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Highlights The dollar seems to have entered a cyclical bear market, which suggests that EUR/USD is in a multi-year bull market. While the euro performs well in the late stages of the business cycle, it has moved ahead of long-term fundamentals. A correction is growing increasingly likely. The euro's rally has been a reflection of hope that the ECB will tighten policy in excess of the Fed's in the coming years. This leaves the euro vulnerable to short-term disappointments on both the inflation front and the global growth front. The trade-weighted pound has downside from current levels as the BoE will be handcuffed by a fall in inflation, courtesy of a diminishing pass-through. Feature Two weeks ago, we explored the confluence of forces facing the euro. We concluded that in all likelihood, the euro had embarked on a new cyclical bull market that could push EUR/USD well above 1.30 over the course of the coming few years. We also highlighted some tactical risks that were present for the euro.1 This week, we delve into how the cyclically positive outlook for the euro is interacting with the more cautious, short-term view, especially in the wake of the U.S. dollar's recent wave of weakness that has pushed the euro above 1.25. The probability of a correction has grown only further. This could represent a shorting opportunity for tactical players, as well as an occasion to deploy more funds into the euro for agents with a longer investment horizon. It's A Bull Market, But... The body of evidence is growing that the U.S. dollar has entered a bear market, which would support the view that the dollar's antithesis - the euro - has entered a bull market. To begin with, my colleague Harvinder Kalirai, who runs BCA's Daily Insights service, has noted that the dollar has been following an interesting pattern since the end of the Bretton Woods era: It tends to depreciate for roughly 10 years, and then rally for five to six years (Chart I-1). Admittedly, there is a small set of bull and bear markets here, but this begs the question: Was the 2011-2016 bull market the heyday for the dollar this decade? Chart I-1USD: Times Up? To answer this question, it helps to understand where we stand in the current business cycle. BCA believes that while a U.S. recession is not imminent, we are nonetheless entering the last two innings of this cycle. Interestingly, as Chart I-2 illustrates, the euro tends to appreciate during the last two years of U.S. economic upswings. This is because historically, European growth begins to outperform U.S. growth in the late stages of the economic cycle. This observation resonates with today's environment. Chart I-2The Euro Rallies Late In The Business Cycle There is a glaring exception to this phenomenon: the period from 1999 to 2000. However, we view this particular interval as rather exceptional. First, the euro had just entered into force, and was still untested. Second, the U.S. basic balance was in a large surplus as M&A waves and the tech bubble were sucking in capital from all over the world. Third, the U.S. was experiencing the apex of its peace dividend, resulting in fiscal surpluses that gave comfort to investors. Beyond the ebullience of U.S. tech stocks, the parallels with this era are limited. The tendency for the European economy to boom late into the cycle also has implications for monetary dynamics. We, as most commenters, have been puzzled by the euro's divorce from interest rate differentials, especially at the short end of the curve. Even indicators that historically have been extremely reliable such as the spread between the European and U.S. 1-year/1-year forward risk-free rate have lost their explanatory power. However, late into the cycle, the European economic boom tends to lift expectations of future European Central Bank policy tightening faster than these same expectations in the U.S. As a result, the European yield curve steepens in contrasts to that of the U.S. We built a simple three-factor model to capture these dynamics. These factors are: real 2-year yield differentials between the euro area and the U.S., to grab the effect of current policy; the euro area minus the U.S. 10/2-year yield curve slope, to incorporate changes in perception of how fast the ECB will hike in coming years compared to the Federal Reserve; and the price of copper relative to lumber, to capture how U.S. growth dynamics - as represented by the price of lumber - are evolving relative to the rest of the world, as represented by the price of copper. Chart I-3 shows the model's results. Over the long run, this model explains nearly 70% of EUR/USD's variations, and most importantly, the significance of the three factors is stable over various samples. Three points are worth noting: Chart I-3A 3-Factor Model To Explain The Euro First, the euro was very undervalued from 2015 to 2017. It was not as cheap as in 1985 or 2000, but the narrative behind the dollar's strength this cycle was the perception that the USD was the "cleanest dirty shirt." This is not the same optimism as what prevailed during former U.S. President Ronald Reagan's Imperial Cycle of the 1980s, or the New Economy boom / unipolar moment for the U.S. in the late 1990s. Second, the euro's fair value has stopped falling as global growth has caught up to the U.S., and as the European yield curve has steepened relative to the U.S. thanks to the reappraisal by investors of the future path of the ECB's terminal policy rate this cycle. Third, the euro is now trading at an 8% premium to its fair value. This last point raises the question of a euro correction. Are we seeing conditions fall into place for the euro to experience a pullback toward its fair value of roughly 1.15? A move to this level would bring the euro straight back into its 38-50% retracement levels, based on the low recorded in late 2016. Bottom Line: It appears as if the dollar has begun a cyclical bear market. As a corollary, this implies that the euro has begun a cyclical bull market that could last many years. The main reason relates to where we stand in the current business cycle: An ageing business cycle is associated with a stronger euro - a result of the euro area's economic outperformance toward the end of the cycle. Despite this positive, it would seem the euro has overshot fundamentals factors that try to capture these dynamics. ... The Correction Is Nigh Conditions are still too precarious to call for a correction in the euro, but some facts need to be kept in mind as they highlight growing short-term risk. Dollar Dynamics From a technical perspective, the dollar is much oversold. Last week we illustrated how our Capitulation Index was inching closer to a buy signal. The "buying" threshold was hit this week. Confirming this message, the Dollar's RSI and 13-week rate of change are also at levels consistent with a dollar rebound (Chart I-4). To be sure, many FX investors have become enthralled by the "twin deficit" narrative. Since 2011, when worries about a growing combined fiscal and current account deficit spike, this tends to represent dollar buying opportunities for the next three to six months (Chart I-5). Chart I-4Oversold Dollar Chart I-5Because The Narrative Is Scary Blood In The Street? When it comes to the twin deficit narrative, at this point it is a very nice-sounding story, but it still lacks substance. For one, while a growing U.S. economy tends to be associated with a growing current account deficit, the U.S. is increasingly morphing from an oil importer to an oil exporter. As Chart I-6 illustrates, net oil imports for the U.S. have collapsed from 13.5 million bbl/day in 2005 to 3.8 million today, as oil production recently hit a 47-year high. Matt Conlan, who runs BCA's Energy Sector Strategy service, anticipates that within the next two to three years the U.S could even become a net exporter of oil. Thus, the expansion of the current account deficit is not baked in the cake. The fiscal deficit may also not widen as much as many fears over the next year or two. As Chart I-7 illustrates, the gyrations in the U.S. 30-year swap spread have been linked to fluctuations in the velocity of money in the U.S. As banks faced the imposition of higher capital ratios, Dodd-Frank, rising supplementary leverage ratios, and so on, they decreased their participation in the swap market. As the supply of funds fell in that market, swap spreads collapsed, punishing the receivers of the 30-year swap rate. But recently, with the growing likelihood that the supplementary leverage ratio rules will be softened, banks are coming back to the market, and the swap spread is rising again. Banks are also easing their credit standards on most things from C&I loans to mortgages. This suggests credit growth could pick up further, lifting money velocity. Chart I-6A Support For The U.S. Current Account Chart I-7Money Velocity To Pick Up Why does this matter? Simply put, the rise in velocity portends to an acceleration in nominal GDP growth. Rising nominal expansion is historically associated with narrowing budget deficits. This cycle is a prime example. The main reason why the U.S. deficit fell from 8% of GDP to 3.5% of GDP this cycle is because activity recovered, which lifted government revenues and narrowed the deficit. To be clear, we do not want to sound overly sanguine. The chickens will come home to roost. If the budget deficit does not blow out as much as many fear over the next two years, it will catch up to these dire expectations once GDP growth slows. Euro Dynamics In a mirror image to the DXY, the euro's 13-week week rate of change and RSI oscillator are also flagging overbought conditions. But more interesting developments are happening that highlight the elevated correction risk for the euro. As Chart I-8 shows, the correlations between EUR/USD and the relative euro area/U.S. yield curve slope as well as the real interest rate gap tends to swing widely over time. Most interestingly, when the euro correlates closely with the relative yield curve slope and ignores real rate differentials, this tends to be followed by a reversal of the previously prevailing trend in the euro. This seems to tell us that when investors are more focused on the potential for an adjustment in relative policy between the euro area and the U.S. instead of current real rate differentials, they expose themselves to surprises - surprises that cause the trend to change. Today, the euro correlates massively with anticipated policy changes - not the current situation - highlighting the risk of a correction if anything dashes hopes of higher European rates in future. Chart I-8Euro: Future Versus Present In terms of potential culprits, inflation expectations rise to the top of the list. Since mid-2016, when euro area CPI swaps began to weaken relative to the U.S., this has typically been followed by a correction in EUR/USD (Chart I-9). Simply put, sagging relative inflation expectations prompt investors to question whether or not they should continue to anticipate a tightening by the ECB relative to the Fed in the years ahead. Additionally, EUR/USD has historically traded as a function of global export growth, reflecting the euro area's greater leverage to global trade than the U.S.'s. However, as Chart I-10 highlights, the euro has overshot the mark implied by global trade growth. Chart I-9Inflation Expectations Point To A Correction Chart I-10Euro Is Stronger Than Global Trade Warrants In of itself, this is a weak signal. After all, the decoupling can be solved by a rebound in global trade. However, the decline in manufacturing production evident across EM Asia suggests this will not be the case, as global trade is dominated by shipments of manufacturing goods (Chart I-11). If these waves were to affect Europe, it could spur a period where investors begin questioning the path for the ECB's policy rate. Some European indicators already highlight this risk. Sweden's economy is very sensitive to global trade growth, as exports represent nearly 50% of Sweden's economy. Moreover, Sweden exports a lot of intermediary goods to Europe. This place within the European supply chain suggests that if any weakness in global trade emerges, it is likely to be felt in Sweden before it is felt in the rest of Europe. Today, while European PMIs are still near record highs, Swedish Manufacturing PMI have been falling significantly after hitting 65 last year (Chart I-12, top panel). This suggests the first ripples of the manufacturing slowdown in Asia are hitting Europe's shores. Chart I-11A Headwind For Global Trade Chart I-12The Slowdown Will Come To Europe In the same vein, Switzerland is a large exporter of machinery and chemicals. Its exports are therefore also sensitive to the global manufacturing cycle. Swiss export orders have been nosediving in recent months, which has historically pointed to periods of vulnerability for EUR/USD (Chart I-12, bottom panel). Finally, as Chart I-13 shows, for the past year, rises in the FX market's implied volatility have been followed by periods of weaknesses in EUR/USD. This also suggests that at the very least, the euro will need to digest its recent strength for another while before rallying anew. At worst, a correction could emerge in the first quarter of 2018. Meanwhile, Chart I-14 illustrates that EUR/JPY could also suffer downside in the wake of a rise in currency implied volatility. We were stopped out of this trade for now, but it remains a high conviction all for the first half of 2018. Chart I-13Higher FX Vol: A Risk For EUR/USD... Chart I-14...And EUR/JPY Bottom Line: The time is nigh for a euro correction to begin. From the dollar's perspective, not only is it oversold, but stories of a 'twin deficit" tend to be associated with selling pressures hitting their paroxysm, at least on a three- to six-month basis. Meanwhile, the euro is not only overbought but is also trading in line with hopes for a rise in policy rates vis-à-vis the U.S. while ignoring the current situation in terms of real rate differentials - a situation that historically has only lasted so long without a reversal, even if temporary. Moreover, European inflation expectations are weakening and Asia's manufacturing cycle is slowing, heightening the risk that investors temporarily curtail their hopes for the ECB and move back to focusing on current real rate spreads. A Few Words On The Pound The Bank Of England is meeting next week. BoE Governor Mark Carney made some hawkish noise this week, highlighting that the impact of the Brexit shock is passing, and that the BoE can narrow its focus on inflation dynamics. This of course begs the question of what the outlook is for inflation dynamics. As Chart I-15 illustrates, inflation across a broad swath of components is likely to slow sharply in the coming months as the trade-weighted pound has stopped depreciating as sharply as it did in 2016. Thus, the pass-through from a lower exchange rate is beginning to dissipate. Moreover, in terms of growth, Brexit risk may have receded, but the British economy continues to face important hurdles. For one, real consumption, which constitutes 63% of the British economy, could decelerate further (Chart I-16). Real disposable income growth is negative and household confidence is declining. Additionally, the savings rate has no downside left, especially as household credit growth is beginning to weaken. The weakness in house prices, especially in London, will not dissipate anytime soon, as the RICS survey is still displays poor showings. Chart I-15U.K.: Less Pass-Through Chart I-16The British Consumer Is Feeling The Pinch On the capex front, the picture is not much brighter. Strength in the global economy along with weakness in the pound have lifted export growth. However, corporate investments have failed to follow. In fact, private credit growth is flagging anew (Chart I-17). The market is currently pricing in 36 basis points of interest rate hikes in the U.K. for 2018, with the first one anticipated in September. Rob Robis, our Chief Global Fixed Income Strategist, does not believe the current economic situation will let the BoE actually follow this lead. Carney's recent emphasis on inflation may actually turn out to be a double-edged sword: If today's inflationary strength justifies higher rate, tomorrow's anticipated weakness will not. Thus, a potentially hawkish BoE next week will probably have to be faded, not heeded. In terms of currency markets, the trade-weighted pound is testing the upper bound of its post-Brexit trading range (Chart I-18). The economics currently at play in the U.K. make it unlikely that it will be able to punch above this line yet, especially as the U.K.'s basic balance is once again dipping as FDI is drying out. Chart I-17Private Credit Growth Is Slowing Chart I-18GBP: Stuck In A Rut Bottom Line: British inflation is set to slow, and the economy remains on a weak footing. The BoE will find it difficult to tighten policy much this year. With the trade-weighted pound at the top end of its post-Brexit range, a correction is likely over the coming weeks. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "The Unstoppable Euro?" dated January 19, 2018 available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data has been decent: Initial jobless claims declined to 230,000, while continuing jobless claims increased to 1.953 million; ISM Manufacturing index beat expectations of 58.8, coming in at 59.1; ISM Prices paid also beat expectations at 72.7; However, the employment subcomponent decelerated sharply; Chicago PMI beat expectations of 64.1, coming in at 65.7; While the Fed stayed pat in this week's FOMC monetary policy meeting, there is a 99% probability currently being priced in that New Chairman Powell will begin his leadership with a hike. This is in line with our own expectations. Report Links: A Cold Snap Doesn't Make A Winter - January 5, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed this week: Consumer confidence, service sentiment, business climate and overall economic sentiment all failed to meet expectations; 2017 Q4 GDP grew at a 2.6% annual pace, implying that the euro area's growth in 2017 once again beat that of the U.S.; German headline inflation came in at 1.4%, less than the expected 1.6%; German unemployment rate decreased to 5.4%, beating expectations; Overall European inflation (headline and core) both outperformed consensus at 1.3% and 1% respectively. However, PMIs remain strong. The overall sentiment on the euro remains very bullish. We are likely seeing the beginning of a protracted cycle of appreciation in the euro as markets align the ascent of the currency with its growth prospects. However, the relationship against the greenback may be blurred as the Fed is hiking faster than the ECB. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 The Unstoppable Euro? - January 19, 2018 Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: The jobs/applicant ratio outperformed expectations, coming in at 1.59. This measure is now at 44 year-highs. Moreover, retail trade yearly growth outperformed expectations, coming in at 3.6%. It also increased from 2.1% the previous month. However, consumer confidence underperformed expectations, coming in at 44.7. Additionally, the unemployment rate also surprised negatively, coming in at 2.8%. It also increased from 2.7% the previous month. After falling precipitously last week, USD/JPY has been flat this week as Japanese policy makers increase purchases and talked down the yen. In the coming 3 months, we expect EUR/JPY to have significant downside, as financial conditions have tighten significantly in Europe relative to Japan. Moreover, rising volatility, particularly from such depressed levels will also weigh on this cross. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Net lending to individuals monthly growth outperformed expectations, coming in at 5.2 billion pounds. This measure also increased from last month's 4.9 billion pound reading. Moreover, nationwide house price yearly growth also surprised to the upside, coming in at 3.2%. This measure also increased from 2.6% last month. However, mortgage approvals underperformed expectations, coming in at 61 thousand. Finally, manufacturing PMI underperformed expectations, coming in at 55.3. GBP/USD has rallied by roughly 0.6% this week. Overall, we expect the ability of the BoE to hike more than once this year to be limited, given that the sharp appreciation that the pound has experienced in recent months should weigh on inflation. This means that cable is unlikely to have much upside from here on. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Australian data this week surprised to the downside: NAB Business Confidence and Conditions came in lower than expected at 11 and 13 respectively; Headline CPI disappointed at 1.9% yoy, while the trimmed mean CPI also failed to perform as expected, coming in at 1.8%; Building permits contracted heavily in monthly terms at 20%, even contracting in yearly terms at a 5.5% rate; The RBA Commodity Index in SDR terms contracted by 0.6%, which was still better than the expected 8.9% contraction; These data support our view that substantial slack remains in the Australian economy. The RBA will need to consider the lackluster inflation figures at their next meeting, and are likely to maintain an easy policy setting this year. Report Links: From Davos To Sydney, With a Pit Stop In Frankfurt - January 26, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been positive: The trade balance outperformed expectations, coming in at -2.840 billion. It also increased from -3.480 billion the previous month. Moreover, exports for December came in at 5.5 billion, increasing from the November reading of 4.61 billion. NZD/USD appreciated by 1.2% this week. Overall the kiwi has upside against the Australian dollar, given that a negative fiscal impulse and decreased investment will likely weigh on Australia's economic outlook. Moreover the NZD would be less sensitive than the AUD to a potential slowdown in Chinese industrial activity caused by the PBoC tightening. These factors will likely weigh on AUD/NZD. That being said, if a Chinese slowdown does occur, NZD/JPY could have significant downside. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was decent: GDP grew at a 0.4% monthly rate, in line with expectations; Raw material prices, however, contracted by 0.9%; Markit Manufacturing PMI increased to 55.9 from 54.7, beating expectations of 54.8; The Canadian economy is still booming alongside a stellar labor market. Higher oil prices and higher wages will add to inflationary pressures this year, prompting the BoC to tighten in line with expectations. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: The trade balance underperformed expectations, coming in at 2.6 billion. However it increased from the previous month reading. The KOF indicator also underperformed expectations, coming in at 106.9 However the SVME PMI outperformed expectations, coming in at 65.3 EUR/CHF has depreciated by about 0.75% this week, as risk-on assets have lost ground due to the perception that a correction in the markets might be overdue. Overall, while Swiss inflation is on the rise, it is not yet high enough to cause the SNB to abandon its current dovish tilt. Thus, unless global markets weaken meaningfully, downside to EUR/CHF will likely be limited. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth surprised to the downside, coming in at -1%. This measure also declined from 2.1% on the previous month. However, Norway's credit indicator outperformed expectations, coming in at 6.3%. USD/NOK has fallen by roughly 0.8% this week, as the fall in the dollar continues to weigh on this cross. Overall, we expect the krone to have upside against the Canadian dollar, as the market is pricing 3 rate hikes in the next 12 months for the BoC, while only pricing 27 basis points for the Norges Bank. While it is true, that the recovery is much more advanced in Canada than in Norway, given the surge in oil prices, the gap in rate expectations should narrow. This will weigh on CAD/NOK. Report Links: Yen: QQE Is Dead! Long Live YCC! - January 12, 2018 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish Manufacturing PMI surprised to the downside, coming in at 57 compared to the expected 60. Manufacturing PMI in Sweden has been declining since April last year. However, inflation has been in line with the target thanks to higher energy prices and the weakness of the cheapness of the SEK. This year, the Riksbank also seems to be slowly moving away from its dovish stance. This has allowed the SEK to recoup some of its 2017 losses against the euro. We may see a stronger SEK this year as the Riksbank is likely to turn hawkish quicker than the ECB. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Controversial gaffes aside, President Trump has started 2018 by moving to the middle; This comes at a time when animal spirits are reawakening thanks to tax cuts; And the path of least resistance for fiscal policy points towards more profligacy; Meanwhile, Chinese growth is imperiled by structural reform efforts; With money growth and import data showing signs of stress; The combination of upside growth risks in the U.S. and downside growth risks in the rest of the world should revive the U.S. dollar and threaten EM performance in 2018. Feature In just the first two weeks of 2018, U.S. President Donald Trump has: Hosted a meeting on immigration policy with Republican and Democratic leaders during which he said that the upcoming legislation should be a "bill of love," while encouraging congressional leaders to think big and pursue comprehensive immigration reform; Claimed that he has a "very good relationship" with Kim Jong-Un, while refusing to deny that he has already spoken privately with the North Korean leader; Supported bringing back "earmarks" in order to grease the wheels of bipartisanship in Congress - i.e., new spending that allocates funds to specific projects; Extended sanction relief to Iran, albeit with the caveat that it would be the last time he does so without demanding modifications to the Joint Comprehensive Plan of Action (the Iran nuclear deal); Broken with his former chief political strategist Steve Bannon - dubbing him "Sloppy Steve" in the process - while disparaging Bannon's penchant for scorched-earth tactics.1 On the whole, Trump's actions in January suggest a move towards the political center. Meanwhile, the media and political opponents continue to dwell on Trump's alleged comments where he disparaged immigrants from certain countries, obscuring the subtle shift in political strategy. What would be the reason for a Trump shift to the middle? As we wrote last week, the Pocketbook Voter Theory in political science suggests that Trump's Republican Party should be benefiting from a surge in popular support amid strong economic data and record-setting market performance.2 However, the 2018 generic congressional ballot still points to a very challenging midterm election for the Republican Party (Chart 1). Trump has two choices. First, he can ignore the poor GOP polling, as well as his own (Chart 2) in the face of stellar economic performance, and plow into an electoral disaster. This would make him the earliest "lame duck" president in recent U.S. history. As we wrote in December, this choice is a serious market risk for investors.3 Lame duck presidents have often sought relevancy abroad, given the lack of constitutional constraints to executive action in the foreign policy realm. In the case of Trump, we could think of three avenues by which he might increase geopolitical risk premiums: Protectionist policies towards China, the abrogation of NAFTA, or military tensions with Iran. Chart 1History Favors The Opposition Chart 2Trump Is Extraordinarily Unpopular The second option for President Trump is to move to the middle ahead of the midterms. This would be unexpected in every way other than that Trump is the master of the unexpected. We happen to agree with his supporters that he is a political genius. Unless, that is, he continues to waste an extraordinary bull market, strong economy, and soaring consumer/business confidence by refusing to woo the median voter. What would a shift towards the center mean for the equity market? First, the already low probability that domestic political intrigue will upend the ongoing rally would get even lower in a world where Trump moves to the center. Second, the risk of market-moving geopolitical risks prompted by White House policy would decline as Trump would presumably seek and follow the advice of his establishment advisers. In other words, it would be pure nectar for the already buoyant markets. This is not to say that there would not still be reason for a pullback in U.S. equities. The bull-bear ratio is dangerously high (Chart 3), and consumer confidence is ominously stretched (Chart 4). Chart 3Investor Bullishness Is At Record High... Chart 4...And So Is Consumer Confidence U.S.: Business Owners Are Republican While some of our clients in the financial community may fret about Trump's unorthodoxy, our clients in the corporate world clearly do not. This is not merely an offhand observation, it is an empirical fact (Chart 5). America's business leaders have given President Trump the benefit of the doubt since he was elected. Bill Dunkelberg, the Chief Economist of the National Federation of Independent Business (NFIB), which publishes the Small Business Optimism survey, went on to comment this month: "we've been doing this research for nearly half a century ... and I've never seen anything like 2017 ... The 2016 election was like a dam breaking."4 It is dangerous, therefore, to be overly mathematical about U.S. growth prospects in 2017. While we agree with our colleague Peter Berezin that, on face value, the strict growth impact of the tax cuts may merely add 0.3% of GDP growth in 2018, the qualitative impact of unleashing animal spirits is incalculable.5 The risk to growth in the U.S. is therefore very much tilted to the upside. First, as we discussed in a Special Report published with our U.S. Equity Strategy colleague Chris Bowes, a crucial, yet under-reported change in the corporate tax bill allows the immediate expensing of capital investment.6 Most market observers have overlooked this part of the legislation as it is simply a shift in the "time value of money." The IRS already allows significantly accelerated depreciation of capex; this reform merely brings it forward. Our analysis, however, suggests that the impact of bringing it forward could, at the margin, change spending behavior for firms and drive the next upleg in capex. This comes at a time when the prospects for business investment are already positive (Chart 6).7 Chart 5Business Owners Are Depressed When##br## Democrats Control The White House Chart 6Animal Spirits Will ##br##Spur CAPEX Second, investors are underestimating the probability that the current budget impasse - which could lead to a government shutdown in late January - gets resolved through more, not less, federal spending. Trump surprised legislators during a meeting on immigration when he offered his support for "earmarks" - i.e., legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011 by the GOP following the Tea Party-inspired 2010 midterm victory, but they have crept back into the discussion through different guises (Chart 7). Chart 7Pork-Barrel Prohibition Is Ending The timing of Trump's statement on earmarks is interesting as the