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ハイライト 日本経済は好調です。これにより日銀はQQE（量的・質的金融緩和）プログラムから段階的に離脱することが可能になっています。 しかし、インフレが金融環境の直接的な関数であり続けるため、YCC（イールドカーブ・コントロール）プログラムは当面維持されるでしょう。 円のポジショニングとバリュエーションがこれほど歪んでいるため、特にユーロに対して円のリレーが生じる可能性があります。EUR/JPYをショートします。 米連邦準備制度と同様に、カナダ銀行（BoC）も今年に3回利上げするでしょう。しかし、市場はすでにカナダの利上げを米国よりも多く織り込んでいます。USD/CADはニュートラルを維持します。ただし、CADはNOKに対して下落圧力を受けるでしょう。CAD/NOKをショートします。 特集 チャート I-1 JPY 対 債券：決別 JPY対債券：決別 JPY対債券：決別 ここ数か月、USD/JPYに興味深い変化が起きました。米国の国債利回りから切り離され始めたのです（チャート I-1）。大部分は、2017年にドル指数が10%下落したことに起因するドル自身の弱さが反映されています。しかし昨年のドルの弱さにもかかわらず、9月7日以降は実質的に横ばいでした。円が債券利回りから切り離されたもう一つの要因は、欧州中央銀行（ECB）が独自の資産購入プログラムの終了を発表したことで、次に購入縮小の対象になるのは日銀だと見なされたことです。 1月8日、日銀はその方向に動き始め、長期JGBの買入れを縮小し始めました。その日以降、世界の債券は売られ、円も勢いを取り戻しました。我々は円のベア相場が終わったとは考えていませんが、ユーロに対してプレイ可能なリレーが生じる可能性が高いと見ています。 太陽は昇る 日銀が一部の金融刺激を取り除きたいと考えるのは正当です。日本経済は全てのシリンダーで稼働しており、改善は幅広く見られます。 資産価格の上昇と23年ぶりの低水準の失業率に支えられた消費者信頼感は過去最高水準に達しています（チャート I-2）。これは実質家計支出を引き続き支え、2015年から2017年初めまでの持続的な縮小の後、現在はほぼ年率2%のペースで成長しています。 家計支出を支えるもう一つの要因は賃金面です。契約賃金はすでに2006年以来の最速ペースで伸びており、残業代を除く賃金は1998年以来見られなかったペースで拡大しています（チャート I-3）。さらに、求人倍率は1974年以来の高水準にあります。これにより、安倍晋三首相が企業と賃上げを巡って繰り広げている圧力が実を結び、今春の賃金交渉で加速的な上昇が生じる可能性が高まります。 チャート I-2 日本の家計は意気軒昂 消費者信頼感調査 日本の世帯は活気にあふれている 消費者信頼感調査 日本の世帯は活気にあふれている チャート I-3 賃金成長が加速 賃金の伸びが加速している 賃金の伸びが加速している 企業の信頼感も急上昇しています。日本の製造業PMIは日本基準で高い水準にあり、現在54であり、中小企業の信頼感は工業生産の加速を示唆しています（チャート I-4）。 金融市場もこの状況を裏付けています。日経平均の急騰が投資家の注目を集めていますが、さらに印象的なのは小型株の強さで、2015年以降大型株を17%アウトパフォームしています（チャート I-5）。この動きは信用成長の回復と一致しており、通常は堅調な成長見通しと関連します。 我々の系列誌であるザ・バンク・クレジット・アナリストが開発したGDPモデルは、これらの諸現象を要約しており、日本の実質GDP成長率は2018年前半に年率3%に達する可能性があると予測しています（チャート I-6）。したがって、日本経済はさらに勢いを増すと見られます。 チャート I-4 日本企業も好況感を実感##br##している 日本企業も好調を実感している 日本企業も好調を実感している チャート I-5 小型株は明るい見通しを示唆##br##している スモールキャップは明るい見通しを示す スモールキャップは明るい見通しを示す チャート I-6 日本の成長は##br##勢いを持っている 日本の成長に勢いがある 日本の成長に勢いがある では、こうした改善を支えている要因は何でしょうか。 第一に、日本の財政の流れが変わりました。2012年から2016年にかけて財政政策は日本の経済活動に年間平均0.6%分のブレーキをかけていました。しかし2017年には財政政策は緩和に転じ、GDPに0.2%の押し上げをもたらしました。 第二に、日本は新興市場（EM）成長の回復から大きな恩恵を受けています。IMFによれば、新興市場の成長が1%ショックした場合、日本の成長に与える影響は50ベーシスポイントであり、これは米国への同じショックのほぼ5倍に相当します。これは日本の輸出の43%が新興市場向けであるためです。 第三に、新興市場の活動が日本に与える影響は、円の逆循環的な性質によって増幅されます。世界および新興市場の成長がより力強くなると円は弱含み、これが日本の金融環境を緩和します。この現象は昨年顕著に表れ、過去16か月で金融環境は1標準偏差分緩和しました。 これらの動きが成長改善と日銀のトーンの変化の土台を築いたのです。 結論： 日本は非常に好調です。消費者と企業の期待は高く、支出は増加しており、GDPはさらに加速する見込みです。財政引き締めの緩和、強い新興市場、そして金融環境の緩和がこれらの改善を支えています。日銀はこれに注目しています。 日銀はどこまで踏み込めるか？ 日銀はここ数か月、政策変更に動きたがっていました。2017年11月、日銀総裁の黒田氏は「リバーサル・レート」という概念について言及していました。リバーサル・レートとは、金利をそれ以下に下げると追加の利下げが経済活動にとって収縮的になる金利水準を指します。これは、その水準を下回ると金利の低下が銀行の金利マージンを損ない、商業銀行が民間部門への貸し出しを抑制し始めるためです。 日銀がリバーサル・レートについて声を大きくしていた理由は、このレートが商業銀行のバランスシートに保有される証券の量と逆相関関係にあるからです。商業銀行が政府債を多く保有している場合、金利が非常に低い水準に下がるとこれらの証券の評価額が上昇し、低い金利マージンの悪影響を相殺します。日本の問題は、日銀が政府の発行額より多くのJGBを吸い上げたため、銀行の保有残高が急速に減少していたことです（チャート I-7）。これはリバーサル・レートの上昇を意味し、日銀の政策運営がやや制約されていることを示していました。 12月にインフレが上振れサプライズを起こしたとき、金融市場は激しく反応しました。日本の名目利回りはあまり動きませんでしたが、日本のインフレ期待が急上昇し、それが日本の実質金利の急落を促しました（チャート I-8）。これは日本の金融環境を事実上緩和させ、日銀が資産購入を調整するための絶好の口実を作りました：債券購入の微調整による負の影響は緩和され、日銀の見解ではリバーサル・レートの低下により金融環境の制御を失うことはないと考えられたのです。 このような政策行動とレトリックの変化にもかかわらず、我々はまだイールドカーブ・コントロール（YCC）プログラムの終わりを予想していません。食料とエネルギーを除くインフレはわずか0.3%にとどまり、日銀の2%目標や1%ですら大きく下回っています。1%台は緩和をより現実的に解除するレベルでしょう。 さらに、日銀はやや板挟みの状況にあります。確かに経済は大きく改善していますが、これはインフレ動向を十分に説明するものではありません。日本の設備稼働率は日本のコアインフレ変動のわずか3%しか説明しておらず、世界の稼働率は10%にとどまります。むしろ日本のインフレを説明する最良の要因は金融環境（FCIs）でした。他のどの国でも金融環境がこれほどまでにインフレ動向を説明することはありません。最近の日本のインフレの動きは、2010年以来の日本の金融環境の変化と完全に整合しています。この関係に基づくと、食料とエネルギーを除くCPIは2018年6月に0.7%でピークに達する可能性が高いです（チャート I-9）。 チャート I-7 QQEのために##br##リバーサル・レートは低下している 日本のリバーサル・レートはQQEのために低下している 日本のリバーサル・レートはQQEのために低下している チャート I-8 インフレ期待の急上昇 インフレ期待の急上昇 インフレ期待の急上昇 チャート I-9 金融環境の緩和で##br##インフレは上昇している 金融環境が緩和されたため、インフレが加速している 金融環境が緩和されたため、インフレが加速している しかし、日銀が緩和をあまりに速く取り除けば、円は上昇し金融環境は急激に引き締まります。おそらくインフレは大幅に弱まり、当初の利上げ理由が無効化されるでしょう。これらの力学は少なくとも今後12～18か月はYCCが継続されることを示唆しています。 結論：日銀は間もなくQQEプログラムを完全に廃止するでしょう。しかし、これはイールドカーブ・コントロールの解除を意味するものではありません。これは日本のインフレが日銀の目標から極めてかけ離れていることと、日本のインフレ率が金融環境に非常に敏感であることの両方によります。したがって、よりタイトな政策による市場の反応としての強い円が金融環境を引き締めれば、インフレは崩壊し、引き締めの必要性自体がなくなってしまうのです。 投資への示唆 USD/JPYは割高で、購買力平価が示す公正価値より16%高く取引されています。さらに、円はGDP比4%の好ましい経常黒字に支えられています。加えて、グローバル投資家はデュレーションをアンダーウェイトしてきました。こうした現象は円にとってネガティブになる傾向があります。投資家が現在のようにデュレーションを大幅にアンダーウェイトしている場合、円がリレーする可能性が高まります（チャート I-10）。 確かに2014年にも投資家は現在と同様に債券にネガティブでしたが、USD/JPYは下落しました。これは当時、日銀が資産購入プログラムの拡大を発表したためです。今日は日銀がQQEを放棄する方向に動いており、これはショートカバーを伴うリレーを誘発する可能性が高いです。 では、投資家は円に対してどの通貨を売るべきでしょうか。我々はユーロが米ドルに代わる興味深い選択肢であると考えます。 現在、EUR/JPYは極めて割高です。長期的には、購買力平価ベースでEUR/JPYは通常のレンジから大きく外れて取引されています（チャート I-11）。さらに、金利差やリスクアペタイトを織り込む指標ではUSD/JPYはやや割高ですが、同様の比較でEUR/USDは非常に高値圏にあります。つまり、短期的なバリュエーションの観点からEUR/JPYは非常に需要が高い水準で取引されていることになります（チャート I-12）。したがって、戦術的にはこのクロスをショートするタイミングが徐々に整いつつあります。 チャート I-10 デュレーションのポジショニングは##br##円に上昇リスクを示唆 デュレーションのポジショニングは円の上方リスクを示している デュレーションのポジショニングは円の上方リスクを示している チャート I-11 EUR/JPYは割高 EUR/JPYは割高です EUR/JPYは割高です チャート I-12 EUR/JPYに対する戦術的リスク EUR/JPY向けタクティカル・リスク EUR/JPY向けタクティカル・リスク . EUR/JPYをショートすることを支持する追加の理由として、相対的な金融環境があります。ユーロ圏の金融環境は日本に対して米国よりもはるかに引き締まっています（チャート I-13）。その結果、セクターの偏りを調整しても、欧州株は現在日本株に対して米国株よりも大きくアンダーパフォームしています。これは、日本の相対的な経済見通しが米国と比較するよりもユーロ圏と比較した場合により明るいことを示しています。つまり、円は米ドルよりもユーロに対してより大きく上昇する余地があるということです。 最後に、ユーロと円の間のポジショニングも極めて偏っています。チャート I-14 が示すように、投機筋が同時にユーロをロングし円をショートしているとき、EUR/JPYはその後に調整を経験する傾向があります。 チャート I-13 ユーロ圏の金融環境は##br##米国よりも大きく引き締まった ユーロ圏の金融環境指数は米国のそれよりも一層引き締まった ユーロ圏の金融環境指数は米国のそれよりも一層引き締まった チャート I-14 ユーロの##br##偏ったポジショニング EURにおける偏ったポジショニング EURにおける偏ったポジショニング 以上の要因は円の大きなリレーの可能性を示唆しますが、このリレーの持続力は限定的である可能性が高いです。日銀が放棄しようとしているQQEは、ここ数か月にわたって半ばしか実施されておらず、債券買入れは8兆円の目標を大きく下回っていました。 日銀は当面YCCの維持にコミットしています。このプログラムを放棄して初めて円に対する持続的なサポートが生まれます。それまでは、どのような円のリレーも金融環境を引き締めインフレを傷つけるため、円高は「レンタル」するもの（短期的に借りるベット）であり、保有するものではありません。日本の最終的な政策金利が上昇できる余地はまだ小さいのです。 結論：QQEの放棄は円高を引き起こす可能性が高いです。そのリレーは、評価、ポジショニング、金融環境が欧州通貨と比べて特に悪化しているため、ユーロに対して最も顕著になるでしょう。明確に言えば、円高は反動的な動きとなる可能性が高く、強い円は日本に深刻なデフレ圧力を与えるため、日銀のYCCプログラムは堅く維持されるでしょう。我々はEUR/JPYを133.79でショートしています。 CAD：BoCとNAFTAの狭間に チャート I-15 カナダは賃金上昇を経験する見込み Canada:##br## インフレ環境が出現 カナダの賃金は上昇する見込み カナダ：インフレ圧力が高まり始めている カナダの賃金は上昇する見込み カナダ：インフレ圧力が高まり始めている カナダ銀行（BoC）は来週会合を開き、今月政策金利を引き上げる確率が高まっています。カナダ経済も国内部門主導で非常に堅調です。実質消費支出は約10年ぶりの速さで伸び、失業率は40年ぶりの低水準にあり、設備投資は2014年から2016年の原油価格暴落で打撃を受けた後回復しています。 この背景により、カナダ経済は既に自国のキャパシティ制約に達しつつあります。BoCはカナダの産出ギャップが閉じたと見積もっています。さらに、最近のビジネス・アウトルック調査はこのメッセージを裏付けています：記録的な割合のカナダ企業がキャパシティ制約のため需要に応えられないと述べており、人手不足の数と深刻度の増加は労働市場の逼迫を示しています（チャート I-15）。逼迫したキャパシティと賃金上昇は、すでに可視化されているコアインフレの回復を支えるでしょう。現在コアインフレはすでに1.8%に達しています。 その結果、我々はBoCが今年はFRBと同程度に利上げするだろうと見ています。しかし、この展開がCADに与える影響は限定的かもしれません。投資家は今後12か月でカナダの利上げを米国より多く織り込んでおり、それぞれ82ベーシスポイント対60ベーシスポイントとなっています。さらに、投機筋は再びルーニー（カナダドル）を大幅にロングしており、強い経済指標が実際にCADをさらに押し上げるためのハードルは高いままです。 さらに、NAFTAはカナダにとって依然大きなリスクです。当社のチーフ・ジオポリティカル・ストラテジスト、マルコ・パピッチが11月のスペシャル・レポートで述べたように、トランプ大統領はNAFTAの破棄に関してほとんど制約がない権限を持っています（表 I-1）。1 もしNAFTAが崩壊すれば、カナダは最終的に依然として優遇措置のあるカナダ・米国自由貿易協定に戻る可能性が高いでしょう。したがって、カナダと米国間の貿易への影響は一時的である可能性が高いです。しかし、痛みの大部分はカナダの設備投資に及ぶはずです。NAFTA解消に伴う高い不確実性は企業にカナダでの拡張計画を放棄させ、北米の生産能力を直接米国で拡大させるよう促し、サプライチェーンにおける規制リスクを回避するでしょう。これによりカナダの将来の成長プロファイルは抑制されます。 表 I-1 トランプは貿易に関してほとんど制約を受けない 円：QQEは終わった！YCC万歳！ 円：QQEは終わった！YCC万歳！ 石油がCADの穴埋めをする可能性は低いです。ブレントがほぼ70米ドル/バレルに達した時点で、当社のコモディティ＆エネルギー戦略担当の目標に到達しました。OPEC 2.0は価格がさらに大幅に上昇することを容認しないでしょう。なぜならそれはシェール生産者に能力拡大のインセンティブを与え、2014年前の供給過剰のダイナミクスを再生してしまうからです。さらに、カナダにとって最も関連性の高い指標であるウエスト・カナダ・セレクト（WCS）はWTIやブレントに対して大きくディスカウントされたままです。これはアルバータ州外に油を輸送するパイプライン容量が不足しているためで、カナダは自国の石油に溺れている状況です。この状況はすぐには変わりません。 チャート I-16 CAD/NOKは伸び過ぎている CAD/NOKは行き過ぎている CAD/NOKは行き過ぎている これらを踏まえ、我々は12か月ベースでUSD/CADを中立と見ていますが、今後数週間で1.29への戻りは起こり得ると考えます。しかし、カナダ産原油がディスカウントで取引されている一方で、CADはG10のもう一つのペトロ通貨であるNOKよりも良好に推移しています。これは、CADのリスクを織り込むよりクリーンな方法としてCAD/NOKのショートが考えられることを示唆しています。 第一に、カナダドルは現在ノルウェークローネに対して非常に割高で、購買力平価比で11%高く取引されています（チャート I-16）。生産性やコモディティ価格のような他の要因で調整しても、CADは1994年以来の最大のNOKに対するプレミアムで取引されています。これはCAD/NOKにとってリスクを示します。ルーニーは貿易政策リスクにさらされている一方、ノッキー（NOK）はそうではありません。 第二に、国際収支の面はNOKにとって非常に有利です。ノルウェーは経常収支黒字がGDP比で5.5%であるのに対し、カナダは2.8%の赤字です。さらに、ノルウェーはGDP比210%のネット国際投資ポジション（NIIP）を有しており、G10で最大です。強いNIIPは実効実質為替レートの上昇と関連します。 第三に、カナダ経済の勢いは投資家によく知られているため、投資家がCADをこれほどロングし、BoCから多数の利上げを期待している理由となっていますが、ノルウェーの良好な側面は見過ごされています。ノルウェーの先行指標は依然上昇しており、産業生産と実質GDP成長は加速しています。 第四に、ノルゲス銀行はNOKの弱さに反応しています。12月の会合で同行はトーンを調整し、NOKはノルウェー中央銀行の目から見ると金融環境を過度に緩和していると述べました。これはノルウェーから期待される25ベーシスポイントの利上げが過小評価されている可能性を示唆します。また、カナダとノルウェーの間で期待される12か月の利上げ差が現在約60ベーシスポイントと異常に開いていることが正常化する可能性も示しています。 最後に、CAD/NOKは長期的および短期的なヒストリカルレンジの上限に向かって取引されています。CADのポジショニングはロング側にかなり偏っていますが、ノルウェークローネは投機筋によりショートされています（ノルゲス銀行のデータ）。したがって、NAFTAの不確実性、BoCの見通しが既に織り込まれていること、WCSとブレントのディスカウントが縮小する可能性が低いことを考えると、リスクはCAD/NOKの下落方向に偏っています。 結論: カナダ経済は好況です。これはBoCがFRBに歩調を合わせ、今年少なくとも3回は利上げすることを意味します。しかし、市場はすでに米国よりもカナダの利上げを多く織り込んでいます。さらに、原油価格の上方余地は限られており、WCSベンチマークは引き続きブレントに対して大幅なディスカウントで取引されるでしょう。したがって、USD/CADは上値余地が限定的である一方、下値も限定的です。しかし、CAD/NOKは現在水準から多くの下落リスクを抱えています。我々は今週このクロスをショートし、エントリーポイントを6.398に設定します。 マチュー・サヴァリー, 副社長 外国為替ストラテジー mathieu@bcaresearch.com 1 BCAのグローバル・インベストメント・ストラテジー スペシャル・レポート「NAFTA - Populism Vs. Pluto-Populism」（2017年11月10日付）を参照ください。gis.bcaresearch.comで入手可能です。 通貨 米ドル チャート II-1 USD テクニカル 1 米ドルのテクニカル 1 米ドルのテクニカル 1 チャート II-2 USD テクニカル 2 米ドル テクニカル 2 米ドル テクニカル 2 米国の最近のデータは混在しています： 非農業部門雇用者数は下振れし、148千人となりました。 さらに、労働参加率は下振れし、62.7%となりました。 ISM非製造業PMIも予想を下回り、55.9となりました。 しかし、消費者信用の変化は予想を上回り、279.5億ドルとなりました。 週の始め、ドルは強含みで始まりましたが、やがて収束しました。背景には比較的タカ派的なECB議事録や日本の政策調整があります。総じて、市場がフェドのドットプロットを織り込み続けるため、ドルに上昇圧力がかかると予想しています。 レポートリンク： A Cold Snap Doesn't Make A Winter - 2018年1月5日 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - 2017年12月15日 ユーロ チャート II-3 EUR テクニカル 1 EUR テクニカル指標 1 EUR テクニカル指標 1 チャート II-4 EUR テクニカル 2 EUR テクニカル指標 2 EUR テクニカル指標 2 ユーロ圏の最近のデータは良好でした： コアインフレは予想を上回り、1.1%となりました。 さらに、経済センチメント指標も予想を上回り、116となりました。 小売売上高の前年比成長も上振れし、2.8%となりました。 最後に、失業率は8.8%から8.7%に低下しました。 ポジティブなデータにもかかわらずユーロは今週下落しました。ユーロは週初は弱含みでしたが、その後ECBのタカ派的議事録を受けて急騰しました。これは米国での利上げ期待の高まりによるものです。総じて、日銀が超ハト派政策を後退させる余地はECBよりも大きいため、EUR/JPYは下押しされると予想します。 レポートリンク： A Cold Snap Doesn't Make A Winter - 2018年1月5日 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 The Xs And The Currency Market - 2017年11月24日 円 チャート II-5 JPY テクニカル 1 JPY テクニカル 1 JPY テクニカル 1 チャート II-6 JPY テクニカル 2 JPY テクニカル分析 2 JPY テクニカル分析 2 日本の最近のデータは混在しています： 現金給与の前年比成長は予想を上回り、0.9%となりました。10月からも増加しています。 しかし消費者信頼感は下振れし、44.7となり前月から低下しました。 今週、円は急上昇しており、USD/JPYは1.7%下落しました。これは日銀が長期債の買入れを減らす意向を示したためです。市場はこれを日銀が超ハト派の金融政策からの出口に動き始めるシグナルと解釈しました。これらの動きは、特にユーロに対して円に上昇圧力を与え続けるでしょう。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - 2017年12月8日 The Xs And The Currency Market - 2017年11月24日 英ポンド チャート II-7 GBP テクニカル 1 GBPのテクニカルズ 1 GBPのテクニカルズ 1 チャート II-8 GBP テクニカル 2 GBP テクニカル分析 2 GBP テクニカル分析 2 英国の最近のデータは混在しています： 鉱工業生産の前年比成長は予想を上回り、2.5%となりました。 さらに、製造業生産の前年比成長も上振れし、3.5%となりました。 しかし、Halifaxの住宅価格の前年比は予想を下回り、2.7%となり、月次では0.6%の下落となりました。 今週ポンドは対ドルで横ばい、一方で対ユーロでは約1%下落しました。総じて、イングランド銀行（BoE）は大幅な利上げ余地が限られています。さらに、利上げとポンド高の結果としてインフレは緩和し始めるはずで、これがポンドに下押し圧力をかけるでしょう。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 The Xs And The Currency Market - 2017年11月24日 Reverse Alchemy: How To Transform Gold Into Lead - 2017年11月3日 豪ドル チャート II-9 AUD テクニカル 1 AUDのテクニカル分析 1 AUDのテクニカル分析 1 チャート II-10 AUD テクニカル 2 AUD テクニカルズ 2 AUD テクニカルズ 2 オーストラリアの最近のデータは混在しています： 建築許可の前年比成長は予想を上回り、17.2%となりました。 しかし、11月の貿易収支は予想を下回り、-6.28億となりました。前月の-3.02億から悪化しています。 AUD/USDは今週横ばいでしたが、AUD/NZDは約1%下落しました。世界経済の成長は依然強いものの、韓国や台湾の輸出成長などの主要指標は減速に転じています。さらに、中国のマネーサプライ成長は減少を続けています。これらは中国の工業活動の一時的な減速を示唆しており、AUD/USDの弱含みにつながるでしょう。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 The Xs And The Currency Market - 2017年11月24日 通貨ヘッジ：動的か静的か？ - グローバル投資家のための実践ガイド - 2017年9月29日 ニュージーランド・ドル チャート II-11 NZD テクニカル 1 NZDテクニカル 1 NZDテクニカル 1 チャート II-12 NZD テクニカル 2 NZドルのテクニカル指標 2 NZドルのテクニカル指標 2 キウイは年初来でほぼ5%上昇しており、世界成長が堅調に推移していることを反映しています。総じて、NZDは今年AUDをアウトパフォームすると予想します。ニュージーランドは金融環境の引き締まりに対してオーストラリアよりも感応度が低いためです。しかし長期的には、上昇余地は限定的です。新しいポピュリスト政権は移民抑制と、RBNZに複数目標（デュアル・マンダテ）を課すことを公約しており、これらはニュージーランドの中立金利を押し下げ、キウイに下押し圧力をかけるでしょう。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 The Xs And The Currency Market - 2017年11月24日 Reverse Alchemy: How To Transform Gold Into Lead - 2017年11月3日 カナダドル チャート II-13 CAD テクニカル 1 CADのテクニカル 1 CADのテクニカル 1 チャート II-14 CAD テクニカル 2 CADのテクニカル指標 2 CADのテクニカル指標 2 カナダの最近のデータは概ね良好でした： 失業率は5.9%から5.7%へと改善し、ポジティブなサプライズとなりました。 さらに、雇用者数の純増も予想を上回り、78.6千人となりました。 住宅着工件数の年間成長も予想を上回り、217千戸となりました。 しかし、Ivey購買担当者指数は予想を下回り、60.4となりました。 USD/CADは火曜日、トランプがNAFTAから撤退するとの報道を受けて急騰しました。総じて、カナダドルの上値余地は限定的であると考えています。市場はすでにカナダの利上げを米国より多く織り込んでいるためです。この弱さはCAD/NOKのショートで利用できる可能性があります。複数の指標でこのクロスは大きく過大評価されています。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 The Xs And The Currency Market - 2017年11月24日 Market Update - 2017年10月27日 スイスフラン チャート II-15 CHF テクニカル 1 CHF テクニカル 1 CHF テクニカル 1 チャート II-16 CHF テクニカル 2 CHF テクニカル指標 2 CHF テクニカル指標 2 スイスの最近のデータは良好でした： ヘッドラインインフレは予想通り0.8%でした。一方で月次のインフレは上振れし、0%となりました。 失業率も非常に低い水準で予想通り3%でした。 最後に、小売売上高の前年比成長は前月の2.6%に対し-0.2%と大きく上振れしました。 EUR/CHFは先週から比較的横ばいです。総じて、フランの上昇余地は限定的だと見ています。SNBは対外為替市場で積極的に介入を続けるでしょう。SNBが政策を変更するためには、スイスのインフレが相当期間高水準で推移する必要があります。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 The Xs And The Currency Market - 2017年11月24日 長期フェアバリューモデルの更新 - 2017年9月15日 ノルウェー・クローネ チャート II-17 NOK テクニカル 1 NOK テクニカル指標 1 NOK テクニカル指標 1 チャート II-18 NOK テクニカル 2 NOK テクニカル 2 NOK テクニカル 2 ノルウェーの最近のデータは混在しています： ヘッドラインインフレは予想を上回り、1.6%となりました。 さらに、コアインフレも上振れし、1.4%となりました。 しかし製造業の生産成長は予想を下回り、0.3%となりました。 USD/NOKは原油価格が70ドル近辺に迫る中、約0.7%下落しています。それでも、USD/NOKの上値余地はここから限定的だと考えています。市場はフェドのさらなる利上げを織り込み始めるでしょう。それでも、より強い原油を見込む投資家はEUR/NOKをショートすることを検討できるでしょう。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - 2017年12月15日 The Xs And The Currency Market - 2017年11月24日 スウェーデン・クローナ チャート II-19 SEK テクニカル 1 SEK テクニカルズ 1 SEK テクニカルズ 1 チャート II-20 SEK テクニカル 2 SEKのテクニカル分析 2 SEKのテクニカル分析 2 2017年末に急落した後、USD/SEKは今年に入って比較的横ばいです。総じて、イングヴェス総裁は依然として非常にハト派ですが、最新の議事録では金融政策の変更が近づいていることを認めました。一方、副総裁のヤンソンは資産購入を継続することを支持しつつも、レポ金利を据え置くことは「受け入れがたい」と述べました。金融環境の引き締まりによるユーロ圏の減速を見込む投資家はEUR/SEKをショートすることを検討できます。 レポートリンク： 10 Charts To Digest With The Holiday Trimmings - 2017年12月22日 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - 2017年12月15日 The Xs And The Currency Market - 2017年11月24日 トレード & 予測 予測サマリー コア・ポートフォリオ 戦術的トレード クローズド・トレード

ハイライト ビットコインの「合成」供給が金融デリバティブを通じて増加し、大手既存テクノロジー企業によるビットコイン類似の代替通貨の立ち上げが加わると、暗号通貨市場は自らの重みで崩壊するでしょう。 今後数年で供給増に起因する圧力を受け得る他の分野としては、原油、ハイイールド債、世界の不動産、低ボラティリティ取引が挙げられます。 対照的に、米国株式市場は自社株買いと自発的な上場廃止により株式供給の減少が観察されています。 投資家はハイイールド債に対して米国株をロングすることを検討しつつ、ボラティリティ上昇に備えるべきです。 このような結果は1990年代後半に起きた状況に類似している可能性があり、その期間はVIXとクレジットスプレッドが上昇傾向にある一方で株式は史上最高値を更新し続けました。 NAFTA交渉の決裂はカナダドルとメキシコ・ペソにとって依然として主要なリスクです。 特集 供給過剰でバブルが崩壊する 価格上昇の「治療法」はさらなる価格上昇である。ドットコムと住宅バブルは完全に自然消滅したわけではない。その崩壊は市場に新たな供給が波のように押し寄せたことで促進された。ドットコム・バブルの場合、2000年には新規公開（IPO）や二次公募による株式の洪水が投資家を圧倒し（チャート1）、インターネット株の価格に大きな下押し圧力を与えた。住宅ブームも同様に新規建設の急増によって覆された。住宅投資は2006年にGDP比6.6%と55年ぶりの高水準に達した（チャート2）。 チャート1 供給過剰による崩壊：例1 Burst By Too Much Supply: Example 1 Burst By Too Much Supply: Example 1 チャート2 供給過剰による崩壊：例2 Burst By Too Much Supply: Example 2 Burst By Too Much Supply: Example 2 ビットコインは同様の運命をたどろうとしているのだろうか？表面的には「いいえ」のように見えるかもしれない。より多くのビットコインが「マイニング」されるにつれ、追加生産の計算上のコストは指数関数的に上昇する。理論上、流通可能なビットコインは2100万枚に制限され、その約80%は既に生成されている（チャート3）。しかし、表面の下を見れば、ビットコインはさまざまな「供給側」要因に脆弱である可能性がある。 チャート3 ビットコイン：大部分は既に採掘済み ビットコイン：大部分はすでにマイニング済み ビットコイン：大部分はすでにマイニング済み まず第一に、ビットコインの価値に連動する金融デリバティブの拡大は、暗号通貨の「合成」供給を生み出す脅威となる。 株式のコールオプションを売る（ライトする）とき、オプションの売り手は実質的に弱気の賭けをし、買い手は強気の賭けをしている。オプションを売るという行為自体が追加のロング・ポジションを生み、それは追加のショート・ポジションによってちょうど相殺される。さらに、特定のコールオプションを売る決定が類似のコールオプションの価格を押し下げる程度に、基礎となる株価も押し下げられるだろう。これは単純に、株式に対するロングエクスポージャーは現物株を保有するかそのコールオプションを保有することで得られるからである。後者の価格を傷つけるものは前者の価格も傷つける。 ビットコイン先物が取引され始めると、ビットコインに対して弱気の投資家はショートポジションを作り、結果として流通するビットコインの実質的な数量を増加させることができる。これは公式の発行枚数が同じままであっても起こり得る。 模倣は最大の賛辞 ビットコインの合成的な供給増はビットコイン投資家の懸念の一つである。もう一つの懸念は、ビットコイン類似の代替通貨からの競争の増大である。現在、数百もの暗号通貨が存在し、その多くはビットコインを支えるブロックチェーン技術のわずかな変形を使用している。 チャート4 政府は取り分を要求するだろう 政府は取り分を求めるだろう 政府は取り分を求めるだろう これまで新通貨の拡散は主に寝室やガレージで働く技術に精通した起業家によって牽引されてきた。しかし今や企業も参入している。営業しているらしいコダックの株価は、今週自社の暗号通貨を発表したことで3倍になった。これはこれから起こることのほんの一例に過ぎない。 フェイスブック、アマゾン、ネットフリックス、グーグルのような巨大企業が自社の暗号通貨を発行するのを妨げるものは何だろうか。彼らはすでに安全なグローバルネットワークを持っている。アマゾンは販売ごとに数コインを配り始め、消費者が新通貨で同社のオンラインストアから商品を購入できるようにすることもできる。やり方は簡単だ。1 唯一のもっともらしい制約は法的なものである：政府が自国の法定通貨への需要が落ちることを恐れて新興の暗号通貨を潰す脅威だ。数週間前に述べたように、米政府は通貨を印刷しその資金で財やサービスを購入する能力から年間約$100 billion、約1000億ドルのシニョレッジ収入を得ている（チャート4）。2 大企業が暗号通貨分野に参入すると、政府は遅かれ早かれ厳しい対応を取る可能性が高い。今週の韓国政府が取引所での暗号通貨取引禁止を検討するという報道は、その兆候である。 他にどの分野が？ 新規供給の津波に脆弱な他の分野はどこか？四つが思い浮かぶ： 原油：BCAの強気の原油見通しは大当たりだった。ブレントは昨年6月の44ドルから現在の69ドルまで上昇した。しかし今後の追加上昇はそれほど容易ではないかもしれない。当社のエネルギー・ストラテジストは米国シェール生産者の損益分岐点を50ドル台前半と見積もっている。3 現在はその水準を大きく上回っており、シェール供給は加速するだろう。これは短期的に価格がさらに上昇し得ないという意味ではないが、原油の長期的な上昇余地を制限する。 不動産：世界の多くで超低金利が住宅価格の急増を後押しした。カナダ、オーストラリア、ニュージーランド、および欧州の一部では、インフレ調整後の住宅価格は大不況前の水準を大きく上回っている（チャート5）。米国の実質住宅価格はまだ2006年のピークを下回っているが、商業用不動産（CRE）価格は新高値に達している（チャート6）。米国のCREセクター内の賃料上昇は鈍化し始めており、供給が徐々に需要に追いつきつつあることを示唆している（チャート7）。 チャート5 低金利が##br##住宅価格を押し上げた地域 低金利が住宅価格を押し上げた地域 低金利が住宅価格を押し上げた地域 チャート6 商業用不動産価格が##br##不況前の水準を上回った 商業用不動産の価格は景気後退前の水準を上回っている 商業用不動産の価格は景気後退前の水準を上回っている チャート7 賃料の伸びは鈍化している 家賃の伸びが鈍化している 家賃の伸びが鈍化している 企業債務：低金利は企業にクレジットを活用させた。米国および多くの国で企業債務の対GDP比はほぼ過去最高水準にある（チャート8A およびチャート8B）。クレジットスプレッドは依然として非常にタイトだが、これも企業債が市場に出てくるにつれて変わる可能性がある。 チャート8A 企業債務の対GDP比が##br##過去最高水準に近い 企業債務対GDP比は過去最高水準に迫っている 企業債務対GDP比は過去最高水準に迫っている チャート8B 企業債務の対GDP比が##br##過去最高水準に近い 企業債務の対GDP比は記録的高水準に迫っている 企業債務の対GDP比は記録的高水準に迫っている 低ボラティリティ取引：最近のブルームバーグの見出しは「ショート・ボラティリティ・ファンドに史上最多の資金が流入」と叫んでいた。4 Cboeで取引されるボラティリティ契約の数は2012年以降で10倍以上に増加した。ネットのショート投機ポジションは現在史上最高水準にある（チャート9）。トレーダーはここ数年、ボラティリティが低下することに賭けて巨額の利益を上げてきた。問題は、ボラティリティが上昇し始めると、同じトレーダーがポジションを一斉に手放す可能性があり、さらにボラティリティが高まる懸念があることだ。 前掲の分野とは対照的に、株式市場は自社株買いと自発的な上場廃止により株式供給の侵食を受けている。S&Pの除数（ディバイザー）は2005年以降8%以上低下している。米国の上場企業数は1990年代後半以降ほぼ半減している（チャート10）。この傾向がすぐに逆転する可能性は低く、利益率の高止まりと多くの企業が法人税減税を利用して自社株買いを加速させる誘惑があることを考えれば、なおさらである。 チャート9 低ボラティリティへの需要が高い 低ボラティリティへの需要が高まっている 低ボラティリティへの需要が高まっている チャート10 株式市場における供給の減少 株式市場における供給の侵食 株式市場における供給の侵食 株価上昇に賭ける一方、ボラティリティとクレジットスプレッドの上昇も見込む 前述の議論は、今後数か月で株価とボラティリティ、クレジットスプレッドの関係が変化する可能性を示唆している。これは初めてのことではない。チャート11は、1990年代後半にVIXとクレジットスプレッドが上昇傾向に転じた一方でS&P500は史上最高値を更新し続けたことを示している。今、我々は類似の局面に入る可能性がある。 米国でのトレンド超過の成長継続とインフレ上昇は米国債利回りを押し上げるだろう。我々は2016年7月5日に「35年間の債券ブルマーケットの終焉」と宣言したが、これはちょうど10年物米国債利回りが終値で史上最安の1.37%を記録したその日だった。5 利上げは資金繰りに苦しむ借り手を苦しめ、クレジットスプレッドを拡大させる。企業の業況が悪化し次の景気後退の時期が近づくにつれて株式のボラティリティも上昇するだろう。我々の基本シナリオでは、米国および世界は2019年後半に景気後退に陥ると見ている。 金融市場は景気後退を実際に起こる前に嗅ぎつける。ただし歴史が示すように、それは景気後退開始の約6か月前にしか起こらないことが多い（表1）。これは、世界の株式は今後12か月程度は上昇を続け得ることを示唆する。これを念頭に、我々はS&P500のロング対ハイイールド債を新規トレードとして開始する。 チャート11 株価が上昇する中でもボラティリティは上昇し、スプレッドは##br##拡大し得る 株価が上昇すると、ボラティリティが高まり、スプレッドが拡大する可能性があります。 株価が上昇すると、ボラティリティが高まり、スプレッドが拡大する可能性があります。 表1 手仕舞いにはまだ早い ビットコインはDeFANG化されるか？ ビットコインはDeFANG化されるか？ 通貨に関するクイック・ヒット（4点） 今週は4つの項目が通貨およびフィクスト・インカム市場を揺るがした。第一は中国が米国債の購入を減速または停止するという報道だ。中国の国家外為管理局（SAFE）はその報道を「フェイクニュース」と非難した。 騒ぎの中で見落とされがちなのは、中国の保有する米国債残高が2011年以降ほぼ横ばいで推移しているという事実である（チャート12）。中国は依然として高度に管理された通貨を持つ。資本流出がもはや発生していないため、中国人民銀行（PBoC）は外貨準備の再構築を始めるだろう。米国債市場が世界で最大かつ最も流動的であることを考えれば、中国が余剰外貨の多くを米国に置かざるを得ないのは避けがたいように思える。 第二は日本銀行が保有する国債の買入目標を引き下げると発表したことだ。これは既に1年以上続いている動きを形式化したに過ぎない。日本銀行のJGB買入は過去12か月で急減しており、主因は80兆円という目標が国債の年間ネット発行額30〜35兆円のほぼ2倍であるためだ（チャート13）。 チャート12 中国の米国債保有：##br##2011年以降ほぼ横ばい 中国の米国債保有高：2011年以降ほぼ横ばい 中国の米国債保有高：2011年以降ほぼ横ばい チャート13 日銀は国債買入を##br##削減している 日本銀行（BoJ）は国債の買入を縮小している 日本銀行（BoJ）は国債の買入を縮小している 最終的には、これらはそれほど重要ではないはずだ。日本銀行は価格（JGBの利回り）をターゲットにすることも、数量（保有国債の枚数）をターゲットにすることもできるが、両方を同時にターゲットにすることはできない。日銀がすでに前者を行っているという事実は後者を無意味にする。そして長期インフレ期待が日銀の目標からほど遠い現状では、前者が変わる見込みは低い。 では円には何を意味するのか。円は割安であり、経常収支の黒字はGDP比で4%に膨らんでいる（チャート14）。投機筋の円ショートも非常に大きい（チャート15）。これは短期的な上昇の可能性を高めるが、同僚のMathieu Savaryが今週指摘したように、6世界の国債利回りが上昇する一方で日本の利回りが据え置かれる場合、円が大きく上昇して持続するのは難しい。総合的には、今年はUSD/JPYがやや強含むと予想している。 チャート14 円は既に割安... 円はすでに安い… 円はすでに安い… チャート15 ...かつ不人気 ...そして愛されない ...そして愛されない 第三の項目はECBの12月議事録で、中央銀行が2018年初めにコミュニケーション方針を見直すと示唆された点だ。市場が織り込んでいるより速くECBが金融政策を正常化するという憶測がある。もしそうなればEUR/USDはさらに強含むだろう。 もちろんこれは起こり得るが、それにはユーロ圏の成長が上振れサプライズを出す必要があるだろう。それは決して確実ではない。ユーロ圏の経済サプライズ・インデックスは下落に転じ始めており、相対的には米国に対して急落している（チャート16）。米国とは異なり、ユーロ圏のクレジット・インパルスは現在マイナスである（チャート17）。ユーロ圏の金融環境も米国に比べて大幅に引き締まっている（チャート18）。 チャート16 ユーロ圏の経済サプライズが##br##下落に転じ始めている ユーロ圏の経済サプライズが小幅に低下 ユーロ圏の経済サプライズが小幅に低下 チャート17 ユーロ圏のクレジット・インパルスのマイナスは##br##成長の重しとなる ユーロ圏のマイナスのクレジット・インパルスが成長を圧迫するだろう ユーロ圏のマイナスのクレジット・インパルスが成長を圧迫するだろう チャート18 金融環境の乖離は##br##米国をユーロ圏より有利にする 金融環境の乖離は米国をユーロ圏よりも有利にする 金融環境の乖離は米国をユーロ圏よりも有利にする 一方で、EUR/USDは2016年以降、金利差の変化から予想される以上に上昇している（チャート19）。ユーロに対する投機的ポジショニングも、2017年初頭の大幅ショートから今日では大幅ロングへと変化している（チャート20）。妥当な割安感と健全な経常収支の黒字はユーロに有利に働くが、我々の最良の見立てはEUR/USDが今後数か月で上昇分の一部を手放すだろうというものである。 チャート19 金利差で説明される以上にユーロは##br##強含んだ ユーロは金利差で正当化される以上に上昇している ユーロは金利差で正当化される以上に上昇している チャート20 ユーロのポジショニング：大幅ショートから##br##史上最高のロングへ ユーロ・ポジショニング：大幅にショートから過去最高のロングへ ユーロ・ポジショニング：大幅にショートから過去最高のロングへ 最後に、今週は米国がNAFTA交渉から撤退するという報道を受けてカナダドルとメキシコ・ペソが圧迫された。ここで述べた4項目のうち、これが我々にとって最も懸念材料である。グローバルなサプライチェーンは高度に統合されている。それを破壊するものは大きな混乱を招くであろう。ある程度、トランプはこれを理解しているが、支持基盤は貿易に厳しくあってほしいと望んでおり、そうしなければ再選の見込みはさらに厳しくなることも彼は知っている。最終的には新たなNAFTA合意が成立すると期待しているが、そこに至る道のりはでこぼこだろう。 事務連絡 当社のグローバル・インダストリアルのロング／ユーティリティのショートのトレードは、9月29日に開始して以来12.4%の利益が出ている。利益保護のためストップを10%に引き上げる。2年物USD/サウジ・リヤルのフォワード契約のロングは損失2.9%で満了とし、サウジアラビアの財務状況が最近改善していることを踏まえ、同トレードは再導入しない。 ピーター・ベレジン, チーフ・グローバル・ストラテジスト グローバル・インベストメント・ストラテジー peterb@bcaresearch.com 1 本トピックに関する貴重な示唆を頂いたSHIG Partners LLC代表イゴール・ヴァッセルマン氏に感謝する。 2 グローバル・インベストメント・ストラテジー・スペシャル・レポート「ビットコインのマクロ的影響（Bitcoin's Macro Impact）」、2017年9月15日付；およびグローバル・インベストメント・ストラテジー・ウィークリー・レポート「フラット化したイールドカーブを恐れるな（Don't Fear A Flatter Yield Curve）」、2017年12月22日付を参照されたい。 3 エネルギー・セクター・ストラテジー・ウィークリー・レポート「損益分岐点分析：シェール企業が自立するには約50ドルの原油が必要（Breakeven Analysis: Shale Companies Need ~$50 Oil To Be Self-Sufficient）」、2017年3月15日付を参照。 4 Dani Burger, "Short-Volatility Funds Are Being Flooded With Cash," Bloomberg, 2017年11月6日。 5 グローバル・インベストメント・ストラテジー・スペシャル・アラート「35年間の債券ブルマーケットの終焉（End Of The 35-year Bond Bull Market）」、2016年7月5日付を参照。 6 フォーリン・エクスチェンジ・ストラテジー「円：QQEは死んだ！YCC万歳！（Yen: QQE Is Dead! Long Live YCC!）」、2018年1月12日付を参照。 タクティカル・グローバル・アセット・アロケーションの推奨 ストラテジー & マーケット・トレンド タクティカル・トレード 戦略的推奨 クローズド・トレード

Highlights Chinese policymakers are walking a tightrope, attempting to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. Recent price action in EM risk assets resembles a final bear capitulation phase, and a classic top formation. Currency appreciation and moderation in export growth will damp corporate profits of exporters in Korea and Taiwan. Stay short KRW versus THB and short MYR versus RUB and USD. Feature "...at first, a stick may bend under strain, ready all the time to bend back, until a certain point is reached, when it breaks." Irving Fisher, The Debt-Deflation Theory of Great Depressions (1933) China continues to tighten financial regulations1 and onshore corporate bond yields keep marching higher. Yet EM and China-related financial markets have been extremely buoyant, completely ignoring the tightening dynamics underway. This reminds us of the above quote from Irving Fisher. The Chinese economy has been able to "...bend under strain, ready all the time to bend back..." In other words, growth has so far done well, despite ongoing liquidity and regulatory tightening (Chart I-1). This has led many investors and commentators to proclaim that the economy is healthy and will slow only a bit, or not at all. Chart I-1China: Will Economy Continue ##br##Defying Weak Credit Impulse? Yet, financial market risks linger. At a certain point, cumulative pressure from policy tightening will cause China's recovery to falter - "break," as per Fisher's quote above - impacting the rest of the world in general and EM in particular. This precept is pertinent to China at present because its money, credit and property markets are frothy, as we have written repeatedly in recent years, making them especially vulnerable to tightening. We thought such a deceleration in China's business cycle would occur in 2017, but it has not yet transpired. Forward-looking indicators such as money supply growth and the yield curve have been heralding a growth slowdown for many months (see Chart I-1). Nevertheless, this recovery has proved to be enduring; even though some segments have slowed, overall nominal growth, corporate pricing power and profits have done well. Does such growth resilience warrant an upgrade on China's outlook? An economy's past performance does not guarantee its future performance. This is relevant to China now, especially given the cumulative impact of the ongoing triple policy tightening - liquidity, regulatory and anti-corruption efforts in the financial industry2 - which will likely be substantial. Walking A Tightrope China's policymakers are walking a tightrope trying to balance contradictory objectives such as curbing financial speculation and credit excesses, capping inflation and maintaining a stable currency on the one hand, and maintaining robust growth on the other. Inflationary pressures are escalating in the mainland economy. Chart I-2 demonstrates that pricing power for 5,000 industrial companies - a diffusion index for producer prices compiled by the People's Bank of China - is approaching its 2007 and 2010 highs, while nominal interest rates are currently much lower than they were in 2007 and 2010 (Chart I-2, bottom panel). Notably, most of China's nominal recovery in the past two years has been due to prices, not volumes (Chart I-3). Given that rising prices benefit corporate profits much more than rising volumes, Chinese corporate profits have surged. Yet, the flip side of these dynamics is rising inflation. Chart I-2China: Inflationary Pressure Are Rising, ##br##While Interest Rates Are Low Chart I-3China: It Has Been Nominal (Price) Not ##br##Volume Manufacturing Recovery Mounting inflation amid enormous money excesses - the Chinese banking system has originated RMB 142 trillion (equivalent to $22 trillion) since January 20093 - risks triggering rising inflation expectations, which would then feed back into inflation. With real interest rates already extremely low (Chart I-4), increasing inflation expectations could lead to growing demand for foreign currency, in turn exerting downward pressure on the RMB exchange rate. Chart I-4China: Inflation-Adjusted ##br##Interest Rates Are Low Chinese households have been uneasy about the real (inflation-adjusted) value of their deposits, and have been opting for speculative investments that promise higher yields than bank deposits. Hence, policymakers cannot ignore households' desire for higher real interest rates if they aim to cool down speculative investment activities and contain systemic risks in the system. Overall, the authorities need to tread carefully, balancing between the need to preserve decent growth while keeping inflation at bay. Falling behind the inflation curve is as dangerous as being too aggressive in tightening. For now, rising domestic inflationary pressures, robust DM growth and the resilience of financial markets will justify further policy tightening in China. Controlling leverage, curbing financial market excesses and limiting speculation in the real estate market are all major components of the structural reforms agenda that China's top policymakers committed to at the Party Congress in October. Bottom Line: Chinese policymakers are walking a tightrope, trying to balance contradictory objectives. While their task is not impossible, we find that financial markets are overly complacent. The odds of successfully navigating these contradictory objectives amid lingering money, credit and property market imbalances are 30% or lower. In the meantime, financial markets seem priced for perfection. This gap between the market's views and our perception of risks leads us to maintain a negative investment stance. EM's Blow-Out Phase EM stocks and currencies have gone vertical in recent weeks, despite being overbought and not cheap. The recent price actions in EM and global risk assets looks like a final bear capitulation phase and a classic top formation. The EM overall equity and small-cap indexes have reached their 2011 high (Chart I-5, top and middle panels). Meanwhile, EM high-yield (junk) corporate and quasi-sovereign bond yields are at their historical lows (Chart I-5, bottom panel). Economic data, corporate profits and news flows are typically extremely positive at tops of cycles, and very negative at bottoms. Given that share prices have surged and credit spreads are extremely low, a lot of good news has already been discounted. In particular, EM long-term EPS growth expectations have shot up above their previous highs (Chart I-6). This indicator can serve as a proxy for investor sentiment on EM stocks, at the moment suggesting extreme bullishness. EM stocks topped out in the past when this indicator reached the current levels. Chart I-5Are EM At Their Zenith? Chart I-6Analysts Are Super Bullish On EM Profits Growth Needless to say, global investors' positioning is stretched in favor of risk assets. Chart I-7 entails that U.S. individual investors' holdings of cash was at a record low as of December, while their exposure to equities was not far from record highs. Apart from China-related risks, a potential rise in U.S. bond yields and/or the U.S. dollar, could spoil the EM party. Many investors have invested in EM on the assumption of continued weakness in the greenback and subdued U.S. bond yields. It would be unusual if this current robust global growth does not lead to higher inflation expectations or higher bond yields. With respect to market signals, Chart I-8 illustrates that global steel stocks in absolute terms, and the relative performance of emerging Asian stocks versus DM equities have approached their very long-term moving averages. The latter might become a major technical resistance. Failure to break above this resistance level would be consistent with EM share prices rolling over at their 2011 highs (see Chart I-7). Altogether, this could signal a major top in EM risk assets. Chart I-7Asset Allocation Of ##br##U.S. Individual Investors Chart I-8Select Segments Are At Their ##br##Long-Term Technical Resistances Bottom Line: The EM rally has endured much longer and has gone much farther than we envisioned. However, we maintain our cautious stance, and recommend underweighting EM stocks, currencies and credit versus their DM counterparts. Emerging Asia: Currencies And Business Cycle Chart I-9Geopolitics And Asian Currencies Emerging Asian currencies have recently been on the fly, surging versus the U.S. dollar. Apart from strong global manufacturing, one reason behind the emerging Asian currency appreciation has been geopolitics. We suspect political leaders in Taiwan and Korea have instructed their central banks to allow their currencies to appreciate to gratify the Trump administration's aspirations of a weaker greenback. The top panel of Chart I-9 shows that the Taiwanese dollar's sharp appreciation coincided with Trump's controversial phone call with the Taiwanese president on December 3rd, 2016. Similarly, Trump's visit to South Korea on November 7th, 2017 jives with the latest up leg in the Korean won (Chart I-9, bottom panel). It seems President Trump's geopolitical assurances to Taiwan and Korea are somewhat tied to these policymakers' increased tolerance for currency appreciation. Notably, foreign exchange reserves in both Taiwan and Korea have risen little, despite their strong trade surpluses and foreign capital inflows over the past year. This confirms that their central banks have been reluctant to purchase U.S. dollars and in turn cap their currencies' appreciation. In addition to the political context, there are a number of other important drivers of Asian exchange rates and the region's business cycle: The growth rate of Korean and Taiwanese total exports in U.S. dollars has moderated (Chart I-10). This, along with KRW and TWD appreciation, implies a meaningful deceleration in exporters' revenue growth in local currency terms. Besides, China's container freight index - the price to ship containers worldwide - has relapsed and it correlates well with Asia's export cycle (Chart I-11). Chart I-10Moderation In Asian Exports Growth Chart I-11A Negative Signal For Asian Exports Even though DRAM prices are rising, other semiconductor prices have rolled over (Chart I-12). Semiconductor prices and volumes are vital for the tech-heavy Taiwanese and Korean manufacturing sectors. The RMB rally is also late. Enormous pent-up demand for foreign assets from Chinese residents due to low mainland real interest rates creates the potential for capital outflows to cap RMB strength. This would weigh on the ongoing Asian currency rally. Finally, net EPS revisions of Korean and Taiwanese technology companies' have rolled over (Chart I-13), probably reflecting a dampening effect of currency appreciation. This could in turn lead to foreign capital outflows from their equity markets causing currency selloffs. Chart I-12Divergence In Semiconductor Prices Chart I-13Asia Tech Companies: Net EPS Revisions Corroborating budding signs of a slowdown in exports and corporate profits, emerging Asian stocks have begun underperforming DM equities, as shown in Chart I-8 on page 7. The deceleration in export revenues and currency appreciation are adverse developments for share prices in export-related sectors of Korea and Taiwan. Nevertheless, for dedicated EM equity portfolios, we recommend overweighting the Taiwanese bourse and Korean technology stocks (and being neutral on the rest of KOSPI). The basis is that share prices of hardware tech manufacturers have less downside than other EM sectors. Their attractive relative valuations combined with prospects for robust growth in DM warrant their outperformance against the overall EM equity index in common currency terms. As to exchange rates, the Trump factor will delay and mitigate Asian currency depreciation, but will not preclude it if export growth slows, as we expect. In such a scenario, policymakers in Asia will opt for modest currency depreciation, reversing their recent gains. In terms of investment strategy, we have been shorting the Korean won versus the Thai baht. This trade has so far been flat, but we are maintaining it because the won is a higher-beta currency than the baht, and the former will underperform the latter as Asia's business cycle eventually slows. In addition, we are also shorting the Malaysian ringgit versus the U.S. dollar and the Russian ruble due to weak domestic fundamentals in Malaysia. Bottom Line: Currency appreciation will damp corporate profits of exporters in Korea and Taiwan. This will weigh on EM share prices in aggregate, given that the Korean and Taiwanese markets together account for 27% of the MSCI EM market cap, compared with an 12% share of the entire Latin American region. The 12-month outlook for Asian currencies is downbeat: continue shorting the MYR versus both the U.S. dollar and the RUB, and stay long the THB versus the KRW. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 This week the China Banking Regulatory Commission (CBRC) announced a set of sweeping new rules to control banks' entrusted lending (Source: Caixin). This is in addition to a slew of regulatory measures for financial institutions that have been introduced over the past year. 2 We discussed these in details in Emerging Markets Strategy Weekly Report, titled "Questions For Emerging Markets," dated November 29, 2017, a link available on page 13. 3 Please see Emerging Markets Strategy Special Report, titled "The True Meaning Of China's Great 'Savings' Wall," dated December 20, 2017, a link available on page 13. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Before re-capping the performance of our recommendations last year - up 77%, led by oil calls, which posted an average gain of 111% - we take a look at what the re-emergence of financial and monetary factors will mean for commodities this year. Fundamentals - supply, demand, inventories - drove the evolution of industrial commodity prices over the past two years, and will remain supportive for oil and, to a lesser degree, base metals in 1H18. Thereafter, in 2H18, we believe financial and monetary variables will begin to re-assert their importance in the evolution of commodity prices. Forecasting commodity prices becomes more difficult, as a result, as it is not clear the Fed or other systematically important central banks, understand what is driving their principal policy variables - particularly inflation - or how they are evolving. Despite these central-bank uncertainties, we remain long broad commodity exposure via the S&P GSCI (up 6.4% since it was recommended in Dec/17), long call spreads in Brent and WTI across 2018 deliveries (up 78%); and long gold (up 6.7%). 2018 Weightings Energy: Overweight. WTI and Brent crude oil forward curves will become more backwardated as the combination of OPEC 2.0 production discipline and continued strength in demand draws inventories lower. This will boost S&P GSCI returns.1 Base Metals: Neutral. Base metals will continue to be supported through 1Q18 by China's environmental reforms, which are reducing supply in the face of continued strength in global demand. Strong demand ex-China will offset weaker Chinese growth, supporting metals prices. Precious Metals: Neutral. While we expect four rate hikes by the Fed this year, we are wary of policy errors at systemically important central banks, which makes forecasting monetary policy highly uncertain. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Still-high supplies outside the corn market; policy uncertainty re NAFTA; and uncertainty over Fed policy likely keep grain prices weak. A stronger USD would weaken demand for U.S.-sourced grains and softs. Feature Chart of the WeekFundamentals Continue To##BR##Support Commodities That was quick! Oil prices are closely hewing to fundamentals as the year opens. We revised our Brent forecast to $67/bbl in early December (up from a $65/bbl forecast in mid-October 2017), based on our fundamental assessment of the market - supply, demand and inventories - and, voilà, contracts for Mar/18 delivery got there by the end of 2017. Our $63/bbl forecast for WTI is still ~ $2.50/bbl from being realized, but we continue to expect this gap to close. At the moment, fundamentals for industrial commodities - oil and, to a slightly lesser extent, base metals - will support firmer prices in 1H18 (Chart of the Week). For oil, this will be an extension of the fundamental realignment initiated by OPEC 2.0 at the end of 2016. The producer coalition agreed to remove ~ 1.1mm b/d from the market, which, along with another 300k to 400k barrels of natural declines, tightened the supply side considerably. On the demand side, the synchronized global economic upturn that powered consumption up by 1.65mm b/d last year, by our estimation, will push demand higher by 1.67mm b/d this year. Supply-side adjustments in base metals, particularly copper, where strikes and natural disasters combined to tighten markets, will be augmented by the ongoing environmental reforms in China (Chart 2). These supply-side effects in industrial commodities occurred against a backdrop of stronger-than-expected economic growth worldwide last year - the first such upturn since the Global Financial Crisis (GFC) in 2008 (Chart 3). Chart 2Fundamentals Supported Metals Chart 3Global Upturn Powers Commodity Demand We expect this to continue. Part of the recovery in aggregate demand worldwide can be attributed to the massive monetary stimulus by systematically important central banks - led by the Fed, the ECB and BoJ. Lower energy prices last year, which acted like a tax cut, put more discretionary income in consumers' hands and also boosted aggregate demand.2 Monetary Policy Will Re-Assert Itself Chart 4The USD Will Re-Emerge As A##BR##Driver Of Commodity Prices The influence of monetary policy - chiefly how the Fed's actions affect the USD - has been de minimis over the past two years relative to fundamentals, which have driven price formation in industrial commodities (Chart 4). While the Fed raised its policy rate 3 times last year, monetary conditions remained relatively loose in the U.S., which was supportive of commodity prices. Looser monetary conditions kept the USD better offered than other major currencies in 4Q17, which allowed gold prices to recover late in the year. A weaker USD also supported grain markets, which also have staged a somewhat subdued recovery following a mid-2017 sell-off. For at least 1H18, we see commodities generally continuing to be supported by strong fundamentals and relatively accommodative monetary policy globally, even with the Fed lifting its policy rate as many as four times this year, per our House view. Inflation Pressures Could Start Building By 2H18, inflationary pressures could start to build: In the U.S., tax cuts coupled with fiscal stimulus from the federal government in the form of disaster relief and higher discretionary spending - could add ~ 0.5% to GDP growth this year, based on calculations by BCA's Global Investment Strategy team (Chart 5).3 This should, all else equal, increase demand for labor and push the U.S. unemployment rate lower, lifting wages, inflation and inflation expectations in turn (Chart 6). At least that's how it's supposed to work. Our colleagues in BCA Research's U.S. Bond Strategy note, the "dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 5U.S. Inflation Is Ticking Higher Chart 6Still Waiting On The Phillips Curve "... Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995."4 We're inclined to agree with former Fed Chair Ben Bernanke on this. In 2016, he noted that, given the years-long stretch of errors in forecasting key economic variables - output, unemployment and the Fed funds rate - "Fed-watchers should probably focus on incoming data and count a bit less on Fed policymakers for guidance."5 This is a mixed blessing (or curse) for commodity markets: Increased economic activity raises demand for commodities, so at least in 1H18, and most likely for the second half as well, commodity demand will remain well supported globally. If we do get higher inflation, the Fed likely would feel it could lean into its rate-normalization with greater vigor, and start guiding to more frequent or bigger rate hikes. If we don't see higher inflation - if, as Chicago Fed President Charles Evans fears, inflation expectations have been marked down in a meaningful way - and the Fed cannot justify further rate hikes, we could see the real side of the global economy take another leg higher, lifting commodity demand in the process.6 This is the big issue for the coming year. We cannot say at this point how it plays out, which is why we recommend commodity investors remain in tactical mode, as we did a year ago. Recapping 2017's Recommendations Our trade recommendations were up an average of 77% last year, led by a 111% gain in our oil calls. This was a touch better than the 95% average gain we posted on our oil recommendations in 2016 (Table 1). Table 1Average Quarterly Returns 2017 Without a doubt, most of our recommendations were in the oil markets, as the accompanying tables show, and we maintained an exposure of one sort or another in oil throughout the year (Table 2). Table 2Trades Closed In 2017 The big drivers of our view in oil markets were fundamentals: On the supply side, we maintained the view OPEC 2.0 would not waver in its commitment to draining global storage levels, particularly in the OECD commercial inventories via supply reductions. On the demand side, by mid-2017, it became apparent to us the big data providers - the U.S. EIA and the IEA in Paris - and most of the sell-side analysts were underestimating demand. Information flows during 1H17 were often contradictory, which injected enormous volatility in crude-oil spread markets - particularly the calendar spreads trading markets employ to take a view on the shape of the forward curve (e.g., long a near-term futures contract like Dec/17 Brent, vs. short a deferred delivery contract like Dec/18). This intense volatility drove us toward the relative safety of call-option spreads in 2H17, where the risk of loss is limited to the net premium paid for the call spread. As we did last year, we constructed an information ratio (IR) to determine whether the additional volatility produced by our recommendations was adequately compensated for by the returns (simple percent changes of the opening level for a recommendation vs. the closing level). Our IR uses the S&P GSCI as a benchmark, given it has a relatively high weight in energy-related exposures. Our ratio looks at the average excess return of the active portfolio against this benchmark. This average excess return is divided by its standard deviation (also referred to as the tracking error volatility) in order to generate a risk-adjusted metric to measure returns on our recommendations relative to the risk we took to generate them. BCA's IR thus is calculated as: The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: High returns in the portfolio; low returns in the benchmark, or low tracking error volatility. Hence, this measure provides a numeric value to analyze the risk-reward trade-off; it tells us whether or not the risk assumed in our trades was compensated for by larger returns. Viewing our energy recommendations as a portfolio over the course of 2017, our average return was 111%, while the GSCI return was 5.8%. The tracking error volatility was 112%.7 Using these inputs, the IR of our recommendations was 0.94. While not as stellar as our 2016 IR of 1.47, this risk-adjusted return is still stout, and indicates the consistent positive excess returns of our portfolio relative to passive GSCI exposure compensated for the high volatility of those returns. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is the name we've given the OPEC + non-OPEC producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 For a summary of our 2018 outlooks, please see BCA Research's Commodity & Energy Strategy Weekly Report "Oil Fundamentals Remain Bullish Heading Into 2018," published on December 21, 2017, and "Opposing Forces: Stay Neutral Metals In 2018" in the same issue. It is available at ces.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," published December 22, 2017. It is available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Ill Placed Trust?," published December 19, 2017. It is available at usbs.bcaresearch.com. 5 Please see "The Fed's shifting perspective on the economy and its implications for monetary policy," by Ben S. Bernanke, published by the Brookings Institution on its website August 8, 2016. 6 Please see "All Talk, Few Answers From FOMC for Yellen's Long Inflation Miss," published by bloomberg.com on January 3, 2018. 7 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 224 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking-error volatility. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017

Bank Credit Analyst

Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? Chart I-10Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances Chart II-15Anti-Corruption Is Popular Chart II-16Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... Chart II-17B...But There's A Long Way To Go Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations Chart II-10U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield ComponentsChart II-13U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Chart II-20Euro Technicals Chart II-21Euro/Yen Technicals Chart II-22Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Chart II-24Commodity Prices Chart II-25Commodity Prices Chart II-26Commodity Sentiment Chart II-27Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot Chart II-30U.S. Growth Outlook Chart II-31U.S. Cyclical Spending Chart II-32U.S. Labor Market Chart II-33U.S. Consumption Chart II-34U.S. Housing Chart II-35U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China

Dear Client, We are sending you this last issue of the year, a lighter fare than usual, highlighting 10 charts we find important. The first two charts tackle two of the key economic questions of the day: U.S. inflation and Chinese construction. The next seven charts are displays of technical action that has captured our attention for key currency pairs. The last chart tackles the topic du jour, bitcoin. We will resume regular publishing on January 5th, 2018. Finally, the Foreign Exchange Strategy team would like to thank you for your continued readership, and wishes you and your families a joyful holiday season as well as a healthy, happy and prosperous 2018. Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) U.S. Inflation Chart I-1AU.S. Inflation Is On Its Merry Way (I) Chart I-1BU.S. Inflation Is On Its Merry Way (II) U.S. inflation has been moribund in 2017, dismaying believers of the Philips curve, the Federal Reserve included. A few factors have been at play. The Fed sigma models show that the negative impact of a dollar rally on U.S. inflation is at its strongest with a two-year lag. Additionally, the fall in capacity utilization that happened following the industrial recession in late 2015/early 2016 continued to affect inflation negatively this year. These headwinds are passing. As the left panel of Chart I-1 illustrates, the easing in U.S. financial conditions this past year is likely to continue and become most salient for inflation in 2018. Meanwhile, the right panel of the chart shows that as the deceleration in money velocity growth forecasted the weakness in core inflation in 2017, its recent re-acceleration points to a pick-up in inflation next year. The Fed might be able to achieve its interest rate forecast of 3.1% in 2020 after all. 2) Chinese Housing Chart I-2AFrosty Outlook For Chinese Construction (I) Chart I-2BFrosty Outlook For Chinese Construction (II) Chinese monetary conditions have been tightened in 2017, fiscal expansion has been curtailed, and the growth of the M3 broad money supply has fallen to 8.8%. So far, the Chinese economy is hanging in, still benefiting from the fact that real interest rates have collapsed since November 2015 as producer price inflation rebounded from a 6% contraction to a 6% expansion today. This increase in producer prices has also helped industrial profits, which are expanding at a 23% pace, helping put a floor under industrial production. However, the outlook for residential investment needs to be monitored. Construction contributed 17% of GDP growth during the past two years. Chinese construction also contributed to 20% and 32% of the global consumption of refined copper and steel, respectively. This means that Chinese construction was a key driver of metal prices. Yet our leading indicator for Chinese house prices points toward a marked deceleration in the coming quarters. As the right panel of Chart I-2 shows, this could get translated into additional downside for iron ore. 3) EUR/USD Chart I-3The Euro Is At A Key Threshold 1.20 continues to represent a big hurdle to cross for EUR/USD. For the euro to punch above this mark, U.S. inflation will have to remain moribund in 2018. The rally in EUR/USD tracked an improvement in market estimates of the European Central Bank's terminal policy rate relative to the Fed's. Yet this improvement did not reflect an upgrade of the ECB's terminal rate itself, but rather a major downgrade of the Fed's, as U.S. inflation disappointed. If U.S. inflation rebounds as BCA anticipates, the dollar should be able to rally toward 1.10, especially as euro area inflation is unlikely to follow suit, as euro area financial conditions have tightened massively relative to the U.S. If U.S. inflation does not rebound, a move toward 1.30 is possible. Glimpsing at Chart I-3, it should also be obvious that any strength in the dollar next year is likely to prove a long-term buying opportunity for the euro. The EUR/USD has only traded below current levels when the U.S. dollar has been in the thralls of a major bubble. Additionally, global portfolios are deeply underweight euro area assets, therefore, a long-term rebalancing of portfolios toward euro area assets will support the euro down the road. Finally, when the next recession hits, the ECB is likely to have less room to stimulate its economy than the Fed will have. This means that during the next recession, the euro could behave like the yen has over the past 20 years: because the ECB will be impotent to fight deflationary pressures, falling euro area inflation will result in rising euro area real interest rates, especially against the U.S. This helped the yen then, and it could help the euro in the future, especially as the euro area's net international investment position is set to move into positive territory over the next 24 months. 4) EUR/GBP Chart I-4Brexit And Valuations Will Keep EUR/GBP Range-Bound For Now EUR/GBP is at an interesting juncture. EUR/GBP has rarely traded above current levels (Chart I-4). On one hand, Brexit would suggest that EUR/GBP could actually rise. The uncertainty around the U.K. leaving the EU has caused the U.K. economy to be among the rare ones to not accelerate in unison with global growth this year, despite the stimulative effect of a lower pound. This suggests that the hands of the Bank of England will remain tied, limiting its capacity to increase the cash rate. Moreover, U.K. politics continue to take an increasingly populist tone, and the growing popularity of Jeremy Corbyn suggests that the discontent is present on all sides of the political spectrum. Populist policies are rarely good for a currency. On the other hand, the GBP is trading at such a discount to its fair value against both the USD and the EUR that historically, buying the pound at current levels has generated gains for investors with investment horizons measured in years. Moreover, if the EUR weakens in the first half of 2018, historical antecedents argue that EUR/GBP would also weaken in this context. When taken altogether, these factors suggest that EUR/GBP is likely to remain stuck in its post-Brexit trading range for as long as political uncertainty remains, especially as it is unlikely that the U.K. will receive a sweetheart FTA deal from the EU. Thus, while we expect EUR/GBP to retest 0.84 over the course of the next three to six months, at these levels we would buy EUR/GBP with a target of 0.90. 5) EUR/SEK Chart I-5EUR/SEK Will Fall From 10 To 9 EUR/SEK flirted with 10 this month. As Chart I-5 illustrates, this only happened during the financial crisis. Sweden is a much more pro-cyclical economy than the euro area, hence EUR/SEK exhibits very strong counter-cyclical behavior. It only trades above 10 when global growth is in tatters, and below 9 when it is booming. The recent spate of strength in EUR/SEK is thus perplexing, since global growth has been very robust and broad-based this year. The very easy policy of the Riksbank has been the main culprit. Timing a reversal in EUR/SEK is tricky, as it remains a function of the rhetoric of the Riksbank. But today, Swedish inflation is on the rise, with the CPIF, the inflation gauge targeted by the Swedish central bank, being at target. Thus, the days of super easy monetary policy in Sweden are numbered, especially as the output gap is a positive 1%, unemployment stands nearly 1% below equilibrium, and resource utilization measures have spiked up. Today, it makes sense to buy the SEK versus the euro. However, EUR/SEK is unlikely to move below 9, as the best of the global business cycle is probably behind us. 6) USD/JPY Chart I-6A Big Move In USD/JPY Is On Its Way USD/JPY is at an interesting technical juncture. This pair has been forming a very large tapering wedge in recent years (Chart I-6). This type of formation can be resolved in either a bullish fashion or a bearish one. Our current inclination is to bet on a bullish resolution for USD/JPY, as global bond yields seem to finally be regaining some vigor, which historically has been poison for the yen. Supporting our bias is the fact that we see more interest rate increases in the U.S. than are currently priced in, as we foresee a pick-up in inflation in 2018. The one thing that keeps us awake at night when thinking about our bullish disposition for USD/JPY is that EM carry trades have begun to weaken. Historically, this has led to a softening in global activity which foments further EM-carry-trade reversals and weakness in USD/JPY. Investors should keep an eye on this space. 7) AUD/USD Chart I-7AUD/USD At 0.8 Is A Line In The Sand The Australian dollar possesses the poorest outlook among the G10 currencies. The Australian economy continues to be plagued by large amounts of overcapacity, inflation is still absent, and Australia is the economy most exposed to a slowdown in Chinese construction activity as Australian terms-of-trade shocks follow metals prices. Additionally, China's push to fight pollution points to weakening coal prices, another key export of Australia. Moreover, Chart I-7 illustrates that the AUD rarely trades above 0.8. To do so, it needs an especially robust global economy, with China firing on all cylinders. We do not think China is about to crash, but it is not about to accelerate either, especially when it comes to demand for metals. Thus, with AUD/USD trading at 0.77, we see more downside for this pair than upside. In fact, when observed in a broader, longer-term context, the rally since 2016 in the AUD looks like a consolidation within a larger downtrend. 8) AUD/CAD Chart I-8AUD/CAD Will Breakdown AUD/CAD seems to have hit its natural ceiling this year. Only in the first half of the 1990s and when China was reflating its economy with all its might right after the financial crisis was AUD/CAD able to punch above 1.03 (Chart I-8). We do not see a repeat of this performance in the coming two years. First, as we mentioned, BCA does not anticipate any re-acceleration in Chinese investment or EM demand. Second, AUD/CAD is expensive, trading 9% above its fair value. Third, BCA remains more bullish on oil prices than metals prices. Fourth, a weakening AUD/USD tends to be associated with a weakening AUD/CAD. Finally, if these four factors cause AUD/CAD to weaken below 0.964, a key upward trend line that has supported AUD/CAD since late 2008 will be broken, which should prompt additional selling in this cross. 9) AUD/NZD Chart I-9AUD/NZD: Buffeted Between China, Jacinda, And Valuations AUD/NZD is likely to remain stuck in its trading range established since 2013 (Chart I-9). To begin with, the Australian dollar is trading at a 10% premium to the NZD. This has happened three times over the previous 17 years. Each of these instances were followed by vicious corrections in this cross. Additionally, while the AUD is very exposed to a slowing in Chinese construction and the associated problems for base metals prices, the NZD is not. In fact, the NZD may even benefit from the new economic objectives set by China's leadership. One of these new key objectives is to rebalance the economy toward the consumer. Moreover, Chinese consumer preferences have seen a switch toward higher quality foodstuffs.1 Higher quality foodstuffs, meat and dairy in particular, are exactly what New Zealand exports. Thus, a relative negative terms-of-trade shock is likely to come for AUD/NZD. The one big negative to our view is the political situation in New Zealand. The recent wave of populism points toward a fall in the potential growth rate, and thus a fall in the terminal policy rate of the Reserve Bank of New Zealand. The limit on foreign investment in Kiwi housing is another negative.2 Thus, we are not yet willing to bet on AUD/NZD falling below parity. 10) Bitcoins Chart I-10Groupthink Points To A Bitcoin Correction Toward 11,000 Valuing bitcoins is an arduous exercise. A lack of clearly defined fundamentals is the key difficulty. It is also why bitcoin prices can move so violently. We have already covered the technological elements behind Bitcoin and the blockchain,3 but to uncover what could be driving investors' imaginations, we have to move back to the realm of economics and finance. One theory tries to value bitcoin by linking it to a mode of payment. Using this method, Dhaval Joshi, who writes our BCA European Investment Strategy service, estimates a fair value for BTC/USD. Using the quantity of money theory, he shows that if the market assumes that bitcoins can support US$0.5 trillion of global GDP, and if the velocity of money historically averages 1.5 times, with 21 million potential bitcoins in issuance, a bitcoin should be worth US$17,000.4 Changing estimates for velocity or how much of global GDP will be transacted using bitcoins varies this estimate. Another approach has been to value bitcoins as an asset with a limited supply, like gold. Using this methodology, the global gold stock is worth approximately US$7 trillion, but cryptocurrencies, with their high volatility, are unlikely to steal the yellow metal's entire market share. Instead, they might be able to carve out 25% of gold's current total market capitalization. In this case, cryptos would be worth US$1.75 trillion. Bitcoin could represent half of this amount, which equates to a total market capitalization of US$875 billion. With a stock of 21 million bitcoins, the "fair value" would be around US$42,000. A third approach exists, and it is the simplest (Occam Razor's alert?). As Peter Berezin argues in BCA's Global Investment Strategy service, global governments extract seigniorage benefits from issuing currency.5 As an example, by printing cash, the U.S. government can buy services and good worth roughly US$90 billion per year, at a near zero cost. This is a very significant amount. Governments are unlikely to ever give up this source of funding. Since crypto currencies are a direct threat to this, they will likely be made illegal as a result. This would imply a fair value of BTC/USD of zero. The current fair value is likely to be a probability weighted average of all three scenarios. We assign a 10% probability for the first case (mode of payment), a 10% probability to the second case (store of value), and an 80% probability to the last case (zero value due to illegality). This would give a current fair value of roughly US$6,000. At the current juncture, bitcoin trading is exhibiting strong herd-like tendencies. When groupthink takes over a market, as is the case right now with crypto-currencies in general and bitcoin in particular, a trend reversal is likely to materialize. Today, bitcoin's "fractal dimension" has hit the 1.25 neighborhood, where such reversals have tended to happen (Chart I-10). As such, a correction is very likely. The average correction since 2016 has been around 35%. Following similarly parabolic moves as the one observed over the past month, pullbacks have been closer to 45%. A retracement toward BTC/USD of 11,000 is very probable over the coming quarters. That being said, it is too early to call the ultimate top for bitcoin. With the narrative among the bitcoin investing public increasingly switching to bitcoin being a store of value akin to gold, a move to the US$40,000 neighborhood is, in fact, not a tail event. However, this is a move to play at one's own peril, since fair value is likely to be well below these levels. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Atkinson, Simon. "Why are China instant noodle sales going off the boil?" BBC News, BBC, 20 Dec. 2017, www.bbc.com/news/business-42390058. He, Laura. "China's growing middle class lose appetite for instant noodles." South China Morning Post, 20 Aug. 2017, www.scmp.com/business/companies/article/2107540/chinas-growing-middle-class-lose-appetite-instant-noodles. 2 For a more detailed discussion of the political situation in New Zealand as well as its potential impact, please see Foreign Exchange Strategy Weekly Report, titled "Reverse Alchemy: How to Transform Gold into Lead" dated November 3, 2017, available at fes.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, titled "Blockchain And Cryptocurrencies" dated May 12, 2017, available at fes.bcaresearch.com 4 Please see European Investment Strategy Weekly Report, titled "Bitcoins And Fractals" dated December 21, 2017, available at eis.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, titled "Don't Fear A Flatter Yield Curve" dated December 22, 2017, available gis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed: Housing starts increased by 1.3 million units, beating expectations, building permits also outperformed; Both the Philadelphia Fed Manufacturing Survey and Chicago Fed National Activity Index outperformed expectations; However, annualized Q3 GDP growth came in at 3.2%, less than the expected 3.3%; Growth in headline and core personal consumption deflators also failed to meet expectations, coming in at 1.5% and 1.3% respectively. Easier financial conditions are expected to slowly push the core PCE deflator back to the Fed's 2% target. This will allow Jerome Powell to continue in Janet Yellen's footsteps. As credit continues to grow, the large U.S. consumer sector will become an increasingly important tailwind to growth. The fiscal thrust from the new tax plan will could also accentuate growth and inflationary pressures. Therefore, investment and consumption activity are both likely to pick up next year. This will should support the Fed as well as the USD. Report Links: Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 European data was mixed: German ZEW Current Situation increased to 89.3, outperforming expectations of 88.5; European ZEW Current Situation slightly underperformed expectations of 18, coming in at 17.4; Manufacturing and services PMIs for Germany and Europe as a whole both outperformed expectations; European trade balance decreased to EUR 19 bn from EUR 25 bn, and the current account also underperformed; European CPI was in line with expectations, contracting at a monthly pace, and growing at a 0.9% annual pace, under the expected 1% rate. On the Back of strong momentum in activity indicators, the ECB upgraded its growth and inflation forecasts for the upcoming years. However, since inflation is expected to remain under target for the whole forecast horizon, the ECB is likely to tighten policy at a much slower pace than the Fed. Report Links: The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 Market Update - October 27, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Annual Import growth came in at 17.2%, surprising to the downside. Moreover, the All Industry Activity Index monthly growth also underperformed expectations, coming in at 0.3%. However, export annual growth surprised to the upside, coming in at 16.2%, an acceleration relative to last month's reading. On Wednesday, the Bank of Japan left its policy rate unchanged at -0.1%. Furthermore, the yield curve control policy, in which 10-year yields are kept around 0%, has been maintained. We stay bullish on USD/JPY, as we expect U.S. bond yields to rise when inflation picks up next year. However the yen could appreciate against commodity currencies if a risk-off period is triggered by tightening in China. Report Links: Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Gfk Consumer confidence underperformed expectations, coming in at -13. This measure also decline from the November reading. However, CBI industrial Trend Survey for orders, surprised to the upside, coming in at 17. Finally, public sector borrowing also surprised to the upside, coming in at 8.118 Billion pounds. The pound has been flat against the U.S. dollar this week. Overall we remain skeptical in the ability of the Bank of England to tighten much in the near future, given that real disposable income growth is very depressed, house price growth continues to be tepid, and uncertainty weighs on capex. Moreover, inflation will likely come down from present levels, as the pass through from the pound depreciation dissipates. All of these factors will limit any upside to cable in the next months. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The AUD rallied solidly in recent weeks thanks to buoyant data out of Australia and China. Last week's labor numbers were especially important in this regard. The growth in full-time employment has outperformed that of part-time since summer, while the underemployment rate has declined by 0.3% since 2017Q2.. Moreover, RBA officials identified further positives in the housing market: excessive price appreciation has slowed down considerably and household's balance sheets are improving. For now, the biggest risk to the Australian dollar remains the Chinese economy. Xi Jinping's commitment to clamp down on pollution, debt and inequalities is a bearish prospect for the AUD. Additionally, Chinese house prices could decline substantially - something which would have negative repercussions for the AUD. Report Links: The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been mixed: The current account surprised to the downside, coming in at -2.6% of GDP. However this number did improve from last quarter's -2.8% reading. However, both imports and exports outperformed expectations, coming in at 5.82 billion and 4.63 billion respectively. Moreover, GDP growth outperformed expectations, coming in at 2.7%. However, this number did decline from the 2.8% reading in Q2. NZD/USD was flat this week, even as the USD weakened. We continue to believe that carry currencies like the NZD, will be affected by tightening of financial conditions in China. However, the NZD has upside against the AUD, as the New Zealand dollar is cheaper than the AUD, and it is not as levered to the Chinese industrial cycle as the Australian dollar is. Report Links: The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Canadian data was strong this week: Retail sales increased month-on-month by 1.5%, outperforming expectations by 0.8%; core retail sales also increased by a 0.8% monthly pace; Core inflation is at 1.3%, outperforming the expected 0.8%; Headline CPI is at 2.1%, above the expected 2%; The Canadian economy is growing in line with our expectations. A strong U.S. economy has allowed the export sector to flourish, while high demand for jobs has caused the labor market to tighten substantially. As labor shortages intensify, wages should gain traction in the near future, paving way for the BoC to tighten at least twice next year. Report Links: The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recently, the SNB released its 4th quarter quarterly bulletin. This report highlighted that the Swiss economy continues to recover, and GDP growth is expected to reach 2% in 2018, after a 1% expansion this year. Furthermore, the bulletin remarked that the labor market continues to tighten, with unemployment reaching 3% and employment growth finally hitting its long term average. The SNB also remarked that although the output gap continues to be negative, measures of capacity utilization are very close to reaching their long term average. However, the SNB continues to be unapologetically committed to its dovish bias and to intervention in currency markets, as inflation in Switzerland continues to be too weak for the SNB to change its stance. Thus, the CHF is likely to continue depreciating. Report Links: The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Balance Of Payments Across The G10 - August 4, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 USD/NOK has appreciated by nearly 1.5% since last week, even as Brent has rallied by more than 2.5%. This dynamic highlights the fact that USD/NOK continues to be more correlated to interest rate differentials between Norway and the U.S. than to oil prices. Inflationary pressures and economic activity continue to be too tepid for the Norges to adopt a much more hawkish tone than it did last week. Meanwhile, the Fed is likely to surprise the market next year, by following up on its "dot plot". These dynamics will continue to put upward pressure on USD/NOK. Nevertheless, foreign exchange investors can still use the krone to bet on higher oil prices resulting from the extension of the OPEC supply cuts. The way to do so is by shorting EUR/NOK, which is more correlated with oil prices. Report Links: 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 Updating Our Long-Term Fair Value Models - September 15, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Swedish data has bounced back considerably: Headline CPI increased by 1.9% annually and CPIF grew by 2% annually; The unemployment rate dropped substantially from 6.3% to 5.8%, while the seasonally adjusted figure dropped from 6.7% to 6.4%. This week, the Riksbank announced a formal end to additional bond purchases by the end of December. However, reinvestments will continue until the middle of 2019, which means that the Bank's holdings of government bonds will actually increase into 2019. Additionally, the Swedish central bank also forecasts the repo rate to begin gradually increasing in the middle of 2018. This makes sense as the Swedish economy is running beyond capacity conditions. Given Sweden's stellar growth period, an appreciation in the SEK is long-awaited, but this will have to wait until Governor Ingves convinces markets that his perennial dovish-bias is ebbing. At that point, any hint of hawkishness will cause a sharp appreciation in the SEK, especially against the euro. Report Links: 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 Updating Our Long-Term Fair Value Models - September 15, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Dear Client, This is our final publication for the year. We will be back on January 5th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Prosperous New Year! Best regards, Peter Berezin, Chief Global Strategist Highlights Global bonds have sold off in recent days, but the spread between long-term and short-term Treasury yields remains well below where it was at the start of the year. A flatter Treasury yield curve suggests that the ongoing U.S. business-cycle expansion is getting long in the tooth. Nevertheless, three factors dilute the potentially bearish message from the curve. First, the yield curve has flattened largely because short-term rate expectations have risen thanks to better economic data. Second, both the 10-year/2-year and 10-year/3-month spreads are still above levels that have foreshadowed poor returns for risk assets in the past. This is particularly true for equities. Third, a structurally low term premium has distorted the signal from the yield curve. The U.S. yield curve is likely to steepen over the next six months, before flattening again in the lead-up to a recession in late-2019. We reveal the One Number that will kill bitcoin. Feature A Harbinger Of Recession? The U.S. yield curve has steepened in recent days, but is still much flatter than it was at the start of the year. The 10-year/3-month spread currently stands at 113 bps, down 84 bps year-to-date. The 10-year/2-year spread has fallen from 125 bps to 62 bps. Numerous academic studies have highlighted the importance of the yield curve as a leading indicator of recessions.1 In fact, every U.S. recession over the past 50 years has been preceded by an inverted yield curve (Chart 1). Chart 1An Inverted Yield Curve Has Often Been A Harbinger Of A Recession The converse has generally been true as well: Most inversions in the yield curve have coincided with a recession. The only two exceptions were in 1967 - when credit conditions tightened and industrial production decelerated, but the U.S. still managed to avoid succumbing to a recession - and in 1998, when the yield curve briefly inverted during the LTCM crisis. Considering that recessions and equity bear markets typically overlap (Chart 2), it is not surprising that investors have begun to fret about what a flatter yield curve may mean for their portfolios. Chart 2Recessions And Bear Markets Usually Overlap Don't Worry... Yet Chart 3U.S. Growth Expectations Revised Higher We would not be as dismissive of a flatter yield curve as Fed Chair Yellen was during her December press conference. Policymakers and investors alike have been too quick to downplay the signal from the yield curve in the past. In 2006, they blamed the "global savings glut" for dragging down long-term yields. In 2000, they argued that the federal government's budget surplus was reducing the supply of long-term bonds. In both cases, the bond market turned out to be seeing something more ominous than they were. That said, there are three reasons why we would discount some of the more bearish interpretations of what a flatter yield curve is telling us. First, the flattening of the yield curve has occurred mainly because of an increase in short-term rate expectations, rather than a decrease in long-term bond yields. The increase in rate expectations has been largely driven by stronger growth data. The economic surprise index has surged far into positive territory and analysts are now scrambling to revise up their 2018 and 2019 U.S. GDP growth projections (Chart 3). The Fed now sees growth of 2.5% in 2018 and an unemployment rate of 3.9% by the end of next year. Back in September, the Fed expected growth of 2.1% and an unemployment rate of 4.1%. Second, our research suggests that the slope of the yield curve only becomes worrisome for the economy when it falls to extremely low levels. This conclusion is reinforced by the New York Fed's Yield Curve Recession Model, which uses the difference between 10-year and 3-month Treasury rates to estimate the probability of a U.S. recession twelve months ahead.2 The model's current recession probability stands at a modest 11% (Chart 4). The last three recessions all began when the implied probability was over 25%. Chart 4NY Fed's Yield Curve Model Suggests That The Probability Of A Recession Is Still Quite Low Third, the slope of the yield curve is weighed down by a structurally low term premium. The term premium measures the additional return investors can expect to receive by locking in their money in a 10-year Treasury note instead of rolling over a short-term Treasury bill for an entire decade. Historically, the term premium has been positive. Over the past few years, however, it has often been negative - meaning that investors have been willing to pay a premium to take on duration risk. Many commentators have attributed this peculiar state of affairs to central bank asset purchases, which they claim have artificially depressed long-term bond yields. There is some truth to this, but we think there is an even more important reason: Bonds today provide a good hedge against bad economic news. When fears of an economic slowdown mount, equities tend to sell off, while bond prices rise. This differs from the circumstances that existed in the 1970s and 1980s, when bad economic news usually meant higher inflation. To the extent that long-term bonds now serve as insurance policies against recessions, investors are more willing to accept the lower yields that they offer. Empirically, one can see this in the shift of the correlation between equity returns and bond yields. It was strongly negative up until the mid-1990s. Now it is strongly positive (Chart 5). A low term premium implies that the slope of the yield curve should be structurally flatter. That is exactly what we see today. Chart 6 shows that the 10-year/3-month spread would be well above its long-term average if the term premium were removed from the picture. This implies that investors have little to fear from the shape of today's yield curve, at least over the next six-to-twelve months. Chart 5Bond Prices Now Tend To Rise When Equity Prices Go Down Chart 6Stripping Out The Term Premium,##BR##The Yield Curve Is Not So Flat Rising Odds Of A Recession In Late-2019 Beyond then, things start to get dicey. The Fed's end-2018 unemployment rate projection of 3.9% is 0.7 percentage points below its long-term estimate of the unemployment rate. This means that at some point in the future, the Fed will need to lift interest rates above their "neutral" level in order to push the unemployment rate up to its equilibrium level. That's a risky gambit. There has never been a case in the post-war era where the unemployment rate has risen by more than one-third of a percentage point without a recession ensuing (Chart 7). Modern economies are subject to feedback loops. Once economic conditions begin to deteriorate, households cut back on spending. This leads to less hiring and even less spending. Bad economic news begets worse news. Chart 7Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Implications For Equities And Credit A flatter Treasury yield curve suggests that the U.S. business cycle is entering the home stretch. Nevertheless, as we pointed out two weeks ago, the 7th-to-8th innings of business-cycle expansions are often the juiciest for equity investors (Table 1).3 Table 1Too Soon To Get Out Chart 8 shows that the term spread today is still at levels that have signaled positive equity returns in the past. In fact, today's term spread is close to levels that prevailed in the second half of the 1990s, a period that coincided with the greatest bull market in American history. This message is echoed by our forthcoming MacroQuant model, which continues to flag upside risks for stocks over the next 6-to-12 months (Chart 9). Chart 8Current Term Spread Is Still Pointing##BR##To Positive Equity Returns Chart 9MacroQuant Still Positive##BR##On The Stock Market Globally, we favor euro area and Japanese equities (in local-currency terms) in the developed market sphere due to our expectation that the euro and yen will depreciate somewhat next year. Both the euro area and Japan also have greater exposure to cyclical sectors. This fits with our bias towards owning cyclicals over defensive stocks. Today's term spread is a bit more worrying for corporate credit. As our bond strategists have noted, a flatter yield curve is consistent with lower, though still positive, monthly excess returns for high-yield bonds (Chart 10).4 Again, the second half of the 1990s provides a potentially useful template: Despite a sizzling stock market, high-yield spreads actually widened as corporations loaded up on debt (Chart 11). The deterioration in our Corporate Health Monitor over the past five years suggests that a similar dynamic may be afoot (Chart 12). Chart 10Junk Monthly Excess Returns##BR##And The Yield Curve Chart 11Second Half Of 1990s: When High-Yield Spreads##BR##Rose With Stock Prices Chart 12Corporate Health Has##BR##Been Deteriorating Yield Curve Should Steepen Over The Coming Months Of course, much depends on what happens to the yield curve going forward. We suspect that it will flatten again towards the end of next year. However, it is likely to steepen over the next six months. U.S. GDP growth will remain above trend next year, as wages start to rise more briskly and firms boost capital spending to meet rising demand for their products. Fiscal policy should also help. Tax cuts will lift growth by 0.2%-to-0.3% in 2018. Higher disaster relief efforts following the hurricanes and a pending agreement to raise caps on discretionary spending will also translate into increased federal government spending. Investors have largely overlooked this source of fiscal stimulus, but increased spending will contribute almost as much to growth next year as lower taxes. Unfortunately, all this additional growth, coming at a time when the output gap is all but closed, is likely to stoke inflationary pressures. Our Pipeline Inflation Pressure Index has risen sharply since early 2016, while the ISM prices paid index has shot up. The New York Fed's Underlying Inflation Gauge has accelerated to an 11-year high of 3% (Chart 13). Historically, rising inflation expectations have led to a steeper yield curve (Chart 14). The implication is that investors should favor inflation-linked securities over government bonds. Chart 13U.S. Inflation Pressure Are Building Chart 14Rising Inflation Expectations Lead To A Steeper Yield Curve The One Number That Will Kill Bitcoin In a normal world, most reasonable people would regard a flatter yield curve and continued weak inflation readings as evidence that fiat money was, if anything, doing too good a job as a store of value. However, nothing is normal or reasonable about bitcoin.5 Chart 15Governments Will Want Their Cut:##BR##U.S. Seigniorage Revenue No one knows when the bitcoin bubble will burst. Only a tiny fraction of the public owns the virtual currency. The value of all bitcoin in circulation represents 0.35% of global GDP. At its peak in 1996, the value of all pyramid scheme assets in Albania amounted to almost half of GDP. Never underestimate the lure of easy money. While we do not know where the price of bitcoin will be ten months from now, we do have a good guess of where it will be ten years from today. And that price is zero, or thereabouts. When the U.S. Treasury issues a $100 bill, it gains the ability to buy $100 of goods and services with it. The government's cost is whatever it pays to print the bill, which is next to nothing. This so-called "seigniorage revenue" is set to reach $100 billion this year (Chart 15). That is the number that will kill bitcoin. There is no way the U.S. government will forsake this revenue in order to make room for bitcoin and other cryptocurrencies. Not when there are entitlements to pay and gaping budget deficits to finance. A variety of other countries have a love-hate relationship with bitcoin, partly because of their "the enemy of my enemy is my friend" attitude towards the dollar. But that will change when they see their tax bases eroding as more commerce gets done in the anonymous world of cryptocurrencies. Bitcoin's days are numbered. The only question is who will be holding the bag when the party ends. Peter Berezin, Chief Global Strategist peterb@bcaresearch.com 1 Please see Jonathan H. Wright, "The Yield Curve And Predicting Recessions," FEDs Working Paper No. 2006-7, May 3, 2006; Michael Owyang, "Is the Yield Curve Signaling a Recession?"Federal Reserve Bank Of St. Louis, March 24, 2016; and Arturo Estrella and Mishkin, Frederic S., "The Yield Curve as a Predictor of U.S. Recessions," Federal Reserve Bank Of New York, (2:7), June 1996. 2 Please see "The Yield Curve As A Leading Indicator: Probability of U.S. Recession Charts," Federal Reserve Bank Of New York. 3 Please see Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017. 4 Please see U.S. Bond Strategy, "Proactive, Reactive Or Right?" dated December 12, 2017. 5 Please see European Investment Strategy Weekly Report, "Bitcoins And Fractals," dated December 21, 2017; Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" dated December 12, 2017; Global Investment Strategy Special Report, "Bitcoin's Macro Impact," dated September 15, 2017; and Technology Sector Strategy Special Report, "Blockchain And Cryptocurrencies," dated May 5, 2017. 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Highlights As bitcoin has developed into a fledgling form of money, the best valuation framework for it is the quantity theory of money. This states that the bitcoin money supply (in dollars) times bitcoin's velocity of circulation = the amount of world GDP carried out in bitcoin. In the short term, excessive herding signals a likely countertrend reversal, and implies that the bitcoin price will retest $12,750 at some point in the next 130 days. In the long term, the wholesale acceptance of cryptocurrencies in the global economy will be deflationary. Feature Bitcoin's near-vertical price ascent to $19,000 has left many commentators crying "bubble!" The problem with this is that you cannot define an asset bubble simply from the behaviour of a price. You need to assess fundamental value, and the extent of deviation above this fundamental value. Conceivably, bitcoin's near-vertical price ascent could be a correction from an "anti-bubble", in which the price was a long way below its fundamental value and rapidly corrected upwards. Which begs the question: what is the best way to assess the fundamental value of bitcoin and other cryptocurrencies? Chart of the WeekCryptocurrencies Will Prevent Inflation, Just Like The Gold Standard A Valuation Framework For Bitcoin As bitcoin has developed into a fledgling form of money, one potential valuation framework is the quantity theory of money. This states that the money supply times its velocity of circulation equals nominal GDP. Given that the supply of bitcoin will not exceed an upper limit of 21 million coins, we can say that the bitcoin money supply (in dollars) is the bitcoin price times 21 million. We can then use the quantity theory to deduce: Bitcoin price times 21 million times bitcoin's velocity of circulation = Amount of world GDP carried out in bitcoin. If we additionally assume that bitcoin's velocity is similar to that of the stock of broad fiat money, 1.5, then we can rearrange and simplify the equation to approximately: Bitcoin price = Amount of world GDP carried out in bitcoin divided by 30 million So if the market was discounting that $0.5 trillion of world GDP would be carried out in bitcoin, then its price should be $16,700. Given the purported nefarious uses of cryptocurrencies at the moment, and an estimated size of the world's shadow economy at around $16 trillion, an assumption of $0.5 trillion of bitcoin use in the world economy does not seem excessive. On the other hand, nefarious use might make bitcoin's velocity of circulation a lot higher than conventional money. Which would pull bitcoin's fair price much lower. Suffice to say, the above assumptions are broad-brush and open to challenge. Nevertheless, despite the many caveats, the above framework is probably the most valid for valuing a cryptocurrency once it gains acceptance as a fledgling form of money. Putting Bitcoin Through Fractal Analysis The behaviour of price alone cannot gauge an asset bubble. But the behaviour of price alone can gauge a shortage of liquidity in the asset which implies a potential countertrend reversal. Liquidity is plentiful when the market is split between short-term momentum traders and longer-term value investors. This is because the two herds generally disagree with each other. If the price fluctuates up, the momentum trader wants to buy while the value investor wants to sell; and vice-versa. So the herds trade with each other with plentiful liquidity and little movement in price. This raises an obvious question. Can there really be any value investors in cryptocurrencies? The answer is potentially yes, if these investors believe that cryptocurrency acceptance will increase over time. And if they apply the aforementioned valuation framework from the quantity theory of money. Still, liquidity will periodically evaporate if too many value investors join the short-term momentum herd. Instead of dispassionately investing on the basis of a valuation framework, value investors get lured into participating in a strong rally, and their buy orders add fuel to the rally. A tipping point comes when all the value investors have joined the momentum herd. If a value investor then suddenly reverts to type and puts in a sell order, he will find that there are no buyers left. Liquidity has evaporated, and finding new liquidity might require a substantial reversal in the price to attract a buy order from an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument has reached its tipping point, signalling a likely end of its price trend. Today, the 130-day herding indicator for bitcoin is at a level which has indicated three previous countertrend reversals of at least one fifth of the preceding 130-day move (Chart I-2, Chart I-3, Chart I-4). Chart I-2Bitcoin: The 130 Day Fractal Dimension Signalled A Reversal In 2015 Chart I-3Bitcoin: The 130 Day Fractal Dimension Signalled Two Reversals In 2017 Chart I-4Bitcoin: The 65 Day Fractal Dimension Also Signalled Two Previous Reversals If this herding indicator signals a fourth countertrend reversal, it implies that the bitcoin price will retest $12,750 at some point in the next 130 days. Are Cryptocurrencies Inflationary Or Deflationary? On the face of it, the emergence of cryptocurrencies sounds inflationary. After all, if the general acceptance of cryptocurrencies for commercial transactions increases, there will be new money supply. And this new money supply will increase the nominal demand for goods and services. However, the truth is more nuanced. Unlike fiat money supply - which can expand without limit - each cryptocurrency has a defined limit to its supply. Although new cryptocurrencies can emerge, there seems to be a limit to the aggregate amount of cryptocurrency supply. The limiting factor is that it takes energy to create cryptocurrency through so-called 'mining'. Miners must compete to validate transactions that occur in a cryptocurrency. The competition takes the form of solving a mathematical problem - for example, finding the prime factors of a very large number. And the computational demands are energy sapping. Furthermore, the computational demands - known as 'proof of work' - get progressively more difficult for each additional new coin mined. Given that the computational resources in the world are finite and growing at a gentle and predictable rate, the implication is that the growth in the total amount of cryptocurrency is also limited. So while the emergence of cryptocurrencies does increase the money supply in the near-term (Chart I-5), a large-scale rejection of fiat money would make it impossible for uncouth policymakers to spike the overall money supply over the longer-term. Chart I-5Cryptocurrencies: Market Cap Is Now Non-Trivial Here's a further thought. Imagine if the proof of work computations, instead of being random mathematical calculations, solved useful problems that expanded the envelope of knowledge. This could boost real productivity, which is ultimately just a function of the stock of human ingenuity. In which case, any increase in money supply would be matched by an increase in potential real output. Interestingly, a recent paper from the Bank of Canada proposes that a wholesale acceptance of cryptocurrencies in the global economy could act as a new gold standard, whose effect would be mildly deflationary1 (Chart of the Week) and Table I-1). We fully agree with the Bank of Canada analysis. Table I-1No Persistent Inflation For 700 Years! The sting in the tail is that the analysis describes prices denominated in cryptocurrency terms. In fiat currency terms, the quantity theory of money implies that prices would rise2 - unless central banks reacted to the emergence of cryptocurrencies by shrinking the supply of fiat money. Would they? Very likely yes. If they didn't, the demise of fiat money would accelerate as people voted with their wallets and switched to superior stores of purchasing power. Nevertheless, we suspect that any central bank response would just delay the inevitable. As Larry Summers puts it: I am much more confident that the world of payments will look very different 20 years from now than I am about how it will look. And with that observation, I am signing off for 2017. I do hope you have enjoyed our provocative and counterintuitive insights this year. In the vast majority of cases, these insights have led to highly profitable investment recommendations. We promise to continue the success in 2018! Early next year, we will also unveil a major enhancement to our proprietary fractal trading strategy. So stay tuned. It just remains for me to wish you all a very enjoyable Festive Season and a prosperous 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Bank of Canada Staff Working Paper, A Bitcoin Standard: Lessons from the Gold Standard https://www.bankofcanada.ca/2016/03/staff-working-paper-2016-14/ 2 Please see the Global Investment Strategy Special Report titled "Bitcoin's Macro Impact", dated September 15, 2017 available at gis.bcaresearch.com and Technology Sector Strategy Special Report titled "Cyber Currencies: Actual Currencies Or Just Speculative Assets?", dated December 12, 2017 available at tech.bcaresearch.com. Fractal Trading Model* As discussed in the main body of this report, this week's trade is to expect a countertrend reversal in bitcoin. Go short with a profit target at $12750 and stop-loss at $28000. In other trades, long silver has had a strong 1-week bounce while long U.K. personal products / short U.K. food and beverages reached the end of its 65 day maximum holding period and closed with a small profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-6 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations