the variation in 12-month excess junk returns. This model currently forecasts excess junk returns of close to zero during the next 12 months (Chart 3), a forecast that is based on our expectation of a modest improvement in default losses (bottom panel). In a recent report,3 we examined the relationship between default-adjusted spreads and excess junk returns in more detail. We showed that a model based purely on ex-ante estimates of default losses explains around 34% of the variation in excess junk returns. We also showed that, historically, negative excess returns to junk bonds are only likely if the ex-ante default-adjusted spread is below 100 bps. Our current ex-ante default-adjusted spread is 201 bps. Historically, when the ex-ante default-adjusted spread is between 200 bps and 250 bps, junk earns positive excess returns 81% of the time. However, junk earns positive excess returns only 65% of the time if the spread is between 150 bps and 200 bps. Although our economic outlook for next year is fairly optimistic, high-yield valuations are stretched and we expect to get a better entry point from which to upgrade the sector during the next couple of months. MBS: Underweight Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 47 basis points in November. Other than municipal bonds, MBS has been the worst performing fixed income sector relative to Treasuries, earning year-to-date excess returns of -17 bps. The conventional 30-year MBS yield rose 53 bps in November, driven by a 59 bps increase in the rate component. The compensation for prepayment risk (option cost) declined 10 bps, while the option-adjusted spread widened by 4 bps. Prior to the election, we had been tactically overweight MBS on the view that higher Treasury yields would lead to a lower option cost, benefitting MBS in the near term. Now that Treasury yields have moved substantially higher, our focus returns to the extremely depressed levels of MBS option-adjusted spreads (Chart 4). Extremely low option-adjusted spreads coupled with a housing market that should continue to recover - leading to steadily increasing net supply (bottom panel) - make for a poor risk/reward trade-off in MBS relative to other fixed income sectors. Against this back-drop, MBS are only worth a tactical trade if you have high conviction that Treasury yields are about to rise and option costs about to tighten. We do not expect the Fed to cease the reinvestment of its MBS purchases in 2017. But, if Janet Yellen is replaced as Fed Chair in early 2018, then it is possible that the new Fed will seek to end its involvement in the MBS market. This is a tail risk for MBS in 2018. Government Related: Overweight Chart 5Government Related Market Overview The government-related index underperformed the duration-equivalent Treasury index by 19 basis points in November (Chart 5). Domestic Agency bonds and Local Authority bonds outperformed the Treasury index by 2 bps and 61 bps, respectively. Sovereign debt underperformed by 122 bps, Foreign Agency debt underperformed by 54 bps and Supranationals underperformed by 6 bps. More than half of the underperformance in the Foreign Agency sector came from Mexico's state oil company, Pemex, in the aftermath of Donald Trump's election win. Losses in the Sovereign debt sector were similarly concentrated in Mexican issues. Strength in oil prices should permit Foreign Agency debt to outperform going forward, while the strong U.S. dollar will remain a drag on Sovereign debt. Local Authority and Foreign Agency debt both continue to offer attractive spreads relative to U.S. investment grade corporate bonds, after adjusting for duration and credit rating. In contrast, Supranationals and Sovereigns both appear expensive. We continue to recommend an underweight allocation to Sovereign debt within an otherwise overweight allocation to the government related sector. Bullet Agency issues outperformed callable Agency bonds in November, despite the large increase in Treasury yields (bottom panel). We expect this trend will soon reverse, and remain overweight callable versus bullet Agencies. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal bonds underperformed the duration equivalent Treasury index by 83 basis points in November (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio rose from 99% to 107% in November, and is now above its post-crisis average (Chart 6). We downgraded municipal bonds to underweight on November 15,4 following Donald Trump's election victory. Lower tax rates under the new administration will undermine the tax advantage in municipal bonds, leading to outflows and higher M/T yield ratios. ICI data show that outflows have already begun. Net outflows from Muni funds have exceeded $7 billion in the four weeks since the end of October (panel 4). There are also longer-run concerns related to supply and state & local government credit quality. Depending on how it is structured, increased infrastructure spending next year could lead to a large increase in municipal bond supply. Also, state & local government downgrades are likely to increase later next year, following the lead of the corporate sector. Both of these issues are discussed in more detail in a recent Special Report.5 In October, the SEC finalized new liquidity management standards for open-ended investment funds. Funds must now determine a minimum percentage of net assets that must be invested in highly liquid securities, and no more than 15% of assets can be invested in securities deemed illiquid. At the margin, the new rule could limit funds' appetites for municipal bonds. Treasury Curve: Laddered Chart 7Treasury Yield Curve Overview November's bond rout was concentrated in the belly (5-10 years) of the Treasury curve. The 2/10 Treasury slope steepened 28 basis points on the month, while the 5/30 slope flattened by 8 bps. We believe that the yield curve has room to steepen further in 2017, based largely on the expectation that the Fed will maintain an accommodative stance of monetary policy at least until TIPS breakeven inflation rates are at levels more consistent with the Fed's 2% inflation target (Chart 7). In our view, this level is between 2.4% and 2.5% for long-dated TIPS breakevens. However, we are reluctant to initiate a curve steepener one week before the Fed is poised to lift rates. Although we view a "dovish hike", i.e. an increase in the fed funds rate with no upward revision to the Fed's interest rate forecasts, as the most likely outcome. If we are wrong, an upward revision to the Fed's forecasts would cause the curve to bear-flatten on the day. At present, the market expects 55 bps of rate hikes during the next 12 months (panel 1). If expectations remain at these levels until after next week's FOMC meeting they will be consistent with the Fed's median forecast, assuming there are no upward revisions. Also, as we pointed out on the front page of this report, the selloff at the long-end of the Treasury curve appears stretched relative to fundamentals and is likely to take a pause. This should provide us with a more attractive level from which to enter curve steepeners heading into next year. TIPS: Overweight Chart 8TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 148 bps in November. The 10-year breakeven rate increased 21 bps on the month, and currently sits at 1.91%. The 5-year, 5-year forward TIPS breakeven inflation rate has risen to 2.06% from its early 2016 trough of 1.41%. However, it still has room to rise before it returns to levels that are consistent with the Fed's 2% target for PCE inflation (Chart 8). As economic growth improves next year the Fed will be keen to allow TIPS breakevens to rise toward its target, and will be slow to shift to a less accommodative policy stance. As such, we maintain our recommendation to overweight TIPS relative to nominal Treasuries, with a target of 2.4% to 2.5% for the 5-year, 5-year forward TIPS breakeven rate. While breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. With the Fed in the midst of a tightening cycle, it will be difficult for the Fed to lead inflation expectations sharply higher as in past cycles. Trends in realized inflation will be more important for long-dated breakevens this time around. Core and trimmed mean PCE inflation continue to grind slowly higher, a trend that is supported by the PCE diffusion index (panel 4). Assuming the current trend remains in place, core PCE inflation should finally reach the Fed's 2% target before the end of next year. ABS: Maximum Overweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 10 basis points in November, bringing year-to-date excess returns up to +111 bps. Aaa-rated ABS outperformed the Treasury benchmark by 11 bps on the month, while non-Aaa issues outperformed by 5 bps. Credit card ABS outperformed by 14 bps, while auto ABS outperformed by 7 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps in November and, at 43 bps, it is well below its average pre-crisis level. Last month we observed that after adjusting for trailing 6-month spread volatility, Aaa-rated auto loan ABS no longer offer a compelling spread pick-up relative to Aaa-rated credit card ABS. We calculate that it will take 12 days of average spread widening for Aaa-rated auto ABS to underperform Treasuries on a 6-month horizon and 9 days of average spread widening for Aaa-rated credit card ABS to underperform (Chart 9). This spread cushion is not sufficient to compensate for the fact that credit card quality metrics are in much better shape than those for auto loans. The auto loan net loss rate has entered a clear uptrend, while credit card charge-offs are still near all-time lows (bottom panel). CMBS: Underweight Chart 10CMBS Market Overview Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 74 basis points in November, bringing year-to-date excess returns up to +269 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 16 bps in November, and has now fallen below its average pre-crisis level (Chart 10). Rising delinquency rates and tightening lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Further adding to our caution is that more than 6000 commercial real estate loans backing public conduit CMBS deals are set to mature in 2017. This is almost 5x the number that matured last year, according to data from Trepp. Agency CMBS outperformed the duration-equivalent Treasury index by 52 basis points in November, bringing year-to-date excess returns up to +158 bps. Agency CMBS still offer 45 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (43 bps) and greater than what is offered by conventional 30-year MBS (22 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Treasury Valuation Chart 11Global PMI Model The current reading from our 3-factor Global PMI model (which includes global PMI, dollar sentiment and global policy uncertainty) places fair value for the 10-year Treasury yield at 1.82%. However, the low reading mostly reflects a large spike in global policy uncertainty in November. Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor Global PMI model (which includes only global PMI and dollar bullish sentiment) as more representative of 10-year Treasury yield fair value at the moment. The fair value reading from our 2-factor model is currently 2.26% (Chart 11). At the time of publication the 10-year Treasury yield was 2.4%. For further details on our Global PMI model please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). Using assumptions for the time until the MCI converges with equilibrium and the annual appreciation of the trade-weighted dollar, it is possible to calculate the expected change in the fed funds rate for the cycle. The shaded region in Chart 13 shows the expected path for the federal funds rate assuming that the MCI reaches equilibrium at the end of 2019. The upper-end of the region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, "The Fourth Tantrum", dated November 29, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Secular Stagnation Vs. Trumponomics", dated November 15, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)

特別レポート

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