House Rules Committee is holding public hearings on the originally GOP-instituted earmark ban. In fact, the 115th Congress (the current one) almost reinstated earmarks at the beginning of 2017, only to be held back by House Speaker Paul Ryan and the newly elected White House. In January 2017, Ryan and the White House agreed that it would be unseemly to approve "pork barreling" so quickly after the election of a man who promised to "drain the swamp." Apparently, a year later, the appropriate amount of time has passed to make the move okay! What about the fears that the budget deficit is unsustainable? Investors may be fretting about a problem that does not exist (at least not yet). Chart 8 shows that budget deficits have decreased in almost every case ahead of a recession by 1.16% on average in the eight quarters before a downturn. This is because revenues are very important in determining deficit dynamics. Only just before the recession hits, as growth slows, does the deficit start to flatline or expand. If the risk to the U.S. economy is to the upside, as we believe it is, then deficits will come down regardless of tax or spending policy. Chart 8The Deficit Is Not A Problem... Yet Fiscal policy rhetoric may alone be far more important to the equity, bond, and currency markets than the market is currently pricing. Talk of draconian spending cuts - remember the May 2017 White House budget? Anyone? - could very quickly be replaced with an appropriation bill in late January that combines higher defense spending with higher discretionary spending. Given the current low levels of discretionary spending (Chart 9), the move towards greater spending could be sizeable and surprising. And if earmarks make a comeback, look out! Chart 9Government Spending Is Bottoming Chart 10Global Economy Is Firing On All Cylinders This fiscal fuel is coming when the fire of the U.S. economy is already well lit. Yes, global growth is strong (Chart 10), but U.S. growth is likely to beat it in 2018 (Chart 11). The global and U.S. economy may diverge just as the BCA's two-factor 10-year Treasury yield model is showing that U.S. long-dated bonds are expensive (Chart 12), while dollar bearishness is overcrowded (Chart 13). Chart 11U.S. May Outperform Global Growth Chart 12More Room For Yields To Rise Chart 13The Dollar Will Be Great Again Bottom Line: Tax cuts will unleash animal spirits in the U.S. in 2018. Meanwhile, the political path of least resistance on fiscal policy is towards profligacy. Fade any talk of austerity or entitlement reform, earmarks are back! A combination of easy fiscal policy and tax cuts should be good for equity markets, bad for Treasuries, and good for the greenback in 2018. Technical indicators flag some near-term risks to the dollar, but over the course of the year, our assessment is that it will hold at current levels or rally. China: Reform Reboot Is Growth-Constraining Unlike the U.S. economy, where risks lie to the upside, China is our top candidate for growth disappointments in 2018. Premier Li Keqiang has announced that China's GDP grew by 6.9% in 2017, slightly above expectations at the beginning of the year. However, growth momentum is already slowing due to cyclical factors, the waning of fiscal and credit stimulus, and the government's financial tightening measures that were implemented over the past year (Chart 14). Chinese imports are what really matter from a global macro perspective, and the latest import data suggest that the domestic economy is slowing more abruptly than expected. Import growth fell sharply to 5% year-on-year in December and 0.46% month-on-month. Import volume growth fell from 27.1% in early 2017 to 9.3% in December (Chart 15). Chart 14Chinese Economy: Weakness Ahead Chart 15What Happens In China, Does Not Stay In China Policy changes are highly likely to add to this slowdown. There can no longer be much doubt about the reformist turn in government policy that we highlighted last year.8 All of the policy announcements that came out of the nineteenth National Party Congress in October so far have had a reformist bent. The market agrees, as the sectors of the equity market most likely to benefit from reforms - health care, IT, energy and consumer staples - have outperformed the broad market significantly since President Xi's five-year policy speech on October 18, 2017 (Chart 16). Two separate news items that caused market jitters over the past week reflect the reformist turn. First came unconfirmed rumors that China would make its exchange rate more flexible by abandoning a "counter-cyclical factor" in its daily fixing rate; second came a "fake news" report that China planned to diversify its foreign exchange reserves away from U.S. Treasuries (Chart 17). The rumors were not significant in themselves, at least not without more information, but they were significant in suggesting that debates on major macro policies are intensifying.9 The question is how much resolve will China's central government have in executing its renewed reform agenda? President Xi obviously does not want to self-impose a recession, yet meaningful reform will constrain credit, investment, and growth. For instance, the current financial regulatory crackdown has caused a precipitous drop in the growth of wealth management products (WMPs), which are investment products that make up about 60% of the burgeoning non-bank credit flows; non-bank credit, for its part, makes up 28% of total credit (total social financing). And regulators have gone on to tackle entrusted loans, corporate bonds, and other innovative financial products as well (Chart 18). The impact could be material over the course of this year. Chart 16Markets Believe In China Reforms Chart 17Chinese Treasury Reserves Can Be Weaponized Chart 18China's Dodd-Frank Moment We strongly urge clients to fade the narrative that China is already "easing up" on reforms. In the three months since China's party congress we have seen a handful of false media narratives about how the government is backtracking on its policy agenda. For instance, both The Wall Street Journal and The New York Times declared that the outcome of the major annual economic policymaking meeting - the Central Economic Work Conference - included a turn away from deleveraging. This was not only a misreading of the high-level policy priorities but also a mistranslation of the Economic Work Conference documents, which argued that deleveraging remains a key policy focus.10 It would be humiliating for President Xi - who, not incidentally, has achieved Mao-like authority within the Communist Party - to backtrack on his second-term economic agenda before he has even officially been elected to his second term. Xi will be re-elected in March and he is looking at 2020-21 deadlines for progress on key reforms according to the thirteenth Five Year Plan (2015-20) and his own three-year plan to fight the "Three Battles" of systemic financial risk, poverty, and pollution. The only way to meet these deadlines while ensuring that the country is strong and stable for the 100th anniversary of the Communist Party in 2021 is to frontload the reform push in 2018-19.11 In Table 1 we update our "Reform Reboot Checklist" to reflect the reality that the Central Economic Work Conference produced a strikingly reform-oriented outcome. This is significant because it was billed as the first major statement of economic policy under "Xi Jinping Thought on Socialism with Chinese Characteristics for the New Era." Table 1How Do We Know China Is Reforming? The money growth (M2) target for 2018, for instance, is rumored to be the lowest in China's history after that meeting (supposedly it will be 9%, down from the low- to mid-teens seen in previous years). Now all we need to confirm that serious reforms are afoot is slower bank loan growth (which will likely be tipped in January numbers due in early February), or substantially tighter interbank rates, plus the announcement of significant reform initiatives at the annual "Two Sessions" in early March. It is very common in China for central government decrees to be too draconian initially and then to be modified after an outcry from industry. This year, however, we would advise clients to avoid confusing the inevitable back-and-forth between the central and local governments for a lack of resolve from the central government.12 China's bark will have bite this time around because the political and macroeconomic constraints to the core leadership are lower than they have been at any point in the past ten years. Table 2 shows the issues that we are watching to gauge the reform process and its impact on growth. In light of the above initiatives, we give a 30% subjective probability that China's policymakers will overtighten this year, which could lead to a global risk-off move in financial assets. Table 2China Is Rebooting Economic Reforms Even in our baseline case - China slows abruptly but remains stable - we believe financial markets have yet to understand the shift in Chinese policymaker thinking, which means that China is the prime candidate for negative surprises in a year in which markets are priced for perfection. Chart 19China's Trade Surplus Is A Geopolitical Risk Finally, China is still a major geopolitical risk this year. It scored the largest trade surplus ever with the U.S. in 2017 (Chart 19) and several key U.S. trade rulings are looming that could trigger a tit-for-tat conflict. This was, of course, the real reason behind the rumors about halting U.S. Treasury purchases. We will discuss the trade and geopolitical tensions in a forthcoming report. Bottom Line: China's reform reboot is gaining steam. It will threaten to constrain growth via the anti-corruption campaign, financial and regulatory tightening, corporate and industrial restructuring, and local government scrutiny. In combination with a stronger U.S. economy, China's downward-sloping business cycle and reform-capable political cycle spell disappointments for global markets this year. Investment Implications A faster growing U.S. economy and a slower growing China is beneficial for DM versus EM, the USD versus the RMB and other EM and commodity-linked currencies, U.S. stocks relative to DM stocks (because China's slower growth will weigh on Japanese and European earnings), and Chinese stocks relative to EM. It is bearish for China/EM corporate bonds. It will have varying impacts on commodity prices, depending on the role of Chinese supply-side reforms, but in the long term - as overcapacity cuts are priced in - it should be marginally bearish base metals as a result of China's desired switch of the growth model to a less investment-intensive model.13 Could stronger U.S. growth compensate for slower Chinese growth? We doubt it very much. China is alone expected to make up a third of all global economic growth in 2018, with China-leveraged EM making up the other 45%, according to the latest IMF World Economic Outlook (Chart 20). It is unfathomable to see how the U.S., which is expected to contribute just 10% of all growth, can compensate for slower growth in developing nations. Even if U.S. growth massively surprised to the upside, the U.S. economy is far too domestically driven to make a genuine difference through higher imports. Chart 20Chinese Growth Outweighs U.S. Globally As for the U.S. economy and markets, a global slowdown may be precisely what the doctor ordered. With stretched valuations, a foreign-induced correction may be healthy from a valuation perspective while having no impact on domestic economic fundamentals. Meanwhile, a dollar rally combined with some market volatility later in the year may be enough to give the Fed just enough pause to slow down the pace of hikes. Technical indicators are flagging some near-term risks to the dollar, but over the course of the year our assessment is that it will hold at current levels or rally. While this is not our base case, it would be the type of event that could prolong the current economic cycle. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 In his official statement on the break with Mr. Bannon, President Trump concluded with an important paragraph: "We have many great Republican members of Congress and candidates who are very supportive of the Make America Great Again agenda. Like me, they love the United States of America and are helping to finally take our country back and build it up, rather than simply seeking to burn it all down." The statement was important as it aligned President Trump firmly with Congressional Republicans in their opposition to the Bannon/Breitbart Clique. 2 Please see BCA Geopolitical Strategy Weekly Report, "The American Pocketbook Voter," dated January 10, 2018, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, available at gps.bcaresearch.com. 4 Please see NFIB, "December 2017 Report: Small Business Optimism Index," dated December 12, 2017, available at www.nfib.com. 5 Please see BCA Global Investment Strategy Weekly Report, "Four Key Questions On The 2018 Global Growth Outlook," dated January 5, 2018, available at gis.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and U.S. Equity Strategy Special Report, "Tax Cuts Are Here - Equity Sector Implications," dated December 11, 2017, available at gps.bcaresearch.com. 7 The biggest pushback against our view comes from the oft-repeated anecdote of a meeting between Gary Cohn, the Director of the National Economic Council, and American business leaders. Apparently, when Cohn asked the attendees how many would invest if their corporate taxes were cut, only one executive raised their hand. We have now heard this anecdote repeated to us so many times by clients that it has become clear that it is essentially the only evidence that U.S. corporations have no intention of increasing capex. Needless to say, we do not base our analysis on a single anecdote! 8 For this theme, please see BCA Geopolitical Strategy Weekly Report, "China Down, India Up?" dated March 15, 2017, available at gps.bcaresearch.com. 9 The change to the RMB fixing method is not confirmed, while the rumor of a change in the forex reserve portfolio management came from an unreliable media report that was denied by China's State Administration of Foreign Exchange (SAFE). China's purchases of U.S. Treasuries peaked in 2011; China would harm itself if it sold its Treasuries rapidly. However, it may want to highlight this threat in response to U.S. President Donald Trump's threats of broad tariffs on Chinese imports. 10 The official communique from the 2017 Central Economic Work Conference did not specifically use the term "deleveraging," as in the 2015 and 2016 statements. This omission triggered U.S. news reports claiming that Beijing was backing off its deleveraging goal. However, the 2017 communique clearly emphasized preventing financial risk, including the first of the administration's "three battles" for the next three years. It also indirectly referred to "deleveraging" by citing the "Three De's, One Lower, and One Make Up," which is shorthand for the policy phrase "De-capacity, de-stocking, deleveraging, lowering costs and making up for weaknesses," which has been a fixture in rhetoric on China's supply-side reforms. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 For instance, the central government is facing pushback on new asset management regulations that are set to be fully in force by June 2019. While there may be some compromise, we do not expect the regulations themselves to be watered down too much. 13 Please see BCA Commodity & Energy Strategy Weekly Report, "China's Environmental Reforms Drive Steel & Iron Ore," dated January 11, 2018, available at ces.bcaresearch.com; and BCA Emerging Markets Strategy Special Report "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com.

Highlights Question #1: Will global growth remain above trend? Yes. Question #2: Will growth continue to outperform outside the U.S.? No. Question #3: Will productivity growth pick up? Yes, but only cyclically. The structural outlook remains bleak. Question #4: Will continued strong global growth finally deliver higher inflation? Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Feature Global Growth In Focus We wish all our readers a joyous and prosperous 2018. As the new year begins, four questions about the global growth outlook loom large. Question #1: Will global growth remain above trend? Our answer: Yes. It is likely that global growth will come down a notch from its current elevated pace. However, it should remain firmly above trend. For one thing, the global economy continues to exhibit a lot of positive momentum. Real-time measures of economic activity, such as the Goldman Sachs Current Activity Indicator (CAI), highlight that global real GDP is rising at a robust pace (Chart 1). Our global leading indicator, as well as a wide swath of PMI data, suggest that this trend has legs (Chart 2). Chart 1APositive Global Growth Momentum Can Be Seen Here Chart 1BPositive Global Growth Momentum Can Be Seen Here Since 1980, above-trend global growth in one year has been accompanied by above-trend growth in the following year nearly three-quarters of the time. This bodes well for 2018. Chart 2... And Here Too Chart 3Financial Conditions Tend To Lead Growth By Six-To-Nine Months Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions tend to benefit growth with a 6-to-9 month lag (Chart 3). The 6-month global credit impulse, which tends to lead activity, is also positive (Chart 4). Fiscal policy should remain stimulative. The fiscal thrust moved into positive territory in advanced economies in 2016-17 and this should remain the case in 2018 (Chart 5). Tax cuts will add about 0.3 percentage points to U.S. growth, while hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending will add another 0.2 points. Chart 4Positive Credit Impulse Is Another Tailwind For Growth Chart 5Fiscal Policy Has Turned More Stimulative Our political strategists expect further fiscal easing in Japan this year. They also believe that German coalition talks will produce more government spending, with the SDP extracting concessions from Merkel on public investment and the CSU securing a commitment for more defense expenditure. On the flipside, our strategists expect some fiscal tightening in France as President Macron takes steps to trim France's bloated welfare state. Question #2: Will growth continue to outperform outside the U.S.? Our answer: No. Global revisions were more favorable outside the U.S. in the first nine months of 2017, which helps explain why the dollar came under downward pressure (Chart 6). More recently, U.S. growth estimates have begun to drift higher. As a result, the U.S. surprise index has surged relative to those of other economies (Chart 7). Chart 6U.S. Growth Expectations Were Lagging... ##br## But Not Anymore Chart 7U.S. Economic Surprise Index Increased ##br## Relative To Those Of Other Countries We expect the data to continue to favor the U.S. Aggregate U.S. hours worked in November was up 3.4% at an annualized rate over Q3 levels. If we add in productivity growth, Q4 GDP growth was probably in excess of 4% - well above current consensus estimates. Financial conditions have eased a lot more in the U.S. than in the rest of the world. Fiscal policy is also set to loosen relatively more in the U.S. Euro area growth is likely to tick lower next year from its current stellar pace, as the impact of a stronger euro begins to bite. The 6-month credit impulse has already turned negative there. Japanese growth should also cool somewhat from the heady pace of 2.7% seen over the past two quarters. The Chinese economy will decelerate modestly in 2018. The authorities are tightening the screws on the shadow banking system, expediting efforts to reduce excess capacity in the industrial sector, and clamping down on corruption. All of these reforms will pay off in the long run, but they could dent growth in the short run. Question #3: Will productivity growth pick up? Our Answer: Yes, but only cyclically. The structural outlook remains bleak. U.S. nonfarm productivity rose by 1.5% over the prior year in Q3, well above the post-2010 average of 0.8%. This improvement occurred despite the fact that low-skilled workers continue to re-enter the labor market - dragging down output-per-hour in the process - a phenomenon that is not well captured by the official productivity data. Productivity growth elsewhere in the world also appears to be on the upswing (Chart 8). Increased business investment should support productivity in 2018. Corporate surveys indicate that a rising percentage of companies anticipate boosting capital budgets (Chart 9). This often happens in the last few innings of business-cycle expansions, as more companies begin to experience capacity constraints. Chart 8Productivity Growth Showing Signs Of ##br## A Tentative Recovery Chart 9Surveys Are Signaling Acceleration ##br## In Capex Unfortunately, while the cyclical outlook for productivity is improving, the structural backdrop remains downbeat. As we have discussed in the past, flagging educational achievement, decreased creative destruction, and a shift in technological innovation towards consumers and away from businesses all augur poorly for future productivity trends.1 The much-hyped Amazon effect makes for good news stories, but is not borne out by the data.2 Question #4: Will continued strong global growth finally deliver higher inflation? Our answer: Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Chart 10A Pick-Up In Wage Growth Would Put Upward Pressure ##br## On Service Inflation Going into 2017, the Fed had expected core PCE inflation to end the year at 1.9%. It is likely to have finished the year at only 1.5%. We expect core PCE inflation to move toward 2% by the end of 2018. Wage growth should accelerate as the labor market continues to tighten. This should put upward pressure on service inflation (Chart 10). Goods price inflation should also recover due to the lagged effects of a weaker dollar and the bleed-through of higher energy prices into several core components of the CPI (airline fares being a notable example). Slower rent growth will dampen inflation. However, this will be partially offset by higher health care prices. The cost control measures introduced in the Affordable Care Act helped push down PCE health care services inflation from 3% in late 2010 to less than 0.5% in early 2016 (Chart 11). Many of these measures have been realized, and as a consequence, health care inflation has begun to revert to its long-term trend (though in level terms, the savings to consumers remain). The Republican tax bill could put some upward pressure on health care costs. The Congressional Budget Office estimates that the repeal of the Individual Mandate will raise premiums on health care exchanges by 10% because a larger share of healthy individuals will decide to forgo buying health insurance.3 Japanese inflation should move modestly higher in 2018, but from extremely depressed levels. The Japanese unemployment rate is now a full percentage point lower than in 2007 and the ratio of job opening-to-applicants has reached the highest level since 1974 (Chart 12). Chart 11U.S. Inflation Breakdown Chart 12Japan's Tightening Labor Market Euro area inflation will be held down by the lagged effects of a stronger euro and continued high levels of slack across southern Europe. Outside Germany, labor market underutilization is still 6.3 percentage points higher than it was in 2008 (Chart 13). U.K. inflation should edge lower as the spike in import prices stemming from the post-Brexit pound depreciation dissipates. Chart 13There Is Still Labor Market Slack Outside Of Germany Investment Conclusions A shift in global growth leadership back towards the U.S. would benefit the beleaguered U.S. dollar. Higher U.S. inflation will prompt the Fed to raise rates four times in 2018, one more hike than implied by the dots and two more hikes than implied by current market expectations. Rising inflation should also keep Treasury yields on an upward trajectory. We expect the 10-year yield to finish 2018 at around 3%. As long as inflation is rising in response to stronger growth, and from below-target levels, both U.S. and global risk assets should continue to rally. Only once U.S. inflation rises above 2% in 2019, and growth begins to slow on the back of binding supply-side constraints, will equities flounder. Stay long stocks for now, but look to significantly trim exposure towards the end of the year. Regionally, we favor euro area and Japanese equities over U.S. stocks for the next 12 months on a currency-hedged basis. Both the euro area and Japanese stock markets are dominated by large multinational companies whose prospects are geared more towards global growth than demand in their own regions. Above-trend global growth and rising capital spending should disproportionately benefit European and Japanese bourses, given that they have a greater tilt towards cyclically-sensitive companies. Valuations also tend to favor non-U.S. stocks. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?," dated May 31, 2017; Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 3 Please see "Repealing the Individual Health Insurance Mandate: An Updated Estimate," Congressional Budget Office, dated November 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

特別レポート

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Chart 13...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights Global growth will remain strong in 2018, but the composition of that growth will shift in favour of the U.S. The surprise results of the Alabama Senate election are unlikely to scuttle the Republicans' tax plans. We expect a bill to be finalized by the end of the year. The Fed is poised to raise rates four times next year, two more hikes than the market is pricing in. The dollar should stage a modest rebound in 2018. China's economy will decelerate over the coming months, but merely from an above-trend pace. Near-term concerns about Chinese debt levels are overblown. Stay cyclically overweight global risk assets at least for the next six months. Feature Tax Cut Or Not, U.S. Growth Is Likely To Stay Strong In 2018 We expect global growth to remain strong in 2018. However, the composition of that growth is likely to shift back towards the United States. The weakening of the dollar this year should boost net exports, while dwindling spare capacity and faster wage growth should spur business investment and consumer spending. A looser fiscal policy will also help buoy the U.S. economy, but as we have discussed in recent reports, the contribution to growth from lower tax rates is likely to be fairly modest.1 We estimate that the final bill will lift real GDP growth by about 0.2%-0.3% in 2018 and 2019. The effects will diminish thereafter, eventually turning negative as larger budget deficits crowd out the savings that are necessary to finance private-sector investment. Democrat Doug Jones' surprise victory in the Alabama Senate election has thrown a wrench into the legislative process. Outgoing Senator Bob Corker voted against the original bill. If the reconciled House and Senate bill is not passed by the time Jones is seated in January, the Republicans may not have enough votes to get it through the chamber. Our geopolitical strategists expect the bill to pass by the end of the year, but this will likely require that Congressional Republicans acquiesce to Senator Collins' demand that Congress adopt legislation to help health insurers deal with the proposed abolition of the individual mandate. It may also require that Republican dealmakers ditch their last-minute effort to cut the marginal personal tax rate to 37% (the House version of the bill penciled in a top rate of 39.6%, while the Senate version envisioned a rate of 38.5%). The Fed Keeps On Hiking The Federal Reserve hiked rates again this week, taking the fed funds target range up to 1.25%-1.50%. The Fed's determination to tighten monetary policy at a time when inflation is still below target has many investors fretting. We are not particularly concerned. Inflation is a highly lagging indicator. The New York Fed's Underlying Inflation Gauge, which includes various forward-looking inflation components such as producer prices and the ISM prices paid index, has accelerated to a cycle high of 3.0% (Chart 1). The unemployment rate is likely to fall to 3.5% by the end of next year. This would leave it more than one full point below NAIRU and 0.4 points below the median dot in the Summary Of Economic Projections released on Wednesday. Auxiliary measures of labor market slack, such as the U-6 rate and the share of the working-age population that is out of the labor force but wants a job, have also fallen back to pre-recession levels (Chart 2). Chart 1U.S. Inflationary Pressures Starting To Brew Chart 2Labor Market Slack Has Largely Vanished If U.S. growth surprises on the upside next year, as we expect, the Fed is likely to raise rates four times in 2018. This is roughly two more hikes than the market is currently pricing in. We recommended shorting the December 2018 fed funds futures contract on September 7th. The trade is up 48 basis points since then, but we think there is still scope for further gains. Modestly Slower Growth Elsewhere Outside the U.S., growth is likely to come down a notch in 2018. Japanese growth should cool somewhat from the heady pace of 2.7% seen over the past two quarters. Euro area growth is also likely to tick lower, as the impact of a stronger euro begins to bite. Financial conditions in the U.S. have loosened significantly relative to those in the euro area since the start of 2017. If history is any guide, this will cause euro area inflation to rise less than U.S. inflation over the coming year (Chart 3). This, in turn, will keep the ECB's forward guidance on the dovish side. This week's ECB meeting reinforced the message that the central bank is unlikely to raise rates at least until the summer of 2019. Chart 3Diverging Financial Conditions Will Have Inflationary Consequences Chart 4 shows that the euro has strengthened more against the dollar since the beginning of this year than can be accounted for by changes in interest rate expectations. We expect EUR/USD to fall back to 1.11 by the end of 2018. Chart 4AEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials Chart 4BEUR/USD Has Strengthened More Than What One Would Have Expected Based On Changes In Interest Rate Differentials The Chinese Wildcard The biggest question mark over growth surrounds China. Real-time measures of industrial activity such as electricity generation, freight traffic, and excavator sales have slowed since the start of the year (Chart 5). The Caixin manufacturing PMI has also dipped, signaling weaker growth prospects among the country's small-to-medium sized private enterprises. Monetary conditions have tightened (Chart 6). How worried should investors be? So far, there is no reason to panic. Growth has weakened, but from an above-trend pace. Nominal GDP growth reached 11.2% year-over-year in Q3 2017, up from 6.4% in Q4 2015. Producer price inflation rose to 6.9% in October before backing off to 5.8% in November. Some cooling in the economy was both inevitable and desirable (Chart 7). Chart 5Growth Has Ticked Down ##br##Modestly In China Chart 6Monetary Conditions Have##br## Tightened In China Chart 7Chinese Growth Has Merely Weakened##br## From An Above-Trend Pace A more ominous slowdown cannot be ruled out, but that would require a substantial policy error. Such errors have occurred in the past. In 2015, the government undertook measures to reduce credit growth and cool the property market just as the global manufacturing sector was entering a recession on the heels of a sudden decline in energy sector capex. The Chinese authorities amplified the problem by trying to tippy-toe over the question of whether to devalue the currency, even as other EM currencies were sinking. This led to large capital outflows, thereby exacerbating the tightening in Chinese financial conditions. The circumstances today are quite different from 2015. While the authorities have clearly stepped up the pace of reforms following the Party Congress, the global and domestic backdrop is a lot more favorable. Global growth is much stronger. The yuan is also a lot cheaper - down 8.8% in real trade-weighted terms since its peak in 2015 (Chart 8). Chart 8The Yuan Has Cheapened Since 2015 Domestic demand remains on a firm footing. The service sector PMI ticked up further in November, an important development considering that China's service sector is now larger than its manufacturing sector (Chart 9). Alibaba reported sales of over U.S. $25 billion on its platform on "Singles Day" last month, up 39% from last year, and greater than U.S. online sales on Black Friday and Cyber Monday combined. The Chinese government is unlikely to take measures that allow growth to fall significantly below trend. Indeed, if anything, the recent evidence suggests that the authorities are tentatively easing their foot off the brake. Bond yields and credit spreads have come off their recent highs. New loans to the real economy clocked in at RMB 1.12 trillion in November, well above consensus estimates of RMB 800 billion. While the year-over-year change in M2 growth remains close to historic lows, the three-month change has hooked up (Chart 10). Chart 9It's Not All About Manufacturing In China Chart 10China: Money Growth Starting To Accelerate Higher core inflation has pushed real deposit rates into negative territory, making it increasingly painful for households to hold cash. This should cause the velocity of money to speed up, allowing nominal GDP growth to exceed money growth. Don't Bet On A Chinese Debt Crisis... Yet What about the longer-term debt issues haunting China? Here, there is both good and bad news. The bad news is that China's need to keep piling on debt may be an even more vexing problem than typically assumed. Pundits often claim that the government simply needs to bite the bullet and take the painful measures that are necessary to curb debt growth. The problem with this argument is that it sidesteps the question of what will offset the loss in spending from slower debt accumulation. Chinese households are massive net savers (Chart 11). As a matter of arithmetic, these savings must either be transformed into domestic investment or exported abroad via a current account surplus. China used to emphasize the latter. Its current account surplus reached 10% of GDP in 2007, mainly due to a widening trade surplus. It would be economically and politically impossible to pursue such a beggar-thy-neighbour strategy today. Economically, China is simply too big. Its economy has more than doubled relative to the rest of the world over the past decade (Chart 12). Politically, no major economy these days is prepared to tolerate a massive trade deficit with China - certainly not the U.S. Chart 11Mattresses Are ##br##Thicker In China Chart 12China's Size Limits Its Ability To Export Its ##br##Way Out Of Its Problems This means that China must now recycle excess savings internally. One way that Chinese households have done this is by purchasing real estate. In many respects, the Chinese property market has served as a piggy bank of sorts for much of the population. Large amounts of savings have also been placed into bank deposits and, increasingly, so-called wealth management products. These funds have then been used to satisfy the borrowing needs of local governments and business enterprises. It is no surprise that credit growth in China began to accelerate in 2009, just as the current account surplus was starting to narrow (Chart 13). In practice, the distinction between fiscal and corporate spending in China is rather blurry. Chart 14 shows China's official general government budget deficit as well as an augmented version constructed by the IMF which includes various off-balance sheet expenses. The former stands at a reasonably slim 3.7% of GDP, while the latter weighs in at a hefty 12.6% of GDP. Chart 13Credit Growth Took Off As ##br##Current Account Surplus Shrunk Chart 14China's "Secret" ##br##Budget Deficit A large chunk of these off-balance sheet items consist of losses incurred by China's state-owned enterprises. In many respects, these companies are the equivalent of Japan's fabled "bridges to nowhere": They exist to prop up demand in an economy where there is too much savings. Rather than making the economy more efficient, the risk is that structural reforms, if undertaken too rapidly, will simply depress growth. The most misallocated resource is a worker who wants a job but cannot find one. The troubling implication is that deleveraging may be difficult to achieve without causing significant economic distress. On The Bright Side... Fortunately, a number of factors mitigate the risks of a Chinese debt crisis. As Japan's experience shows, as long as a country has ample domestic savings and borrows primarily in its own currency, debt can increase to levels that many people might have thought impossible. Moreover, most of China's debt mountain consists of loans made by state-owned banks to SOEs and local governments. These loans often carry implicit guarantees from the central government. While this exacerbates the moral hazard problem, it does limit the potential of "leveraged losses" to lead to a massive credit crunch of the sort experienced during the Global Financial Crisis. China also has reasonably good long-term growth prospects. Output-per-worker is only a quarter of U.S. levels. Likewise, capital-per-worker is a fraction of what it is among advanced economies (Chart 15). Even with its bleak demographics, China would need to grow by around 6% per year over the coming decade if it were to remain on course to catch up to South Korea in output-per-worker by 2050 (Chart 16). Chart 15China Has More Catching Up To Do (1) Chart 16China Has More Catching Up To Do (2) Given China's well-educated labor force, it is likely that productivity levels will continue to converge with richer economies in the years ahead (Chart 17). Rapid growth, in turn, will allow China to outgrow some its debt and overcapacity problems more easily than would be the case for slower growing economies. Chart 17A Well-Educated Labor Force Bodes Well For China's Development Lastly, not all credit creation in China represents the intermediation of savings into productive investment. A lot of it is simply driven by speculative activities that contribute little to growth. Curbing the ability of individuals and companies to use extreme amounts of leverage to supercharge financial returns would enhance economic stability. To its credit, the government is actively addressing this issue. The bottom line is that Chinese growth is likely to slow modestly next year, but not by enough to imperil the global economy. Investors should remain cyclically overweight global equities and other risk assets at least for the next six months. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017; and Weekly Report, "Fiscal Follies," dated November 17, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Recommended Allocation Highlights We are late cycle. Strong growth could turn in 2018 from a positive for risk assets into a negative. More risk-averse investors may thus want to turn cautious. But the last year of a bull run can be profitable, and we don't expect a recession until late 2019. For now, therefore, our recommendations remain pro-risk and pro-cyclical. We may turn more defensive in 2H 2018 if the Fed tightens above equilibrium. We expect inflation to pick up in 2018, which will lead the Fed to hike maybe four times. This will push long rates to 3%, and strengthen the U.S. dollar. Equities should outperform bonds in this environment. We prefer euro zone and Japanese equities over U.S., and remain underweight EM. Late-cycle sectors such as Financials and Industrials, should do well. We also favor corporate bonds and private equity. Feature Overview Fin de cycle Global economic growth in 2017 was robust for the first time since the Global Financial Crisis (Chart 1). Forecasts for 2018 put growth slightly lower, but are likely to be revised up. However, as the year rolls on, the strong economic momentum may turn from being a positive for risk assets into a negative. U.S. output is now above potential, according to IMF estimates. As Chart 2 shows, historically recessions - and consequently equity bear markets - have usually come within a year or two of the output gap turning positive. With the economy operating above capacity, inflation pressures force the Fed to tighten monetary policy, which eventually causes a slowdown. Chart 1Growth Finally On A Firm Footing Global Growth Has Accelerated Chart 2Recessions Follow Output Gap Closing That is exactly how BCA sees the next couple of years panning out, leading to a recession perhaps in the second half of 2019. U.S. inflation was soft in 2017, but underlying inflation pressures are picking up, with core CPI inflation having bottomed, and small companies saying they are raising prices (Chart 3). Add to that wage pressures (with unemployment heading below 4% in 2018), tax cuts (which might boost growth by 0.2-0.3% points in their first year) and a higher oil price (we expect Brent to average $67 a barrel during the year), and core PCE inflation is likely to rise to 2%, in line with the Fed's expectations. This means the market is too sanguine about the risk of monetary tightening in the U.S. It has priced in less than two rates hikes in 2018, compared to the Fed's three dots, and almost nothing after that (Chart 4). If inflation picks up as we expect, four rate hikes in 2018 could be on the cards. Chart 3Inflation Pressures Picking Up Chart 4Market Still Underpricing Fed Hikes The consequences of this are that bond yields are likely to rise. Despite a significant market repricing since September of Fed behavior, long-term rates have not risen much, leading to a flattening yield curve (Chart 5). The market has essentially priced in that inflation will not rebound and that, consequently, the Fed will be making a policy mistake by hiking further. If, therefore, we are correct that inflation does reach 2%, the yield curve would be likely to steepen over the next six months, with the 10-year U.S. Treasury yield reaching 3% by mid-year. Other developed economies, however, have less urgency to tighten monetary policy and we, therefore, see the U.S. dollar appreciating. The only other major economy with a positive output gap currently is Germany (Chart 6). However, the ECB will continue to set policy for the weaker members of the euro area, and output gaps in France (-1.8% of GDP), Italy (-1.6%) and Spain (-0.7%) remain significantly negative. In the absence of inflation pressures, the ECB won't raise rates until late 2019. Japan, too, continues to struggle to bring inflation up the BOJ's 2% target and the Yield Curve Control policy will therefore stay in place, meaning that a rise in global rates will weaken the yen. Chart 5Is Fed Making A Policy Mistake? Chart 6Still A Lot Of Negative Output Gaps This sort of late-cycle environment is a tricky one for investors. The catalysts for strong performance in equities that we foresaw a few months ago - U.S. tax cuts and upside surprises in earnings - have now largely played out. Global earnings will probably rise next year by around 10-12%, in line with analysts' forecasts. With multiples likely to slip a little as the Fed tightens, high single-digit performance is the best that investors should expect from equities. The macro environment which we expect, would be more negative for bonds than positive for equities. That argues for the stock-to-bond ratio to continue to rise until closer to the next recession (Chart 7). And, for now, none of the recession indicators we have been consistently monitoring over the past months is flashing a warning signal (Chart 8). Chart 7Stock-To-Bond Ratio Likely To Rise Further Chart 8Recession Warning Signals Still Not Flashing More risk-averse investors might chose to reduce their exposure to risk assets now, given how close we are to the end of the cycle. But this would be at the risk of leaving some money on the table, since the last year of a bull run can often be the most profitable (remember 1999?). We, therefore, maintain our recommendation for pro-cyclical and pro-risk tilts: overweight equities versus bonds, overweight credit, overweight higher-beta equity markets and sectors, and a preference towards riskier alternative assets. We may move towards a more defensive stance in mid to late 2018, when we see clearer signs that the Fed has tightened above equilibrium or that the risk of recession is rising. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Be The Impact Of The U.S. Tax Cuts? It is not a done deal, but it still seems likely (notwithstanding the Democratic victory in Alabama) that the U.S. House and Senate will agree a joint tax bill to pass before the end of the year. Since the two current bills have only minor differences, it is possible to make some estimates of the macro and sector impacts of the tax reform. The Joint Committee on Taxation estimates that the cuts will reduce government revenue by $1.4 trillion over 10 years - or $1 trillion (5% of GDP) once positive effects on growth are accounted for. The Treasury argues that tax reform (plus deregulation and infrastructure development) will push GDP growth to 2.9% and therefore government revenues will increase by $300 billion. BCA's estimate is that GDP growth will be boosted by 0.2-0.3% in 2018 and 2019.1 For businesses, the key tax changes are: 1) a reduction in the headline corporate rate from 35% to 21%; 2) immediate expensing of capital investment; 3) a limit to deduction of interest expenses to 30% of taxable income; 4) a move to a territorial tax system from a worldwide one, with a 10% tax on repatriation of past profits held overseas; 5) curbs for some deductions, such as R&D, domestic production and tax-loss carry-forwards. Corporate tax cuts will give a one-off boost to earnings, since the effective tax rate is currently over 25% (Chart 9, panel 1), with telecoms, utilities and industrials likely to be the biggest beneficiaries. This is not fully priced into stocks, since companies with high tax rates have seen their stock prices rise only moderately (Chart 9, panel 2). BCA's sector strategists expect that capex will especially be boosted: they estimate that the one-year depreciation increases net present value by 14% (Table 1).2 This should be positive for the Industrials sector (supplying the capital goods) and for Financials (which will see increased demand for loans). We are overweight both. Chart 9Tax Cuts Should Boost Earnings Table 1 Is Bitcoin A Bubble, And What Happens When It Bursts? The recent surge in prices (Chart 10) of virtual currencies has pushed Bitcoin and aggregate cryptocurrency market cap to $275 billion and $500 billion respectively. The recent violent run-up certainly bears a close resemblance to classic bubbles, but the impact of a sharp correction should be minimal on the real economy and traditional capital markets. As mentioned above, the market cap of cryptocurrencies has reached $500 billion. Globally, there is about $6 trillion in currency3 outstanding, so the value of virtual currencies is now 8% that of traditional fiat currency. Additionally, an estimated 1000 people own about 40% of the world's total bitcoin, for an average of about $105 million per person. At the moment, the macro impact has been constrained by the fact that most people are buying bitcoins as a store of value (Chart 11) or vehicle for speculation, rather than as a medium of exchange. However, when the public begins to regard them as legitimate substitutes for traditional fiat currencies, their impact will be felt on the real economy. Chart 10A Classic Bubble Chart 11Bitcoin Trading Volume By Top Three Currencies That would raise the issue of regulation. The U.S. government generates close to $70 billion per year as "seigniorage revenue." Governments across the world have no intention of losing this revenue, and would most likely introduce their own competitors to bitcoin. Until then, the biggest potential impact of these private currencies might be to spur inflation in the fiat currencies in which their prices are measured. That would be bad for government bonds, but potentially good for stocks. A further risk - and a similarity with the real estate bubble of 2007 - is the use of leverage. The news of a Tokyo-based exchange (BitFyler) offering up to 15x leverage for the purchase of bitcoins has spooked investors. However, the U.S. housing market is valued at $29.6 trillion, almost 60 times that of cryptocurrencies. Finally, the 19th century free banking era in the U.S., which at one point saw 8000 different currencies in circulation, experienced multiple banking crises. A world with myriad private currencies all competing with one another would be similarly unstable. Why Did The U.S. Dollar Weaken In 2017, And Where Will It Go In 2018? Chart 12Positioning And Relative Rates Supportive For USD We were wrong to be bullish on U.S. dollar at the start of 2017. We think the dollar weakness during most of the year can be attributed to the fact that investors were massively long the dollar at the end of 2016 (Chart 12, panel 2), which made the market particularly vulnerable to surprises. Several surprises did come: inflation softened in the U.S. but strengthened in the euro area. There were also positive geopolitical surprises in Europe - for example the victory of Emmanuel Macron in the French presidential election - while the failure to repeal Obamacare in the U.S. raised investors' concerns on the administration's ability to undertake fiscal stimulus. As a result, the U.S. dollar depreciated against euro despite widening interest rate differentials (Chart 12 panel 4) in 2017. Chart 13late Cycle Outperformance Since investors are now aggressively short the dollar, the hurdle for the greenback to deliver positive surprises is much lower than a year ago. Since the Senate passed the Republican tax bill in early December, we have already seen some recovery in the dollar (Chart 12, panel 1). As the labor market continues to firm, with GDP running above potential, U.S. inflation should finally start to pick up in 2018, which will allow the Fed to hike rates, possibly as many as four times during the year. This will contrast with the macro situation overseas: Japan and Europe are likely to continue loose monetary policy to maintain the momentum in their economies. All this should be supportive of the dollar. Are Convertible Bonds Attractive Over The Next 12 Months? With valuations for traditional assets expensive and investors' thirst for yield continuing, the market is in need of alternative sources of return. Convertible bonds offer a hybrid credit/equity exposure, giving investors the option to participate in rising equity markets but with less risk. An allocation to convertibles could prove attractive for the following reasons: Convertible bonds typically outperform high-yield debt in the late stages of bull markets, because of their relatively lower exposure to credit spreads. Junk spreads have a history of starting to widen before equity bear markets begin. Fifty percent of the convertibles index comprises issuance from small-cap and mid-cap firms. Although equity valuations are expensive, prices should continue to rise as long as inflation stays low. Additionally, our U.S. Investment Strategy service thinks that small-cap equities will outperform large caps in the coming months, partly because the likely cuts in U.S. corporate taxes will disproportionately benefit smaller companies. Convertible bonds do appear somewhat cheap relative to equities (Chart 13, panel 3) but, on balance, there is not a strong valuation case for the asset class. Equities appear fairly valued relative to junk bonds, and convertibles are trading at an elevated investment premium. However, valuation is not likely to be a significant headwind to the typical late-cycle outperformance of convertibles versus high yield. biggest near-term risk for convertibles relative to high yield stems from the technology sector, which makes up 35% of the convertibles index. Technology convertible bonds have strongly outperformed their high-yield counterparts in recent months (Chart 13, panel 4), and are possibly due for a period of underperformance. We recommend investors stay cautious on technology convertibles. Other Than U.S. Tips, What Other Inflation-Linked Bonds Do You Like? Our research shows that inflation-linked bonds (ILBs) are a good inflation hedge in a rising inflationary environment.4 With our house view of rising inflation in 2018, we have been overweight U.S. Tips over nominal Treasury bonds as the U.S. is the most liquid market for inflation-linked bonds, with a market cap of over US$ 1.2 trillion. Outside the U.S., we favor ILBs in Japan and Australia, while we suggest investors to avoid ILBs in the U.K. and Germany (even though the U.K. linkers' market is the second largest after the U.S.), for the following two key reasons: First, even though inflation is below target in Japan, Australia and the euro area, while above target in the U.K., in all of these markets, inflation has bottomed, as shown in Chart 14. Second, our breakeven fair-value models, which are based on trade-weighted currencies, the Brent oil price in local currencies, and stock-to-bond total-return ratios, indicate that ILBs are undervalued in Japan and Australia, while overvalued in the U.K. and Germany, as shown in Chart 15. Chart 14Inflation Dynamics Chart 15Where to Buy Inflation? The shorter duration (in real terms) of ILBs are an added bonus which fits well with our overall underweight duration positioning in the government bond universe. Global Economy Overview: Growth in developed economies remains strong and there is little in the data to suggest it will slow. This is likely to push up inflation and interest rates, especially in the U.S., over the next six to 12 months. Prospects for emerging markets, however, are less encouraging given that China is likely to slow moderately as it pushes ahead with reforms. U.S.: U.S. growth momentum remains very strong. GDP growth in the past two quarters has come in over 3%, and NowCasts for Q4 point to 2.9-3.9%. The Citigroup Economic Surprise Index (Chart 16, panel 1) has surged since June, and the Manufacturing ISM is at 53.9 and the Non-Manufacturing at 57.4 (panel 2). The worst that can be said is that momentum will be unable to continue at this rate but, with business confidence high, wage growth likely to pick up in 2018, and some positive impacts from tax cuts, no significant slowdown is in sight. Euro Area: Given its stronger cyclicality and ties to the global trade cycle, euro zone growth has surprised on the upside even more strongly than in the U.S. The Manufacturing PMI reached 60.6 in December (its highest level since 2000), and GDP growth in Q3 accelerated to 2.6% QoQ annualized. The euro's strength in 2017 seems to have done little to dent growth, and even weaker members of the euro zone such as Italy have seen improving GDP growth (1.7% in Q3). With the ECB reining back monetary easing only slightly, and banking problems shelved for now, growth should remain resilient in early 2018. Japan: Retail sales saw some weakness in October (-0.2% YoY), probably because of bad weather, but elsewhere data looks robust. Q3 GDP came in at 1.3% QoQ annualized and export growth remains strong at 14% YoY. There are even some signs of life in the domestic economy, with wages finally picking up a little (+0.9% YoY), driven by labor shortages among part-time workers, and consumer confidence at a four-year high. Inflation has been slow to rise, but at least core core inflation (the Bank of Japan's favorite measure) is now in positive territory at +0.2%. Emerging Markets: Chinese credit and monetary series, historically good lead indicators for the real economy, continue to decline (M2 growth in October of 8.8% was the lowest since data started in 1996). But, for now, economic growth has held up, with the Manufacturing and Non-Manufacturing PMIs both stably above 50 (Chart 17, panel 3). Key will be how much the government's moves to deleverage the financial system and implement structural reform in 2018 will slow growth. Elsewhere in emerging markets, economic growth remains sluggish, with GDP growth in Brazil barely rebounding to 1.4% YoY, Russia to 1.8%, and India slowing to 6.3% (down from over 9% in early 2016). Chart 16Growth Momentum Very Strong Chart 17Will China And EM Slow in 2018? Interest rates: We expect U.S. inflation to pick up in 2018, as the lagged effects of 2017's stronger growth and the weak dollar start to come through, amid higher oil prices and rising wages. We, along with the Fed, expect core PCE inflation to rise to 2% during the year. This means the Fed is likely to raise rates four times, compared to market expectations of twice. Consequently, we see the 10-year Treasury yield over 3% by mid-year. In the euro zone, the still-large output gap means inflation is less likely to surprise on the upside, allowing the ECB to keep negative rates until well into 2019. The Bank of Japan is unlikely to alter its Yield Curve Control, given the signal this would send to the market when inflation expectations are still well below its 2% target (Chart 17, panel 4). Chart 18Equities: Priced for Perfection Global Equities Still Cautiously Optimistic: Our pro-cyclical equity positioning in 2017 worked very well in terms of country allocation (overweight euro zone and Japan in the DM universe) and global sector allocation (favoring cyclicals vs defensives). The two calls that did not pan out were underweight EM equities vs. DM equities, which was partially offset by our positive stance on China within the EM universe, and the overweight of Energy, which was the worst performing sector of the year. The stellar equity performance in 2017 was largely driven by strong earnings growth. Margins improved in both DM and EM; earnings grew in all sectors, and analysts remained upbeat (Chart 18). Another important contributor to 2017 performance was the extraordinary performance of the Tech sector, especially in China: globally, tech returned 41.9%, outperforming the MSCI all country index by 18.9%. GAA's philosophy is to take risk where it is mostly likely be rewarded. In July, we took profits in our Tech overweight and used the funds to upgrade Financials to overweight from neutral. Then in October we started to reduce tracking risk by scaling down our active country bets, closing our overweight in the U.S. to reduce the underweight in EM. BCA's house view is for synchronized global growth to continue in 2018, but a possible recession in late 2019. We are a little concerned that equity markets are priced for perfection, given that our earnings model indicates a deceleration in the coming months mostly due to a base effect. As such, our combination of "close to shore" country allocation and "pro-cyclical" sector allocation is appropriate for the next 9-12 months. Country Allocation: Still Favor DM Over EM Chart 19China: From Tailwind to Headwind for EM ? Our longstanding call of underweight EM vs. DM since December 2013 was gradually reduced in scale, first in March 2016 (to -5 percentage points from -9) and then in October 2017 (further to -2 points). Going forward, investors should continue to maintain this slight underweight position in EM vs. DM. First, our positive stance on China proved to be timely as shown in Chart 19, panel 4, with China outperforming EM by 54.1% since March 2016, and by 18.8% in 2017. Back then our positive stance on China was supported by attractive valuations (bottom panel) and our view that Chinese politics would be supportive for global growth in the run up to the 19th Party Congress. Now BCA's Geopolitical Strategists think that "China politics are shifting from a tailwind to a headwind for global growth and EM assets".5 In addition, Chinese equities are no longer valued at a discount to the EM average (bottom panel). Second, BCA's currency view is for continued strength in the USD, especially against emerging market currencies. This does not bode well for EM/DM performance in US dollar terms (Chart 19, panel 1). Third, EM money growth leads profit growth by about three months (Chart 19, panel 2). The rolling over in money growth indicates that the currently strong earnings growth may lose steam going forward, while relative valuation is in the fair-value zone (Chart 19, panel 3). Sector Allocation: Stay Overweight Energy Our pro-cyclical sector positioning has worked well in aggregate as the market-cap-weighted cyclical index significantly outperformed the defensive index in 2017. This positioning is also in line with BCA's house view of synchronized global growth and higher inflation expectations, which translates into two major sector themes: capex recovery and rising interest rates. (Please see detailed sector positioning on page 24.) Within the cyclical space, however, the Energy sector did not perform as expected in 2017 (Chart 20). It returned only 3.4%, underperforming the global aggregate by 19.6%. For the next 9-12 months, we recommend investors to stay overweight this underdog of 2017. Chart 20Energy Stocks Lagging Oil Price First, the energy sector is a major beneficiary from a capex recovery. There are already signs of a recovery in basic resources investment in the U.S.6 Second, the energy sector's relative return lagged oil price performance in 2017. Given the generally close correlation between earnings and the oil price, and between analyst earnings revisions and OECD oil inventory growth, earnings in the sector should outpace the broad market. Third, based on price-to-cash earnings, the energy sector is still trading at about a 30% discount to the broad market, and offers a much higher dividend yield (about 1.2 points higher) than the broad market. Even though these discounts are in line with historical averages, they are still supportive of an overweight. Government Bonds Maintain Slight Underweight Duration. One important theme for 2018 will be a resumption of the cyclical uptrend in inflation.7 The implications are that both nominal bond yields and break-even inflation rates will be higher in 2018. We have been underweight duration in government bonds since July 2016. Now with the U.S. 10-year Treasury yield at 2.35%, much lower than its fair value of 2.81%, there is considerable upside risk for global bond yields from current low levels. Investors should continue to underweight duration in global government bonds Maintain Overweight Tips Vs. Treasuries. The base-case forecast from our U.S. bond strategists is that the Tips breakeven rate will rise to 2.4-2.5% as U.S. core PCE reaches the Fed's 2% target, probably sometime in the middle of 2018. Compared to the current level of 1.87%, 10-yr Tips would have upside of 33-38 bps, an important source of return in the low-return fixed-income space (Chart 21, bottom panel). In terms of relative value, Tips are now slightly cheaper than nominal bonds, also supportive of the overweight stance. Underweight Canadian Government Bonds. BCA's Global Fixed Income Strategy has taken profits in their short Canada vs. U.S. and U.K. tactical position, as the market has become too aggressive in pricing in more rate hikes in Canada. Strategically, however, the underweight of Canada (Chart 22) in a hedged global portfolio is still appropriate because: 1) the output gap has closed in Canada, according to Bank of Canada estimates, and so any additional growth will translate into higher inflation; and 2) the rising CAD will not deter the BoC from more rate hikes if the oil prices remain strong. Chart 21U.S. Bond Yields Have Further To Rise Chart 22Strategic Underweight Canadian Bonds Corporate Bonds Our overweights through most of 2017 on spread product worked well: U.S. investment grade (IG) bonds returned around 290 bps over Treasuries in the year to end-November, and high-yield bonds almost 600 bps. Returns over the next 12 months are unlikely to be as attractive. Spreads (Chart 24) are now close to historic lows: the U.S. IG bond spread, at 90 bps, is only about 30 bps above its all-time record. High-yield valuations look a little more attractive: based on our model of probable defaults over the next 12 months, the default-adjusted spread over U.S. Treasuries is likely to be around 240 bps (Chart 25). In both cases, however, investors should expect little further spread contraction, meaning that credit is now no more than a carry trade. However, in an environment where rates remain fairly low and investors continue to stretch for yield, that pick-up will remain attractive in the absence of a significant turn-down in the economic cycle. The key to watch is the shape of the yield curve. An inverted yield curve in history has been an excellent indictor of the end of the credit cycle. We expect the yield curve to steepen somewhat in H1 2018, before flattening again and then inverting late in the year. Spread product is likely, therefore, to produce decent returns until that point. Thereafter, however, the deterioration of U.S. corporate health over the past three years (Chart 23) could mean a sharp sell-off in corporate bonds. This might be exacerbated by the recent popularity of open-ended mutual funds and ETFs: a small widening of spreads could be magnified by a panicked sell-off in such funds. Chart 23Rising Leverage May Worsen Sell-Off Chart 24Credit Spreads Close To Record Lows Chart 25But Default - Adjusted, Junk Still Looks Attractive Commodities Energy: Bullish Energy prices performed strongly in H2 2017, and we expect bullish sentiment to continue. OPEC 2.0 is likely to maintain production discipline, and will maintain its promised 1.8mm b/d production cuts through the end of 2018. Our estimates for global demand growth are higher than those of other forecasters. This, along with potential unplanned production outages in Iraq, Libya and Venezuela (together accounting for 7.4mm b/d of production at present), drives our above-consensus price forecast of $67 a barrel for Brent crude during 2018. Industrial Metals: Neutral Since China accounts for more than 50% of world base-metal consumption, prices will continue to be highly dependent on developments there. (Chart 26, panel 4). Since the government is trying to accelerate environmental and supply-side reforms, domestic production capacity for base metals will shrink, which will be a positive for global metals prices. However, a focus on deleveraging in the financial sector and restructuring certain industries could slow Chinese GDP growth, reducing base-metal demand. Precious Metals: Neutral Gold has risen by 12% in 2017, supported by an uncertain geopolitical environment coupled with low interest rates. We believe that geopolitical uncertainties will persist and may even intensify, and that inflation may rise in the U.S., which would be positives for gold (Chart 26, panel 3). Based on BCA's view that stock market could be at risk from the middle of 2018,8 a moderate gold holding is warranted as a safe-haven asset. However, rising interest rate and a potentially stronger U.S. dollar are likely to limit the upside for gold. Currencies USD: The currency is down over 6% on a trade-weighted basis over the past 12 months (Chart 27). Looking into 2018, the USD is likely to perform well in the first half. U.S. inflation should gather steam in the first two to three quarters, and the Fed will be able at least to follow its dot plot - something interest rate markets are not ready for. As investors remain short the USD, upside risk to U.S. interest rates should result in a higher dollar. Chart 26Bullish Oil, Neutral Metals Chart 27Dollar Likely To Appreciate EM/JPY: Carry trades are a key mechanism for redistributing global liquidity, and they have recently begun to lose steam. A crucial reason for this has been the policy tightening in China which has been the key driver of growth in EM economies. Additionally, Japanese flows have been chasing momentum into EM assets. Further tightening in EM could reverse the flows and initiate a flight to safety, favoring the yen relative to EM currencies. CHF: The currency continues to trade at a 5% premium to its PPP fair value against the euro. However, after considering Switzerland's net international investment position at 130% of GDP, the trade-weighted CHF trades in line with fair value. The CHF will continue to behave as a risk-off currency, and so long as global volatility remains well contained, EUR/CHF will experience appreciating pressure. GBP: Sterling continues to look cheap, trading at an 18% discount to PPP against the USD. However, Brexit remains a key problem. If future immigration is limited, the U.K. will see lower trend growth relative to its neighbors, forcing its equilibrium real neutral rate downward. Consequently, it will be more difficult to finance the current account deficit of 5% of GDP. Until negotiations with the EU come closer to completion, the pound will continue to offer limited reward and plenty of volatility. Alternatives Chart 28Favor Private Equity and Farmland Alternative assets under management (AUM) have reached a record $7.7 trillion in 2017. Lower fees and a broader range of investment types have helped attract more capital. Private equity remains the most popular choice,9 driven by its strong performance and transparency. Many investors have also shifted part of their allocations toward potentially higher-return private debt programs. Return Enhancers: Favor Private Equity Vs. Hedge Funds In 2017 so far, private equity has returned 12.1%, whereas hedge funds have managed only a 5.9% return (Chart 28). We expect private-equity fund-raising to continue into 2018, but with a larger focus on niche strategies with more favorable valuations. Additionally, deploying capital gradually not only provides for vintage-year diversification, but also creates opportunities for investors to benefit from potential market corrections. We continue to favor private equity over hedge funds outside of recessions. During a recession, we recommend investors take shelter in hedge funds with a macro mandate. Inflation Hedges: Favor Direct Real Estate Vs. Commodity Futures In 2017 to date, direct real estate has returned 5.1%, whereas commodity futures are down over 3.7%. Direct real estate as an asset class continues to provide valuable diversification, lower volatility, steady yields and an illiquidity premium. However, a slowdown in U.S. commercial real estate (CRE) has made us more cautious on the overall asset class. With regards to the commodity complex, the long-term transition of the global economy to a more renewables-focused energy base will continue the structural decline in commodity demand. We continue to stress the structural and long-term nature of our negative recommendation on commodities. Volatility Dampeners: Favor Farmland & Timberland Vs. Structured Products In 2017 to date, farmland and timberland have returned 3.2% and 2.1% respectively, whereas structured products are up 3.7%. Farmland continues to outperform timberland. The slow U.S. housing recovery has added downward pressure to timberland returns. Investors can reduce the volatility of a traditional multi-asset portfolio with inclusion of farm and timber assets. For structured products, low spreads in an environment of tightening commercial real estate lending standards and falling CRE loan demand, warrant an underweight. Risks To Our View We think upside and downside risks to our central scenario for 2018 - slowing but robust economic growth, and continuing moderate outperformance of risk assets - are roughly evenly balanced. On the negative side, perhaps the biggest risk is China, where the slowdown already suggested in the monetary data (Chart 29) could be exacerbated if the government pushes ahead aggressively with structural reforms. Geopolitical risks, which the market over-emphasized in 2017, seem under-estimated now.10 U.S. trade policy, Italian elections, and North Korea all have potential to derail markets. Also, when the U.S. yield curve is as flat as it is currently, small risks can be blown up into big sell-offs. This is particularly so given over-stretched valuations for almost all asset classes. Chart 29China Monetary Conditions Suggest A Slowdown Table 2How Will Trump Try To Influence The Fed? The most likely positive surprise could come from a dovish Fed. New Fed chair Jay Powell is something of an unknown quantity, and the White House could use the three remaining Fed vacancies to push the Fed to keep rates low, so as not to offset the positive effect of the tax cuts. Without these new appointees, the Fed would have a slightly more hawkish bias in 2018 (Table 2). The intellectual argument for hiking only slowly would be, as Janet Yellen said last month: "It can be quite dangerous to allow inflation to drift down and not to achieve over time a central bank's inflation target." The Fed has missed its 2% target for five years. It is possible to imagine a situation where the Fed increasingly makes excuses to keep monetary policy easy (encouraged, for example, by a short-lived sell-off in markets or a slowdown in China) and this causes a late-cycle blow-out, similar to 1999. 1 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017 available at gis.bcaresearch.com. 2 Please see U.S. Equity Strategy Insight Report, "Tax Cuts Are Here - Sector Implications," dated December 12, 2017, available at uses.bcaresearch.com. 3 CBNK Survey: Monetary Base, Currency in Circulation. Source: IMF - International Financial Statistics. 4 Please see Global Investment Strategy Special Report, "Two Virtuous Dollar Circles," dated October 28, 2016, available at gis.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 6 Please see U.S. Equity Strategy Weekly Report, "High-Conviction Calls," dated November 27, 2017, available at uses.bcaresearch.com. 7 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated 20 November 2017, available at bca.bcaresearch.com. 8 Please see The Bank Credit Analyst, "Outlook 2018 - Policy And The Markets: On A Collision Course," dated November 20, 2017, available at bca.bcaresearch.com. 9 Source: BNY Mellon - The Race For Assets; Alternative Investments Surge Ahead. 10 Please see Geopolitical Strategy Weekly Report, "From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. GAA Asset Allocation

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

特別レポート

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

Highlights Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This points to a major top in EM share prices. In Brazil, falling inflation has led to a relapse in nominal GDP growth. This has endangered the already-bad public debt dynamics. Without the social security reforms, the country needs to boost nominal growth to stabilize public debt dynamics. Currency depreciation will likely be required to achieve this. When the Brazilian currency sells off, the nation's financial markets perform poorly. Feature Deteriorating EM Equity Breadth Breadth within EM equity markets has been deteriorating, especially in relative terms, versus DM stock markets. This heralds a major downleg in EM versus DM relative share prices, at a minimum, and a relapse in EM share prices in absolute terms as well. Chart I-1 demonstrates that the relative performance of EM equal-weighted stock index versus the DM equal-weighted share price index has decoupled from the relative performance of EM versus DM market cap-weighted equity benchmarks. Such a gap has emerged for the first time since 1999, when MSCI's equal-weighted equity data became available. Chart I-1EM Equity Outperformance Narrowly Based Versus DM... Each stock has the same weight in the equal-weighted index, while the regular indexes are market-cap weighted. Hence, an equal-weighted index reflects performance of an average stock while the market cap-weighted ones are skewed by the performances of large-cap stocks. This confirms what many investors already know: that in 2017, EM outperformance versus DM has been largely due to the surge in four large-cap technology stocks in Asia. Comparing EM against the U.S. only on similar measures, the message is identical (Chart I-2). Chart I-3 illustrates the absolute performance of MSCI EM market cap-weighted and MSCI EM equal-weighted equity indexes. It appears that the EM equal-weighted stock index has failed to make new cyclical highs lately. Thereby, it has not confirmed the new high in the EM market-cap weighted equity benchmark (Chart I-3). Chart I-2...And U.S. Chart I-3EM Equal-Weighted Index Did Not ##br##Confirm EM Market-Cap Recent Highs Similarly, the rally in share prices of EM banks - an important macro-driven sector of the EM equity universe - has lately paused. As such, it has also not confirmed the new high in the overall EM equity benchmark (Chart I-4). Given EM tech stocks (29% of MSCI benchmark index) are extremely overbought, the EM equity rally can be sustained if leadership rotates to EM financials and commodities stocks, which account for 23% and 14% of market cap, respectively. The failure of both EM financials and commodities stocks to make new cyclical highs of late suggests the EM equity rally is wearing off. The advance-decline line for EM stocks has lately dropped below the 50 line (Chart I-5, top panel). By contrast, the DM measure is still above 50 (Chart I-5, bottom panel). This signals a major bout of EM underperformance versus DM, as well as downside risks to EM's absolute performance. Chart I-4EM Banks Also Did Not Confirm ##br##EM Market-Cap Recent Highs Chart I-5Poor Advance-Decline Line In EM Equities The weak technical profile for EM equities is consistent with our fundamental assessment that the main risks to global growth and share prices stem from EM/China rather than DM economies. Therefore, EM/China plays will be the first to roll over, while DM stocks will lag. Investors looking for signs of reversal in the rally in global risk assets should monitor EM/China plays. Finally, EM small cap stocks' relative performance against their DM counterparts has not confirmed the EM outperformance based on an aggregate index (Chart I-6). This is a negative signal as well, and heralds new lows in relative performance. This also corroborates that, outside those EM large-cap tech stocks that have gone exponential, the EM equity rally has been much less exuberant and vigorous. More importantly, the EM rally has recently shown signs of fatigue. Bottom Line: Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This implies that a major downturn in EM share prices as well as EM risk assets generally is approaching. Investors should stay put/underweight EM risk assets. Brazil: A Political Economy Dilemma The Nominal Impediment We are aware that the pace of economic activity in Brazil is presently gathering speed. Manufacturing, retail sales and hiring are all recovering (Chart I-7). Even capital spending that has been shrinking until recently is now starting to show signs of life. Chart I-6EM Small Caps Have Not Confirmed ##br##EM Large Cap Outperformance Chart I-7Brazil: Economic Activity Is Recovering Nevertheless, Brazil's public debt dynamics remain unsustainable. Nominal GDP growth has declined to its 2015 low - as falling inflation has more than offset the revival in real output (Chart I-8). Besides, real interest rates remain elevated and nominal GDP growth is well below the government's borrowing costs (Chart I-9). Chart I-8Brazil: Real Growth Is Recovering ##br##While Nominal Growth Is Relapsing Chart I-9Brazil: Borrowing Costs Are Still High Therefore, without full-fledged social security reforms and/or lowering ex-ante real interest rates substantially, the public debt trajectory will likely spin out of control. Interest rates in real terms are also elevated for the private sector. This suggests that credit stress among companies and households might not recede quickly, and high real interest rates might cap the recovery in loan growth (Chart I-10). Interestingly, Chart I-11 demonstrates that private banks' NPLs (non-performing loans) inversely correlate with nominal GDP growth (nominal GDP is inverted on the chart). This entails that the amelioration in Brazil's NPL cycle is at least due for a pause. Chart I-10Brazil: Bank Loan Growth Is Stabilizing Chart I-11Brazil: Nominal GDP & Bank NPLs In short, to stabilize public and private debt dynamics, higher nominal GDP growth and much lower borrowing costs in real terms are vital. The latter means an unexpected rise in inflation is required. Chart I-12Brazil In the Late 1990s To boost nominal growth considerably and finance government at lower real interest rates, a combination of quantitative easing (QE) and currency depreciation will be needed. This is not a forecast that the Brazilian central bank will certainly implement QE. Rather, our point is that without extensive social security reforms - which are politically unfeasible now (more on this below) - a meaningful currency depreciation and/or public debt monetization by the central bank will be necessary to stabilize public debt dynamics and put the economy on a sustainable expansion path. Remarkably, in the late 1990s, faced with low inflation and weak nominal growth, the Brazilian government opted for large currency devaluation, which boosted nominal GDP growth (Chart I-12). Notably, the currency was devalued despite the large share of public foreign currency debt. This ratio is now very low. Hence, currency depreciation will be less painful now than it was in 1998. A Political Economy Dilemma: Growth Versus Creditors Brazil's elected politicians (congressmen and senators) are facing a political economy dilemma: (a) Should they satisfy interests of government creditors (including foreign investors) - i.e., pursue painful fiscal reforms to make public debt sustainable? Or (b) Should they gratify the electorate - i.e., avoid austerity and stimulate the still-beleaguered economy? To put this in perspective, the economy is just exiting one of the worst recessions of the past century, and the unemployment rate is still at a decade high. Over the next several months, the government of President Michel Temer will try to pass a diluted version of the pension reform bill. The government is desperate to enact this bill to keep financial markets buoyant and preserve the ongoing economic recovery heading into the elections. Being already very unpopular, government officials realize this is the only way their candidate has a chance to get elected in the presidential elections next year. However, the diluted version will not be enough to ensure debt sustainability. Chart I-13Brazil's Median Voter Favors ##br##Anti-Government Candidates Moreover, many of the government's coalition partners have different incentives. Going into the general elections in October 2018, odds favor that the majority of congressmen and senators will likely vote for avoiding austerity. As a result, the pension reforms draft - even in its diluted form - will likely fail. The median voter in Brazil remains on the left. Chart I-13 reveals that according to the latest polls, 60% of voters support anti-market candidates. Hence, any politician who wants to be elected needs to heed to the electorate. Worsening Fiscal Dynamics Public debt sustainability has been worsening: The primary and overall deficits have lately widened to 2.9% and 9.3% of GDP, respectively (Chart I-14). Public debt sustainability necessitates that the primary fiscal balance swings into a surplus, and borrowing costs drop below nominal GDP. None of these requirements have been satisfied or are likely to be anytime soon. Meanwhile, central government total revenue growth has dwindled (Chart I-15, top panel). In turn, central government net revenue - i.e. excluding transfers to local governments - are mildly contracting due to the increase in revenue transfers to the latter (Chart I-15, bottom panel). Chart I-14Brazil: Fiscal Deficit Has Not Improved Chart I-15Central Government Revenues Are Very Weak Furthermore, the overall fiscal deficit excluding social security is at 6% of GDP and has widened over the past year (Chart I-14, bottom panel). Interest payments account for 32% of government spending and 6.4% of GDP. On the whole, without a large fiscal retrenchment and with real interest rates close to current levels, the gross public debt-to-GDP ratio will likely reach 85% by the end of 2018 and 92% in two years' time - even if nominal GDP growth recovers to 6-6.5%. This puts the impetus solely on the central bank to reflate nominal growth aggressively and/or bring down real interest rates. This can be achieved via currency depreciation or public debt monetization. The outcome of the latter will necessarily be a major drop in the currency's value. This, along with our negative view on commodities prices in general and iron ore prices in particular, prompts us to retain our bearish stance on the Brazilian real. Chart I-16 demonstrates that the currency is highly correlated with iron ore prices, and has no correlation with the level of and changes in the interest rate differential between Brazil and the U.S. Investment Implications The path of least resistance for the Brazilian real is down - it will depreciate more than 2% and 4% that are implied by 6- and 12-month forwards, respectively. Stay short. When the Brazilian currency sells off, the nation's financial markets perform poorly. In particular, Brazil's sovereign and corporate credit spreads are very narrow, and will widen as investors begin doubting public debt sustainability. In turn, currency depreciation will raise the cost of foreign currency debt for the private sector. Dedicated EM investors should underweight Brazilian sovereign and corporate credit relative to their benchmarks. The relapse in narrow money (M1) growth presages downside risk in share prices (Chart I-17). Chart I-16Driver Of BRL: Commodities Not Interest Rates Chart I-17Brazil: M1 Growth And Share Prices The broad stock market is not particularly cheap, given the magnitude of the rally that has considerably exceeded the EPS recovery. Finally, in the local fixed-income market we continue recommending a bet on yield curve flattening that typically happens when the currency sells off. Foreign investors should wait for currency depreciation to play out before going long local currency government bonds. Local investors should overweight local bonds versus stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations