Capex

Highlights Chinese fiscal stimulus, both direct fiscal spending and infrastructure investment, has slowed significantly since late last year. This raises a red flag on the sustainability of the cyclical upturn. The Chinese economy should remain buoyant in the near term, despite fiscal retrenchment. Policy initiatives should be closely monitored. Tactically upgrade H shares back to "overweight." Stay cyclically positive, and favor Chinese equities in global and EM portfolios. There are early signs that deflation is re-emerging in Hong Kong. Feature The Chinese economy has maintained strong momentum since the beginning of the year. Some sectors are showing remarkable strength, an extraordinary development considering that January is historically a lackluster month for industrial activity due to seasonality factors. The recent strength is all the more noteworthy as policymakers have apparently rolled back fiscal support significantly since late last year, and have more recently also tightened on the monetary front.1 The divergence between strengthening growth momentum and waning policy support raises hopes that the economy has finally found its footing with self-sustainable dynamics, but at the same time raises the risk that growth may relapse anew without policy tailwinds - especially if struck by an exogenous shock. For now we maintain our benign view on China's cyclical growth outlook, but the risk is tilted to the downside, and policy initiatives should be closely monitored going forward. Meanwhile, we remain positive on Chinese equities on a cyclical basis. This week we are also upgrading our tactical "bullishness rating" on H shares back to "overweight." Strengthening Growth Versus Waning Fiscal Support Despite seasonal noise in the macro data in the first two months of the year, most macro numbers coming out of China of late have surprised significantly to the upside. Producer prices have continued to accelerate, heavy-machine sales have been booming, and even exports have rebounded sharply (Chart 1). The regained strength in the economy is partly attributable to early last year's low base, which has supercharged year-over-year growth rates. However, there is little doubt at this stage that China's growth recovery since early last year has developed into a mini boom. Beneath the robust growth numbers, there are some disconcerting undercurrents on the policy front (Chart 2). Fiscal spending growth has decelerated sharply since early 2016, and actually contracted towards year end. More importantly, capital spending on infrastructure construction, which can be viewed as an indicator for broader policy-driven spending in the economy, also slowed sharply in the last quarter. Fixed asset investment in transportation networks and utility concerns have also abruptly slowed. Investment in railway construction contracted by almost 30% in the final months of last year from a year earlier. All of this underscores a synchronized reduction in the public sector's involvement in the economy of late. Chart 1Growth Recovery... Growth Recovery... Growth Recovery... Chart 2... Meets Waning Fiscal Stimulus ... Meets Waning Fiscal Stimulus ... Meets Waning Fiscal Stimulus It is not immediately clear why the government has significantly scaled back fiscal support. Combined with the latest interest rate adjustments by the People's Bank of China, it is likely that the authorities have become content with the economy's performance to a degree that any direct policy pump-priming in their view is no longer necessary or justified. If China's ongoing cyclical growth improvement was due to the authorities' reflationary efforts, then the abrupt change in policy course certainly raises a red flag on how long the recovery may last. Can The Growth Recovery Continue Without Fiscal Support? Chart 3Monetary Conditions Matter More Than Fiscal Monetary Conditions Matter More Than Fiscal Monetary Conditions Matter More Than Fiscal We expect the Chinese economy to remain buoyant in the next two quarters, even without major acceleration in fiscal spending, for the following reasons: First, China's growth recovery since last year has been driven primarily by easing monetary conditions through a weakening exchange rate and falling real interest rates, rather than strong fiscal boost. Chart 3 shows that industrial sector growth deterioration worsened dramatically in 2014, which in hindsight was due to a combination of aggressive fiscal retrenchment and tighter monetary conditions index (MCI). Even though fiscal expenditures began to accelerate strongly starting in early 2015, the economy only began to improve a year later when the MCI started to ease. In fact, the industrial sector continued to improve throughout 2016 along with a rising MCI when fiscal expenditures decelerated. In other words, the industrial sector's performance is much more tightly correlated with the country's monetary conditions than the cyclical swings in fiscal spending. On one hand, the RMB exchange rate matters fundamentally for the manufacturing sector, which is heavily exposed to overseas markets. On the other hand, lower real interest rates, either through easing deflation or falling nominal rates, has been a primary driver of corporate profitability and overall business conditions, given the country's debt-centric financial intermediation system (Chart 4). As PPI is still rising rapidly and the trade-weighted RMB has once again rolled over, monetary conditions will likely continue to ease, which will further boost the industrial sector despite the fiscal cuts. Second, the slowdown in infrastructure spending will likely be compensated by accelerating investment in other sectors, manufacturing and mining in particular. Easing monetary conditions and ensuing growth improvement have significantly boosted corporate profitability, which should in turn boost manufacturing capital spending (Chart 5). It is likely that the multi-year slowdown in manufacturing sector capital spending has run its course and will accelerate going forward, albeit gradually.2 Investment in the mining sector is still contracting sharply. However, there has also been a dramatic improvement in profits among mining related industries, particularly coal and base metals (Chart 5, bottom panel). If historical correlations hold, the dramatic contraction in mining sector investment has likely already become very advanced, if not already bottomed. At minimum, it is highly unlikely that mining-related capex will continue to contract at an accelerating pace. Chart 4Interest Rates Versus Corporate Profits Interest Rates Versus Corporate Profits Interest Rates Versus Corporate Profits Chart 5Profits Versus Capital Spending Profits Versus Capital Spending Profits Versus Capital Spending A potential revival in manufacturing and mining capex will reverse a major growth headwind the Chinese economy has faced in recent years, which will continue to buoy growth despite slowing infrastructure construction. Manufacturing and mining account for over 33% of China's total fixed asset investment, higher than the 25% share of infrastructure alone (Chart 6). Indeed, there are signs that the corporate sector's intentions to expand capital investment may already be improving. In recent months medium- to long-term new loans to the corporate sector have accelerated strongly, which could be a sign that the corporate sector is beefing up on investment capital (Chart 7). Chart 6Manufacturing And Mining Capex ##br##Versus Infrastructure Construction Manufacturing And Mining Capex Versus Infrastructure Construction Manufacturing And Mining Capex Versus Infrastructure Construction Chart 7Longer Term Loans##br## Have Accelerated Sharply Longer Term Loans Have Accelerated Sharply Longer Term Loans Have Accelerated Sharply Finally, we maintain the view that overall inventory levels in the economy are unsustainably low, and improving growth and easing deflation should push producers to re-stock (Chart 8). This should also ease any near-term pressure on production, even if new orders are hit by slowing public sector demand. In other words, the economy has a built-in buffer for a period of weaker demand which could allow policymakers to re-orient demand-side policies in light of the new growth situation. Chart 8The Case For Inventory Restocking The Case For Inventory Restocking The Case For Inventory Restocking In short, we expect that waning fiscal support in the economy will not derail the cyclical recovery. Macro numbers may look toppy in the coming months, as the favorable base effect from last year's low levels wears out, but business activity should remain buoyant at least in the coming two quarters. Nonetheless, in a global environment that is still facing enormous challenges and mounting uncertainties, domestic policy tightening obviously raises downside risks. The annual People's Congress in early March should offer some important clues on the Chinese government's growth priorities and policy directions, and should be closely monitored. Tactically Upgrade H Shares In terms of Chinese stocks, our attempt to time a market correction in H shares ahead of the U.S. presidential elections in October did not bear fruit as expected.3 This week we are upgrading our tactical "bullishness rating" on H shares back to "overweight". Even though H shares did correct, they found support at key technical levels and have broken out of late, underscoring a strong technical pattern (Chart 9). We are still concerned that some global markets, especially U.S. stocks, appear frothy and are vulnerable to some sort of shakeout, but the market appears to be in a melt-up phase in the near term. The risk of being left out in a rising market is higher than otherwise. More importantly, Chinese H shares are not nearly as frothy, if not outright cheap, which should further limit downside risks. The Trump administration has notably toned down the anti-China rhetoric, and the near term risk of escalating trade tension between the U.S. and China has abated.4 This should also soothe investors' concerns on Chinese stocks. Bottom Line: Tactically upgrade H shares back to "overweight." A shares will likely remain largely trendless. Meanwhile, stay cyclically positive, and favor Chinese equities in global and EM portfolios. Hong Kong: Is Deflation Coming Back? Hong Kong's GDP numbers to be released next week are likely to show the economy accelerated in the final quarter of the year, according to our model (Chart 10). However, the improvement was likely almost entirely driven by exports rather than domestic factors. In fact, retail sales contracted by 3% in December from a year ago. More importantly, with the exception of essential items such as food, alcohol and tobacco, the growth rates of all other major consumer goods are in deeply negative territory. Durable goods, an important barometer for consumer confidence and spending power, dropped by a whopping 20% in value, or 15.8% in real terms from a year ago, underscoring very weak domestic demand. Therefore, Hong Kong's growth outlook will remain heavily dependent on external demand. Chart 9H Shares: A Technical Breakout H Shares: A Technical Breakout H Shares: A Technical Breakout Chart 10Hong Kong's Growth Recovery Hong Kong's Growth Recovery Hong Kong's Growth Recovery Weak domestic demand also weighs heavy on inflation. Hong Kong's headline inflation is falling rapidly, primarily driven by declining rental prices, and odds are high that inflation may dip below zero in the coming months. This means that deflation may re-emerge for the first time since 2005. These developing deflationary pressures underscore the frothy housing market, and also suggest the Hong Kong dollar may have become expensive again. The currency board system prevents nominal exchange rate adjustments, and therefore any adjustment has to be through changes in domestic prices. There is little systemic risk in Hong Kong's financial system, but the re-emergence of deflationary pressures further weakens domestic demand, augments growth difficulties and bodes poorly for asset prices, especially real estate. We will follow up on these issues in the coming weeks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "On Chinese Tightening," dated February 9, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Growth Watch," dated January 19, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard," dated January 26, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Feature For the first time since the beginning of the recovery in 2009, the U.S. economy has the potential - and is showing signs - of entering a self-reinforcing phase. After years of expecting that the next recession is just around the corner, economic agents are now optimistic about the strength and longevity of the business cycle. The likelihood of a period of above-trend growth would be a bullish development for risk assets (Chart 1). Our view is that the surge in business confidence is exaggerated due to federal politics, and Trump's election "honeymoon" effect will partially unwind at some point. However, the U.S. consumer is finally well-placed to shake some of the long-term angst that has been in a fixture for almost a decade. This chart-driven Special Report looks at the U.S. economy from several angles and highlights key themes (Chart 2): Chart 1Self-Reinforcing Recovery Finally At Work Self-Reinforcing Recovery Finally At Work Self-Reinforcing Recovery Finally At Work Chart 2U.S. Consumer Is The Bright Light U.S. Consumer Is The Bright Light U.S. Consumer Is The Bright Light Consumption will be the brightest spot in the recovery: The uptrend in consumer confidence has the potential to be lasting, and therefore lead to an acceleration in real consumption over the next several quarters. Most important is that the main driver of consumption trends, income, is on track to accelerate. Despite a moderation in payroll growth, overall income growth is likely to stay perky, now that the labor market has reached full employment and wages are rising. Residential real estate will be resilient despite the threat of higher rates: Residential construction will continue to make a positive contribution to growth, given that the supply of homes is low, especially relative to our expectations for a pick-up in demand. Capex will continue to lag: Non-residential business investment is likely to remain a sore spot for the economy for some time. Capex spending historically follows consumption with a lag; businesses first wait to see a pick-up in demand for their products and services before undertaking capital expansion. Various measures of capital utilization also suggest that there is still ample capacity, especially in the manufacturing sector, although capital spending growth has historically been driven by the direction of capacity utilization, not its level. Fiscal thrust could be positive but only late in the year: Federal, state and local government spending were only a very modest positive contribution to growth in 2016 and that is likely to be the case at least for the first half of 2017. Thereafter, federal spending may have a much larger impact, although there remain many unknowns. Thus, the coming cyclical improvement in growth will be mainly driven by the consumer sector, at least at first. Although our global leading economic indicators are heading higher, we are wary to extrapolate an overly positive view. There are a number of unresolved headwinds in China, Trump's anti-trade rhetoric is a risk, as is U.S. dollar strength for U.S. exporters. Meanwhile, financial markets are in the midst of a "euphoria rally," based on the expectation that a new U.S. federal government will unleash a powerful combination of pro-business reforms and fiscal ease. Thus, although the U.S. economic recovery rests on improving fundamentals, the stretched level of optimism suggests that investors should be prepared for a reality check. Consumer Spending Rising expectations for real household income growth over the next one to two years and improving job security are a result of a tightening labor market. Since income trends are the main driver of consumption growth, an improved labor market should help boost consumer spending growth to over 3% in 2017 (Chart 3). The cost of essential items as a share of income has declined throughout the recovery. In particular, food and energy costs as a share of income are very low and it is only the seemingly incessant climb in medical payments that keeps overall spending on essential items above 40% of disposable income. Still, at 41% of total disposable income, spending on essential items is far from burdensome relative to historical norms. This leaves plenty of room for spending on discretionary items. The combined wealth effect from real estate and financial markets has been positive for some time. Thus, it is not a new driver of consumer spending, but is nonetheless positive that wealth positions continue to improve. If our forecasts for financial markets and house prices pan out - i.e. that the bull market in stocks continues over time, that bonds experience only a mild bear market and that house price appreciation remains in the mid-single digits - then a positive wealth effect will continue to support consumption in 2017. Wages And The Labor Market U.S. wage growth is in a sustainable uptrend now that the bulk of our indicators suggest that the labor market is at full employment (Chart 4). According to the Atlanta Fed's wage tracker, overall median wages are growing at their fastest pace since the 2008. The gains are broad-based: wage gains have occurred for both "job switchers" and "job stayers." Other measures of wage inflation are also turning higher. The Employment Cost Index (ECI) is the most decisive measure for tracking broad developments for employee wages and benefits among geographic divisions, sectors (services vs goods-producing) and industries. The gains in this index are not as robust, but are nonetheless still rising and, according to business surveys, labor compensation is likely to continue to rise. The Fed views wage growth in the range of 3-4% per year as an important signal that consumer price inflation is moving toward the Fed's 2% target. Although the ECI is still below this range, if the current trend pace continues, 3% inflation in the wages and salaries component is reachable later this year. Chart 3Tailwinds For Robust Consumer ##br##Spending Are Firmly In Place Tailwinds For Robust Consumer Spending Are Firmly In Place Tailwinds For Robust Consumer Spending Are Firmly In Place Chart 4Tight Labor Market Will Boost ##br##Further Wage Growth Tight Labor Market Will Boost Further Wage Growth Tight Labor Market Will Boost Further Wage Growth Residential Investment Residential investment as a percent of GDP normally averages about 5% of GDP; it currently stands at 3.7%. However, it should continue to recover, making a significant positive contribution to GDP growth through 2017. Robust long-term fundamentals suggest that residential construction should continue to follow the recovery path experienced by other developed countries when boom/bust cycles occurred (Chart 5). Household formation is a critical measure of new housing demand over the long-term. The number of households formed continues to build towards pre-recession rates. Demographics may help the housing market over the next few years. According to the Joint Center for Housing Studies of Harvard University, over the next ten years, the aging of the Millennial generation will boost the population in their 30s. The growth in this age cohort implies an increase of 2 million new households each year on average.1 Finally, housing supply is no longer a headwind. This suggests that if final demand continues to improve, the lack of inventory overhang implies that the incentive for builders to take on new projects is high. Non-Residential Investment The corporate sector has been loath to undertake capital investment throughout the recovery. Despite rock-bottom interest rates, the lack of confidence in the outlook for final demand has kept businesses from investing (Chart 6). Business confidence has surged in recent months, although the sustainability of this trend is questionable. Survey respondents' optimism has been buoyed by great expectations about pro-business reform in Washington. This excessive optimism is vulnerable to pullbacks should Trump's leadership and policies disappoint. Only once businesses see a clear upswing in demand for their products and services will a new capex cycle emerge. The BCA Model for business investment tracks broad capex swings and has been trending down for several months now and remaining in contractionary territory. Investment in equipment, the largest portion of business investment, has been falling sharply for the past year. Much of the weakness is concentrated in the energy sector following the collapse in oil prices in late-2014. The U.S. dollar has also been a headwind for the manufacturing sector. Chart 5Housing Market Is ##br##Recovering Gradually Housing Market Is Recovering Gradually Housing Market Is Recovering Gradually Chart 6Corporate Sector Has Yet ##br##To Unleash Capex Spending Corporate Sector Has Yet To Unleash Capex Spending Corporate Sector Has Yet To Unleash Capex Spending Exports Net exports were a slight positive to GDP growth at the end of 2016, after being a drag for the past three years. However, the Q3 2016 improvement is due chiefly to one sector - a surge in soybean exports (Chart 7). Indeed, exports to all regions except Asia remain weak. Exports to the rest of North America, Europe, and Central & South America all peaked in 2014. As mentioned above, the exception to this trend is Asia, which now accounts for about 28% of total U.S. exports. Surging soybean exports to China were the major driver of the Q4 trend change. Government Federal spending was a drag on GDP growth from 2011 to 2015. In 2016, federal spending was a modest positive. Looking ahead, hopes are high that a new government in Washington will significantly boost fiscal spending. Our base case is that the Federal fiscal thrust will rise by about 0.5% of GDP, although the timing is uncertain and may not boost GDP growth until 2018 (Chart 8). Tax cuts could provide an earlier lift, but it would show up as increased consumer and capital spending. State and local spending lost momentum in 2016 after finally recovering the previous year. The 2016 decline in state tax revenues was not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year. Chart 7Nominal Exports Led Mainly By Asia Nominal Exports Led Mainly By Asia Nominal Exports Led Mainly By Asia Chart 8Government Spending Will Expand Modestly Government Spending Will Expand Modestly Government Spending Will Expand Modestly Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see "The State Of The Nation's Housing 2016," Joint Center for Housing Studies of Harvard University.

Theme 1 - Returning U.S. Animal Spirits: I Want To Break Free Animal spirits are making a comeback in the U.S. The catalyst for this development is the hope that a Trump administration will alleviate the regulatory burden that has been a source of worry for corporate America (Chart I-1). Feeding this impression has been Trump's anti-regulation rhetoric. His deal-maker, take-no-prisoners persona, along with a cabinet packed with businessmen and corporate scions further solidifies this perception. However, Trump's electoral victory was only the match igniting the fuel. The conditions for a resurgence of animal spirits were already in place. Animal spirits are only a Keynesian metaphor for confidence. From late 2014 to 2016, a 16% contraction in profits weighed on business confidence. However, pre-tax profits have bottomed and are set to continue their acceleration (Chart I-2). Chart I-1Hurdle To Animal Spirits bca.fes_sr_2016_12_16_s1_c1 bca.fes_sr_2016_12_16_s1_c1 Chart I-2A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing Since profits have bottomed, business capex intentions have picked up steam. As Chart I-3 illustrates, this development not only tends to presage a rise in business investments, it also is a leading indicator of economic activity at large. This rise in capex intentions is not only a reflection of an ebbing contraction in profits. It also indicates that many companies are starting to worry about hitting their capacity constraints if final demand firms up. After having added to their real capital stocks at the slowest pace in decades, U.S. firms are now facing rising sales, a situation that creates a bottleneck (Chart I-4). Chart I-3CAPEX Intentions And Growth bca.fes_sr_2016_12_16_s1_c3 bca.fes_sr_2016_12_16_s1_c3 Chart I-4Improving Sales Outlook ##br##Meets Supply Constraint bca.fes_sr_2016_12_16_s1_c4 bca.fes_sr_2016_12_16_s1_c4 Moreover, the labor market is tightening. All the signs are there: at 4.6%, U.S. unemployment is in line with its long-term equilibrium; the number of individuals outside of the labor force is in line with the 1999 to 2007 period, an era where hidden labor-market slack was inexistent; and the difficulty for small businesses to find qualified labor is growing (Chart I-5). As is the case today, companies are not concerned by a lack of demand, but by the quality of labor - a combination pointing to decreasing slack - wage growth tends to accelerate. Coincidentally, this is also an environment in which companies increase their allocation to corporate investments (Chart I-6). A few factors explain why companies are more willing to invest when slack narrows and wages grow. Obviously, rising labor costs incentivize businesses to skew their production function toward capital instead of labor. Additionally, rising wages support household consumption. Capex is a form of derived demand. A stronger household sector leads to more perceived certainty regarding the robustness of the expected final demand faced by corporations. Thus, when the share of wages and salaries in the national income grows, so do investments (Chart I-7). Chart I-5The Labor Market Is Tight The Labor Market Is Tight The Labor Market Is Tight Chart I-6When Demand Is Solid And Labor Is Tight... bca.fes_sr_2016_12_16_s1_c6 bca.fes_sr_2016_12_16_s1_c6 Chart I-7Animal Spirits At Work bca.fes_sr_2016_12_16_s1_c7 bca.fes_sr_2016_12_16_s1_c7 This means that while we had already expected the consumer to be a key engine of growth next year, we expect the corporate sector to join the fray.1 To us, this combination represents the main reason to expect our Combined Capacity Utilization Gauge to move into "no slack" territory, an environment where the Fed can hike rates durably. Bottom Line: U.S. animal spirits are breaking free. Trump is the catalyst, but conditions for improving business confidence and higher capex have been in place for a period of time. Profits have troughed, capex intentions are on the rise, and capacity constraints are being hit. This will give the Fed plenty of ammo to increase rates in 2017 and 2018. Theme 2 - Monetary Divergences: Pretty Tied Up Monetary policy divergences will continue to be one of the running themes for 2017. As we have argued, the Fed is in a better position to increase interest rates. However, the European Central Bank and the Bank of Japan are firmly pressing on the gas pedal. Last week, the ECB unveiled a new leg to its asset purchase program. True, bond buying will decrease from EUR 80 billion to EUR 60 billion starting April 2017, but the program is now open-ended. Also, the ECB can now buy securities with a maturity of 1-year, as well as securities yielding less than the deposit facility rates. This gives the ECB more flexibility to increase its purchases if need be to placate any potential economic shock in the future. Most crucially, the ECB does not regard its 2019 inflation forecast of 1.7% as in line with its target. Draghi has stressed that this requires the ECB to persist in maintaining its monetary accommodation. This makes sense. While the European economy has surprised to the upside, the recent roll-over in core CPI highlights the continued deflationary forces in the euro area (Chart I-8). These deflationary forces are present because the European output gap remains wide at around 4% of potential GDP.2 While the OECD pegs the Eurozone's natural rate of unemployment at 9%, it is probably lower. Despite a 2.3-percentage-point fall in the Eurozone's unemployment to 9.8% since 2013, euro area wages continue to decelerate, in sharp contrast with the U.S. situation (Chart I-9). This portends to excess capacity in the European labor market. It also limits European household income growth, which has lagged the U.S. by 14% since 2003. (Chart I-9, bottom panel). As a result, European consumption should continue lagging the U.S. Chart I-8Europe's Deflation Problem bca.fes_sr_2016_12_16_s1_c8 bca.fes_sr_2016_12_16_s1_c8 Chart I-9Signs Of Slack In Europe Signs Of Slack In Europe Signs Of Slack In Europe Additionally, European domestic demand has been supported by a rise in the credit impulse - the change in credit flows (Chart I-10). Between 2011 and 2014, to meet the EBA stress test and Basel III criteria, European banks raised capital and limited asset growth, boosting their capital ratios from 7.1% to more than 11% today. Once this adjustment was over, European banks normalized credit flows, boosting the credit impulse. This process is behind us. To keep the credit impulse in positive territory, credit flows would have to keep on expanding, implying that the stock of credit would have to grow at an ever-accelerating pace. However, the poor performance of European bank equities suggests that credit growth will slow (Chart I-11). While this may be too pessimistic a forecast, it is now unlikely that credit growth will accelerate. As a result, the credit impulse will roll over, hurting domestic demand and keeping deflationary pressures in place. Chart I-10Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Chart I-11Another Dark Omen Another Dark Omen Another Dark Omen This should translate into a very easy monetary policy in Europe for 2017 and most likely 2018. European rates, both at the short- and long-end of the curve will not rise as much as U.S. rates. In Japan, economic slack has dissipated and the labor market is at full employment (Chart I-12). The unemployment rate stands at 3% and the job-openings-to-applicants ratio sits at 1991 levels. What has prevented the Japanese output gap from moving into positive territory has been fiscal belt-tightening. Between 2011 and today, the Japanese cyclically-adjusted deficit has fallen from 7.5% to 4.5% of GDP, inflicting a large drag on growth. Going forward, we expect Japan's GDP to actually move above trend. Based on the IMF's forecast, fiscal austerity is behind us, suggesting that the force that has hampered growth is now being lifted. This is a conservative assessment. Abe has sounded increasingly willing to expand the government's deficit following his July upper-house election victory. Japanese military spending should be a key source of stimulus. In 2004, Japan and China both spent US$50 billion in that arena. Today, Japanese defense spending is unchanged but China's has grown to US$200 billion (Chart I-13). Therefore, Japan is ever more exposed to an increasingly assertive China in the region. Moreover, a potential rapprochement between the U.S. and Russia - a country formally still at war with Japan - also increases the need for a more self-sufficient Japanese defense strategy. Chart I-12Little Slack In Japan bca.fes_sr_2016_12_16_s1_c12 bca.fes_sr_2016_12_16_s1_c12 Chart I-13A Catch Up Is Needed bca.fes_sr_2016_12_16_s1_c13 bca.fes_sr_2016_12_16_s1_c13 Outside of the fiscal realm, there is cause for tempered optimism regarding Japan. Payroll growth remains strong despite full employment, pointing toward potentially higher wages. Also, the Business Activity Index, machinery orders, and the shipments-to-inventory ratio are all firming. Encapsulating these forces, our model forecasts further improvement in industrial production (Chart I-14). While these would point toward a monetary tightening, such is not the case in Japan. The Japanese central bank has committed to let inflation significantly overshoot before removing any accommodation. Hence, as growth improves, inflation expectations can rise, dampening real rates, depressing the yen, and further supporting growth (Chart I-15). This new BoJ policy is a game changer. Chart I-14Some Glimmer Of Hope bca.fes_sr_2016_12_16_s1_c14 bca.fes_sr_2016_12_16_s1_c14 Chart I-15The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ Moreover, this policy becomes supercharged when global bond yields rise, a central view for BCA's U.S. Bond Strategy service in 2017.3 Due to their low beta, JGB yields tend to not rise as much as global yields in a bond selloff. With the BoJ targeting near-zero rates at the long-end of the curve, JGB yields have even less upside. Rising global bond yields result in even-wider-than-before global-Japan rate differentials, which hurts the yen. This will stimulate Japanese growth even further, additionally easing monetary policy. Bottom Line: While the U.S. is on the path toward tighter policy, the ECB and the BoJ, by design, are loosening their policy. In Europe, the economy continues to suffer from underlying deflationary forces, forcing the ECB to stand pat for now. In Japan, the BoJ has elected to let inflation overshoot significantly even as the economy strengthens. This is putting downward pressure on Japanese real rates, a de facto further easing of monetary policy. Theme 3 - China And EM Slow-Down: Livin' On A Prayer After a year of respite, in 2017, emerging markets and China will once again be a source of deflationary shocks for the global economy. EM as a whole remains in a structurally precarious position. Since 2008, EM economies have accumulated too much debt and built too much capacity (Chart I-16). Most worrying has been the pace of debt accumulation. In the past five years, debt-to-GDP has risen by 51 percentage points to 146% of GDP. The debt has been backed up with new investments, but such a quick pace of asset accumulation raises the prospects of capital misallocation. When a large economic block like EM spends more than 25% of its GDP for 13 years on investment, the likelihood that many poor investments have been made is high. EM economies show all the hallmarks that capital has been miss-allocated, threatening future debt-servicing capacity. Labor productivity growth has collapsed from 3.5% to 1.5%, despite rising capital-to-labor ratios, while return on equity has collapsed despite surging leverage ratios, a sure sign of falling return on capital (Chart I-17). Chart I-16EM Structural Handicaps EM Structural Handicaps EM Structural Handicaps Chart I-17Symptoms Of A Malaise bca.fes_sr_2016_12_16_s1_c17 bca.fes_sr_2016_12_16_s1_c17 With this backdrop in mind, what happened in 2016 is key to understanding potential 2017 developments. Excess debt and excess capacity are deflationary anchors that raise the vulnerability of EM to shocks, both positive and negative. In 2016, the shock was positive. In the second half of 2015 and early 2016, China engaged in large scale fiscal stimulus (Chart I-18). Government spending grew and US$1.2 trillion of public-private infrastructure projects were rolled out in a mere six months. This lifted Chinese imports from their funk, used up some of the EM's excess capacity, dampened EM deflationary forces, and raised EM return on capital for a period. Additionally, faced with volatile markets, Western central banks eased monetary policy. The ECB and BoJ cut rates, and the Fed backed away from its hawkish rhetoric. The resultant falls in DM real rates and the dollar boosted commodity prices, further dampening EM deflationary forces and boosting EM profitability. Capital flows into EM ensued, easing financial conditions there and brightening the economic outlook (Chart I-19). Chart I-18China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad Chart I-19EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating This process is moving into reverse, the positive shock is morphing into a negative one. The structural handicaps plaguing EM have only marginally improved. Precisely because the Chinese industrial sector has regained composure, the already-fading Chinese stimulus will fully move into reverse (Chart I-20). With credit appetite remaining low and interbank rates already rising as the PBoC slows liquidity injections, the Chinese economy should soon rollover. Moreover, the dollar and global real rates are on the rise. Paradoxically, the return of U.S. animal spirits could endanger the EM recovery. As Chart I-21 shows, an upturn in DM leading economic indicators presages a fall EM LEIs. This simply reflects relative liquidity and financials conditions. Chart I-20China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Chart I-21DM Hurting EM DM Hurting EM DM Hurting EM Strong advanced economies, especially the U.S., lifts DM real rates and the dollar. This process sucks liquidity away from EM and tightens their financial conditions exogenously (Chart I-22). This hurts EM risk assets, currencies, and their economies. Moreover, since trade with the U.S. and other DM economies only account for 15% and 13% of EM exports, respectively, a fall in EM currencies does little to boost growth there. The fall in EM growth to be seen in 2017 will lay bare their structural weaknesses. As a result, EM assets are likely to suffer considerable downside. EM economies will limit the rise in global inflation by exerting downward pressures on globally traded goods prices as well as many commodities. Moreover, with Europe and Japan more exposed to EM growth than the U.S. (Chart I-23), EM weaknesses would further contribute to monetary divergences between the Fed and the ECB/BoJ. Chart I-22Rising DM Rates Equal Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Chart I-23U.S. Is The Least Sensitive To EM Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Bottom Line: 2016 was a great year for EM plays as Chinese fiscal stimulus and easier-than-anticipated DM policy contributed to large inflows of liquidity into EM assets, supporting EM economies in the process. However, as Chinese fiscal stimulus moves into reverse and as DM rates and the dollar are set to continue rising, liquidity and financial conditions in EM will once again deteriorate. Theme 4 - Oil Vs. Metals: Good Times Bad Times From the previous three themes, a logical conclusion would be to aggressively short commodities. After all, a strong dollar, rising rates, and weak EM are a poisonous cocktail for natural resources. However, the picture is more nuanced. In the early 1980s, from 1999 to 2001, and in 2005, commodity prices did rise along with the dollar (Chart I-24). In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan's and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar. In both the 1999-to-2001 and 2005 episodes, the share of U.S. and Japanese commodity consumption had already fallen. Most crucially, in both episodes, the rise in overall commodity price indexes only reflected strong energy prices. Outside of this complex, natural resource prices were lackluster (Chart I-25). Chart I-24Commodities And ##br##The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Chart I-25When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally In these two instances, oil prices were able to escape the gravitational pull of a strong dollar because of supply disruptions. In 1999, following an agreement to reduce oil production by OPEC and non-OPEC states, output fell by around 4 million barrels per day, causing the market to re-equilibrate itself. In 2005, as EM growth was already creating a supportive demand backdrop, a devastating hurricane season in the Gulf of Mexico curtailed global production by around 1 million bbl/day. Today, the situation is a hybrid of 1999 and 2005. While EM economies are in a much weaker position than in 2005, the U.S. economy is gathering strength. Hence, close to 50% of global oil consumption - U.S. and DM oil demand - will stay firm (Chart I-26). But, most vitally, the supply picture once again dominates. Not only did OPEC agree to a deal to curtail production by 1.2 million bbl/day, but Russia agreed to share the burden, cutting its own output by 300 thousand bbl/day. Shortly after this agreement was reached, Saudi Arabia threw in an olive branch by pledging to further cut its production if necessary to reduce global oil inventories. This means that the oil market will firmly be in deficit in 2017 (Chart I-26, bottom panel). Our Commodity & Energy Service, which forecasted the OPEC move, believes WTI oil prices could occasionally peak toward US$65 /bbl in 2017.4 The picture for metals is more complex. The output of iron and copper continues to grow. On the demand side of the ledger, the U.S. only contributes 4% and 8% of global demand for each metal, respectively. Thus even if Trump were able to implement a large infrastructure program in 2017 - a big if for next year - the effect on global demand would be low. Instead, what matters for metal demand is the outlook for EM in general and China in particular (Chart I-27). On this front, our negative take on China and EM is a big hurdle for metals to overcome. Chart I-26Supportive Oil Back Drop Supportive Oil Back Drop Supportive Oil Back Drop Chart I-27Metals Are About China, Not The U.S. Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Yet, all is not dark. Metal and oil prices have historically been co-integrated. In fact, during the previous episodes where oil strengthened as the dollar rallied, metals have more or less been flat. This pattern is likely to repeat itself, especially if as we expect, EM experience a growth slowdown and not an outright recession. Altogether, expectations of strong oil prices and flat metal prices suggest that any EM slowdown should be more discriminating than in 2015 and early 2016. Countries like Russia and Colombia should fare better than Brazil or Peru. This reality is also true for DM economies. Canada and Norway are likely to outperform Australia. Bottom Line: Despite a bullish view on the dollar and a negative EM outlook, overall commodity indices are likely to rise in 2017. This move will mostly reflect a rally in oil - the benchmark heavyweight - a market where supply is being voluntarily constrained. The performance of metals is likely to be much more tepid, with prices mostly moving sideways next year. Theme 5 - Dirigisme: Sympathy For The Devil In 2017, a new word will need to enter the lexicon of investors: dirigisme. This was the economic policy of France after the Second World War. Dirigisme does not disavow the key support systems of capitalism: the rule of law, private property, the sacrosanct nature of contracts, or representative governments. Instead, dirigisme is a system of free enterprise where, to a certain degree, the state directs the economy, setting broad guidelines for what is admissible from the corporate sector. Donald Trump fully fits this mold. He wants business to be conducted a certain way and will try his hardest to ensure this will be the case. What will be the path chosen by Trump? Globalization and laissez-faire capitalism have been great friends of corporate profit margins and the richest echelons of U.S. society (Chart I-28). While it has also greatly benefited the EM middle class, the biggest losers under this regime have been the middle class in advanced economies (Chart I-29). As long as U.S. consumers had access to easy credit, the pain of stagnating incomes was easily alleviated. Without easy credit the pain of globalization became more evident. Chart I-28The (Really) Rich Got Richer Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Chart I-29Globalization: No Friend To DM Middle Class Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Trump has courted the disaffected middle class. While he is likely to cut regulation, he will also put in place potentially erratic policies that may destabilize markets. The key will be for investors to appreciate his ultimate goal: to boost, even if only temporarily, the income of the American middle class. As such, his bullying of Carrier - the U.S. air-conditioner manufacturer that wanted to shift production to Mexico - is only the opening salvo. Tax policy is likely to move in this direction. A proposed tax reform that would cut tax for exporters or companies moving production back to the U.S. towards 0 - that's zero - and punish importers is already in the pipeline. The implications of such policies on U.S. employment are unclear. While U.S. businesses may repatriate production, they may do so while minimizing the labor component of their operations and maximizing the capital component in their production function. In any case, more production at home will support the domestic economy for a time period. However, the global impact is clearer. These policies are likely to be deflationary for the global economy outside the United States. A switch away from production outside of U.S. jurisdiction will raise non-U.S. output gaps. This should weigh on global wages and globally traded goods prices. Additionally, this deflationary impact will cause global monetary policy to remain easy relative to the U.S., particularly hurting the currencies of nations most exposed to global trade. Compounding this effect, nations that currently export heavily to the U.S. - which will lose competitiveness due to tax policy shifts and/or potential tariffs - are likely to let their currencies fall to regain their lost competitiveness. The currencies of Asian nations, countries that have benefited the most from globalization, are likely to get hit the hardest (Chart I-30). Chart I-30Former Winners Become Losers Under Trump's Dirigisme Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Moreover, along with a shift toward dirigisme, the U.S.'s geopolitical stance could harden further, a troubling prospect in an increasingly multipolar world. Tensions in East Asia are likely to become a recurrent theme over the next few years. Ultimately, the rise of dirigisme means two things: First, the influence of politics over markets and economic developments will continue to grow. Economics is moving closer to its ancestor: political-economy. Second, while Trump's dirigisme can be understood as a vehicle to implement his populist, pro-middle class policies, they will add an extra dose of uncertainty to the global economy. Volatility is likely to be on a structural upswing. Interestingly, the risk of rising dirigisme is more pronounced in the U.S. and the U.K. than in continental Europe. Not only are economic outcomes more evenly distributed among the general population in the euro area, recent elections in Spain or Austria have seen centrist parties beat the populists. While Italy still represents a risk on this front, the likelihood of a victory by the right-wing Thatcherite reformist Francois Fillon for the French presidential election in May is very high.Germany will remain controlled by a grand coalition after its own 2017 elections.5 Bottom Line: The U.S. economy is moving toward a more state-led model as Trump aims to redress the plight of the U.S. middle class. These policies are likely to prove deflationary for the global economy outside of the U.S. and could support the U.S. dollar over the next 12-18 months. On a longer-term basis, the legacy of this development will be to lift economic and financial market volatility. Theme 6 - Inflation: It's A Long Way To The Top Our final theme for the upcoming year is that the inflationary outcome of a Trump presidency will take time to emerge and inflation is unlikely to become a big risk in 2017. Much ink has been spilled predicting that Trump's promises to inject fiscal stimulus exactly when the economy hits full employment will be a harbinger of elevated inflation. After all, this is exactly the kind of policies put in place in the late 1960s. Back then, due to the Great Society program and the deepening U.S. involvement in the Vietnam War, President Johnson increased fiscal stimulus when the output gap was in positive territory. Inflation ensued. This parallel is misleading. True, in the long-term, Trump's fiscal stimulus and dirigisme bent could have stagflationary consequences. However, it could take a few years before the dreaded stagflation emerges. To begin with, the structure of the labor market has changed. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart I-31). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. Likewise, cost-of-living-adjustment clauses have vanished from U.S. labor contracts. Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Additionally, today, capacity utilization - a series that remains well correlated with secular inflation trend - remains much lower than in the 1960s and 1970s (Chart I-32). This means that one of the key ingredients to generate a sharp tick up in inflation is still missing. Chart I-31Labor: From Giant To Midget Labor: From Giant To Midget Labor: From Giant To Midget Chart I-32Capacity Utilization: Not Johnson Nor Nixon bca.fes_sr_2016_12_16_s1_c32 bca.fes_sr_2016_12_16_s1_c32 Chart I-33Today's Slack Is Not Where It Once Was bca.fes_sr_2016_12_16_s1_c33 bca.fes_sr_2016_12_16_s1_c33 Also, when looking at the output gap, the 1960s and 1970s once again paint a markedly different picture versus the present. Today, we are only in the process of closing the output and unemployment gaps. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966. Unemployment had been below its equilibrium rate since 1963, and by 1968 it was 2.5% below NAIRU (Chart I-33). Together the aforementioned factors suggest that inflation should remain quite benign in 2017. We probably still have a significant amount of time before raising the stagflationary alarm bells. Finally, the Fed currently seems relatively unwilling to stay behind the curve for a prolonged period and let inflation significantly overshoot its target. Wednesday, the Fed surprised markets by forecasting three rate hikes in 2017, resulting in a much more hawkish communique than was anticipated. Therefore, the FOMC's tolerance for a "high pressure" economy now seems much more limited than was assumed by markets not long ago. This further limits the inflationary potential of Trump's stimulus. Instead, it highlights the dollar-bullish nature of the current economic environment. Bottom Line: Trump fiscal stimulus at full employment evokes the inflationary policies of the late 1960s and early 1970s. However, back then it took years of economic overutilization before inflation reared its ugly head. Additionally, the structure of the labor market was much friendlier to inflation back then than it is today. Thus, while Trump's policy may raise inflation in the long term, it will take a prolonged period of time before such effects become evident. Instead, in 2017, inflation should remain well contained, especially as the Fed seems unwilling to remain significantly behind the curve. Investment Implications USD The U.S. dollar is in the midst of a powerful bull market. While the USD is already 10% overvalued, the greenback has historically hit its cyclical zenith when it traded with more than a 20% premium to its long-term fair value. This time should be no exception. Beyond our positive view on households, resurging animal spirits are beginning to support the economy. This combination is likely to prompt the Fed to move toward a more aggressive stance than was expected a few months ago (Chart I-34). With monetary divergences fully alive and backed up by economic fundamentals, interest-rate spreads between the U.S. and the rest of the G10 will only grow wider. Factors like a move toward dirigisme and an absence of blow-out inflation will only feed these trends. Chart I-34Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Tactically, the dollar is overbought, but clearly momentum has taken over. There is so much uncertainty floating in terms of economic and policy outcomes that evaluating the fair-value path for interest rates and the dollar is an even trickier exercise than normal for investors. This lack of clarity tends to be a fertile ground for momentum trading. Investors are likely to continue to chase the Fed. This process could last until market pricing for 2017 has overshot the Fed's own prognostications. Chart I-35EUR/USD: Technical Picture EUR/USD: Technical Picture EUR/USD: Technical Picture EUR At this point in time, the euro suffers from two flaws. First, as the anti-dollar, shorting the euro is a liquid way to chase the dollar's strength. Second, monetary divergences are currently in full swing between the ECB and the Fed: the U.S. central bank just increased interest rates and upgraded its rate forecast for 2017; meanwhile, the ECB just eased policy by increasing the total size of its asset purchase program. Investors are in the process of pricing these two trends and EUR/USD has broken down as a result (Chart I-35). The recent breakdown could bring EUR/USD to parity before finding a temporary floor. That being said, a EUR/USD ultimate bottom could still trade substantially below these levels. The U.S. economy is slowly escaping secular stagnation while Europe remains mired in its embrace. The euro is likely to end up playing the role of the growth redistributor between the two. JPY The Bank of Japan has received the gift it wanted. Global bond yields and oil prices are rising. This process is supercharging the potency of its new set of policies. Higher oil prices contribute to lifting inflation expectations, and rising global rates are widening interest-rate differentials between the world and Japan. With the BoJ standing as a guarantor of low Japanese yields, real-rate differentials are surging in favor of USD/JPY. USD/JPY has broken above its 100-week moving average, historically a confirming signal that the bull market has more leg. Additionally, as Chart I-36 shows, USD/JPY is a function of global GDP growth. By virtue of its size, accelerating economic activity in the U.S. will lift average global growth, further hurting the yen. Tactically, USD/JPY is massively overbought but may still move toward 120 before taking a significant pause in its ascent. We were stopped out of our short USD/JPY position. Before re-opening this position, we would want to see a roll-over in momentum as currently, the trend is too strong to stand against. GBP While political developments remain the key immediate driver of the pound, GBP is weathering the dollar's strength better than most other currencies. This is a testament to its incredible cheapness (Chart I-37), suggesting that many negatives have been priced into sterling. Chart I-36USD/JPY: A Play On Global Growth bca.fes_sr_2016_12_16_s1_c36 bca.fes_sr_2016_12_16_s1_c36 Chart I-37Basement-Bargain Pound bca.fes_sr_2016_12_16_s1_c37 bca.fes_sr_2016_12_16_s1_c37 For the first half of 2017, the pound will be victim to the beginning of the Brexit negotiations between the EU and the U.K. The EU has an incentive to play hardball, which could weigh on the pound. In aggregate, while the short-term outlook for the pound remains clouded in much uncertainty, the pounds valuations make it an attractive long-term buy against both the USD and EUR. Chart I-38CAD: More Rates Than Oil bca.fes_sr_2016_12_16_s1_c38 bca.fes_sr_2016_12_16_s1_c38 CAD The Bank of Canada will find it very difficult to increase rates in 2017 or to communicate a rate hike for 2018. The Canadian economy remains mired with excess capacity, massive private-sector debt loads, and a disappointing export performance. This suggests that rate differentials between the U.S. and Canada will continue to point toward a higher USD/CAD (Chart I-38). On the more positive front, our upbeat view on the oil market will dampen some of the negatives affecting the Canadian dollar. Most specifically, with our less positive view on metals, shorting AUD/CAD is still a clean way to express theme 4. AUD & NZD While recent Australian employment numbers have been positive, the tight link between the Australian economy and Asia as well as metals will continue to represent hurdles for the AUD. In fact, the AUD is very affected by theme 3, theme 4, and theme 5. If a move towards dirigisme is a problem for Asia and Asian currencies, the historical link between the latter and the AUD represents a great cyclical risk for the Aussie (Chart I-39). Tactically, the outlook is also murky. A pullback in the USD would be a marginal positive for the AUD. However, if the USD does correct, we have to remember what would be the context: it would be because the recent tightening in U.S. financial conditions is hurting growth prospects, which is not a great outlook for the AUD. Thus, we prefer shorting the AUD on its crosses. We are already short AUD/CAD and tried to go long EUR/AUD. We may revisit this trade in coming weeks. Finally, we have a negative bias against AUD/NZD, reflecting New Zealand's absence of exposure to metals - the commodity group most exposed to EM liquidity conditions, as well as the outperformance of the kiwi economy relative to Australia (Chart I-40). However, on a tactical basis, AUD/NZD is beginning to form a reverse head-and-shoulder pattern supported by rising momentum. Buying this cross as a short-term, uncorrelated bet could be interesting. Chart I-39Dirigisme Is A Problem For The Aussie bca.fes_sr_2016_12_16_s1_c39 bca.fes_sr_2016_12_16_s1_c39 Chart I-40New Zealand Is Perkier Than Australia bca.fes_sr_2016_12_16_s1_c40 bca.fes_sr_2016_12_16_s1_c40 NOK & SEK The NOK is potentially the most attractive European currency right now. It is supported by solid valuations, a current account surplus of 5% of GDP and a net international investment position of nearly 200% of GDP. Moreover, Norwegian core inflation stands at 3.3%, which limits any dovish bias from the Norges Bank. Additionally, NOK is exposed to oil prices, making it a play on theme 4. We like to express our positive stance on the NOK by buying it against the EUR or the SEK. The SEK is more complex. It too is cheap and underpinned by a positive current account surplus. Moreover, the inflation weaknesses that have kept the Riksbank on a super dovish bias mostly reflected lower energy prices, a passing phenomenon. However, being a small open economy heavily geared to the global manufacturing cycle, Sweden is very exposed to a pullback from globalization, limiting the attractiveness of the krona. Moreover, the krona is extremely sensitive to the USD. CHF The SNB is keeping its unofficial floor under EUR/CHF in place. Therefore, USD/CHF will continue to be a direct mirror image of EUR/USD. On a longer-term basis, Switzerland net international investment position of 120% of GDP and its current-account surplus of 11% of GDP will continue to lift its fair value (Chart I-41). Hence, once the SNB breaks the floor and lets CHF float - an event we expect to materialize once Swiss inflation and wages move back toward 1% - the CHF could appreciate violently, especially against the euro. Chart I-41The Swiss Balance Of Payment Position Will Support CHF bca.fes_sr_2016_12_16_s1_c41 bca.fes_sr_2016_12_16_s1_c41 Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the consumer and the dollar, please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy", dated December 8, 2016, available at ces.bcaresearch.com. 5 For a more detailed discussion of dirigisme, multipolarity, and rising tensions in East Asia, please see Geopolitical Strategy Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1 bca.fes_sr_2016_12_16_s2_c1 bca.fes_sr_2016_12_16_s2_c1 Chart II-2 bca.fes_sr_2016_12_16_s2_c2 bca.fes_sr_2016_12_16_s2_c2 The Fed hiked rates to 0.75% as expected. The dollar began to rally soon after the updated dot-plot suggested a faster pace of tightening than previously expected. Data from Thursday morning displayed a strengthening labor market, with expectations consistently beaten: Initial Jobless Claims came in at 254 thousand, beating expectations of 255 thousand. Continuing Jobless Claims were recorded at 2.018 million, outperforming by 7 thousand. Additionally, the NY Empire State Manufacturing Index also outperformed expectations of 4, coming in at 9. These figures provided an additional lift to the dollar with the DXY nearing the 103 mark. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3 bca.fes_sr_2016_12_16_s2_c3 bca.fes_sr_2016_12_16_s2_c3 Chart II-4 bca.fes_sr_2016_12_16_s2_c4 bca.fes_sr_2016_12_16_s2_c4 The Euro Area's data releases seem to be a mixed bag. Industrial production failed to meet expectations, and even contracted 0.1% on a monthly basis. The Markit Composite PMI remained steady at 53.9, and was in line with expectations, while the Services PMI fell and underperformed expectations, whereas the Manufacturing PMI rose and beat expectations. The increase in the dollar has also forced down Euro, where it has broken the crucial support level of around 1.055, and traded as low as 1.04. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5 bca.fes_sr_2016_12_16_s2_c5 bca.fes_sr_2016_12_16_s2_c5 Chart II-6 JPY Technicals 2 JPY Technicals 2 Despite the recent collapse in the Yen, Japan continues to be plagued by strong deflationary pressures. The BoJ will have no choice but to continue to implement radical monetary measures and thus the yen will continue to fall as some of the data lacks vigor: The decline in machinery orders accelerated to 5.6% YoY, underperforming expectations. Japanese industrial production is also contracting, at a pace of 1.4%. Particularly, most measures in the Tankan Survey (for both manufacturers and non-manufacturers) also underperformed expectations. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7 bca.fes_sr_2016_12_16_s2_c7 bca.fes_sr_2016_12_16_s2_c7 Chart II-8 bca.fes_sr_2016_12_16_s2_c8 bca.fes_sr_2016_12_16_s2_c8 Both the BoE and the market continue to be very bearish on the U.K. economy, causing the pound to be very cheap. However, the cable has remained resilient amid the recent dollar surge, in part because U.K. data, as we have mentioned many times, keeps outperforming expectations. The recent set of data confirms this view: Retail sales ex-fuel grew by 6.6% YoY, beating expectations of 6.1% YoY growth. Average earnings (both including and excluding bonus) also outperformed. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9 bca.fes_sr_2016_12_16_s2_c9 bca.fes_sr_2016_12_16_s2_c9 Chart II-10 bca.fes_sr_2016_12_16_s2_c10 bca.fes_sr_2016_12_16_s2_c10 Australian new motor vehicle sales are still quite weak: They are contracting 0.6% on a monthly basis, albeit at a slower pace from October's 2.4%; On an annual basis, they are now contracting 1.1%. Labor market data was also released, with unemployment increasing to 5.7%. However, the change in employment was better than expected, with 39,100 new total jobs being added to the economy. The Consumer Inflation Expectation measure for December also highlighted an upbeat outlook on inflation, reading at 3.4%, up from 3.2%. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11 bca.fes_sr_2016_12_16_s2_c11 bca.fes_sr_2016_12_16_s2_c11 Chart II-12 bca.fes_sr_2016_12_16_s2_c12 bca.fes_sr_2016_12_16_s2_c12 The recent dollar rally has been very damaging for the kiwi, as it has fallen by 3% since the Fed policy decision. Recent data has also been negative: Manufacturing Sales slowed down to 2.1% in Q3 from 2.2% in Q2 (this number was also revised down from 2.8%). Additionally Business PMI slowed down slightly from 55.1 to 54.4. The NZD has also shown weakness in spite of the surge in dairy price, which now stand at their highest point since June 2014. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13 bca.fes_sr_2016_12_16_s2_c13 bca.fes_sr_2016_12_16_s2_c13 Chart II-14 bca.fes_sr_2016_12_16_s2_c14 bca.fes_sr_2016_12_16_s2_c14 The outlook for Canada's economy remains murky. Although the Financial Stability Report concluded that Canada's financial system remains mostly unchanged from six months ago, the BoC highlighted three key vulnerabilities that remain in the financial system: household debt, for which the debt-to-disposable income is approaching 170%; imbalances in the housing market, where the prices have reached just under 6 times average household income - their highest recorded level; and fragile fixed-income market liquidity. Therefore, underlying weaknesses are apparent and data is reflective of a weak economy. Pressure from a rising dollar will continue to place additional pressure on the CAD going forward. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15 bca.fes_sr_2016_12_16_s2_c15 bca.fes_sr_2016_12_16_s2_c15 Chart II-16 bca.fes_sr_2016_12_16_s2_c16 bca.fes_sr_2016_12_16_s2_c16 The SNB decided to stay put and leave rates unchanged at -0.75%. In addition, the SNB slightly decreased its forecast for inflation for the coming years. However the central bank remains optimistic on the Swiss economy, as improved sentiment in other advanced economies should help the Swiss export sector. Additionally, the labor market remains solid, with only 3.3% of unemployment. Although the franc should continue to mirror the Euro, all these factors will eventually put upward pressure on this currency. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17 bca.fes_sr_2016_12_16_s2_c17 bca.fes_sr_2016_12_16_s2_c17 Chart II-18 bca.fes_sr_2016_12_16_s2_c18 bca.fes_sr_2016_12_16_s2_c18 The Norges Bank decided to stay put and leave rates at 0.5%. In their Executive Board Assessment the Norges Bank project that rates will remain around their current level in the coming years. They also project that inflation should slowdown given a somewhat slower expected path for growth. However, worries about household debt persist: House prices rose by 11.6% YoY in November, while household debt grew by 6.3%. Additionally household credit is rising faster than household income. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19 bca.fes_sr_2016_12_16_s2_c19 bca.fes_sr_2016_12_16_s2_c19 Chart II-20 bca.fes_sr_2016_12_16_s2_c20 bca.fes_sr_2016_12_16_s2_c20 The Swedish economy has picked up a bit, as annual inflation figures came out at 1.4%, closer to the Riksbank's target. The labor market also displayed resilience as the unemployment rate dropped by 0.2% to 6.2%. Despite the upbeat data, the SEK failed to perform. With the dollar trading at new highs, USD/SEK also reached a new 13-year high, trading above 9.4 for a moment. Additionally, the SEK is trading poorly on its crosses as well, down against most of the G10 currencies. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. is not yet a "high-pressure" economy, but slack is dissipating. U.S. growth, while not torrid, will remain high enough to push interest rates higher. The euro area continues to exhibit tepid domestic demand growth, and slack there remains higher than in the U.S. Monetary divergences will grow, weighing on EUR/USD. The Canadian economy displays underlying weaknesses which will prevent the BoC from hiking for an extended period of time. Stay long USD/CAD, but favor the CAD to the AUD and the NZD on a USD rally. Feature Following Janet Yellen's Boston speech last week, a new phrase has entered the lexicon of investors: "high-pressure economy". The speech was originally interpreted as a clarion call to let the economy overheat in order to absorb the slack created by the shock of 2008. However, Yellen still sees some slack in the economy. In her eyes, an easy monetary stance, at this point, will not cause an overheating, it will only bring back to the marketplace workers that had left the labor force. Chart I-1Drying Global Liquidity bca.fes_wr_2016_10_21_s1_c1 bca.fes_wr_2016_10_21_s1_c1 We have sympathy toward this view, especially when put in an international context where global capacity utilization remains depressed. Also, countries like China, Saudi Arabia, and Mexico have been intervening in the FX markets to preempt or limit downside to their currencies, tightening global liquidity conditions (Chart I-1). Nonetheless, the Fed Chair also highlighted that the FOMC did not want the U.S. economy to overheat as the domestic slack gets absorbed. Doing so would raise the risk that the Fed will have to then overcompensate by tightening rates very aggressively. This would prompt another recession. U.S.: Not High Pressure Yet, But... No indicator suggests that there is a burning need to quickly ratchet U.S. rates higher. However, domestic economic conditions are falling into place to justify a slow move toward higher rates. Our aggregate U.S. capacity utilization gauge is showing a dissipation of U.S. economic slack (Chart I-2, top panel). This is a side-effect of the tepid growth in the capital stock of U.S. businesses this cycle, which limits the expansion of the supply-side of the economy (Chart I-2, bottom panel). Meanwhile, household consumption should remain robust. Not only did 2015 register the strongest growth in the median household's real income since 1967, consumption is unlikely to slow much. In fact, vehicle-miles traveled and the Federal income tax receipts are both pointing toward healthy consumption (Chart I-3). Despite punky construction starts, housing activity shows signs of improvement. Housing inventories are near record lows and construction has underperformed household formation. Moreover, building permits are hooking upward, while housing affordability remains generous (Chart I-4). Additionally, the NAHB survey also points toward a rising share of residential activity in the economy (Chart I-4, bottom panel). Finally, capex intentions are slowly recovering. Moreover, the BCA House view is that the U.S. profit contraction is past its nadir. Going forward, capex and inventories are unlikely to subtract as much from growth as they did in 2015 and 2016. They may even become accretive to GDP growth. Chart I-2Vanishing U.S. Slack Vanishing U.S. Slack Vanishing U.S. Slack Chart I-3Positive Signs For The U.S. Consumer bca.fes_wr_2016_10_21_s1_c3 bca.fes_wr_2016_10_21_s1_c3 Chart I-4Residential Investment Will Improve bca.fes_wr_2016_10_21_s1_c4 bca.fes_wr_2016_10_21_s1_c4 Limited slack and a continued economic expansion imply a high likelihood of a Fed hike this year, and maybe two more next year if no shocks to financial conditions emerge. With markets currently pricing in 65 basis points of rate hikes by the end of 2019, this should lift rates across the curve. Higher interest rates on U.S. assets should drive private inflows into the country, pushing the U.S. dollar higher (Chart I-5). From a technical perspective, the U.S. capitulation index is breaking out to the upside following a pattern of lower highs. Since 2008, such breakouts have been followed by a significant rally in the broad trade-weighted dollar (Chart I-6). Thus, we continue to position ourselves for additional dollar strength this cycle. Chart I-5Flows Into The U.S. ##br##Are Set To Grow bca.fes_wr_2016_10_21_s1_c5 bca.fes_wr_2016_10_21_s1_c5 Chart I-6Favorable Technical ##br##Backdrop For The Greenback bca.fes_wr_2016_10_21_s1_c6 bca.fes_wr_2016_10_21_s1_c6 Bottom Line: The household sector remains healthy, and U.S. economic slack is dissipating. Hence, the Fed will try, rightfully or wrongly, to push rates higher this year and next, lifting the dollar in the process. Euro Area: Less Pressure A dollar rally could be painful for the euro. Yet, the euro is cheap and supported by a current account surplus of 3.3% of GDP (Chart I-7). What to do with this conflicting picture? For a currency to embark on a durable bull market, productivity growth needs to be stronger than that of its trading partners. A strong currency makes the tradeable-goods sector less competitive, hampering growth. A positive terms-of-trade shock, like that undergone by commodity producers during the previous decade can also do the trick. Neither of these statements currently describe the euro area. Another avenue for a country to withstand a strong currency is for growth to be domestically driven. If household consumption is the main locomotive, exporters' loss of market share do not hurt activity as much. This is true until the domestic economy enters a recession, an event usually driven by higher policy rates. This is why when the share of salaries in the U.S. economy expands, the dollar undergoes cyclical bull markets (Chart I-8). More salaries in the national income means more consumption. Chart I-7Euro ##br##Supports Euro Supports Euro Supports Chart I-8Domestically-Driven Growth##br## Is Good For A Currency Domestically-Driven Growth Is Good For A Currency Domestically-Driven Growth Is Good For A Currency In the euro area, GDP growth is above trend, but, in recent quarters, final private domestic demand has been weak (Chart I-9). In fact, last quarter, net exports were the main contributor to growth. This could explain why, since 2015, stronger European business surveys vis-à-vis the U.S. were unable to boost EUR/USD (Chart I-10). Chart I-9European Consumption##br## Isn't Strong Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-10If EUR/USD Could Not ##br##Rally Then, When Will It? bca.fes_wr_2016_10_21_s1_c10 bca.fes_wr_2016_10_21_s1_c10 We do expect eurozone final domestic demand to remain tepid. Yes, the credit impulse has improved, but this amelioration will prove temporary. The previous rebound in credit flows reflected the movement from a large contraction to a small expansion. Today, the dismal performance of euro area bank stocks - which have been a good leading indicator of European loan growth - points to slowing credit growth (Chart I-11). Fiscal policy is also moving from a small positive to a small negative. Work by the ECB staff shows that the cyclically adjusted budget balance in Europe fell by 0.3%, from -1.7% to -2.0% of GDP in 2016. Aggregate cyclically-adjusted budget balances are forecasted to improve to -1.8% and -1.6% of GDP in 2017 and 2018, respectively, representing a 0.2% fiscal drag each year. While a small number, we have to keep in mind that euro area trend growth is between 0.5% and 1%. This suggests that the European economy remains ill-equipped to handle a stronger euro. Moreover, the European economy exhibits much more slack than the U.S. economy. While total hours worked in the U.S. are 14% above Q1 2010 levels, in Europe, they are only 1.5% above such levels (Chart I-12), a gap much greater than demographics alone would have suggested. This means that monetary divergence will continue between Europe and the U.S. Chart I-11Euro Area Credit Impulse Will Weaken bca.fes_wr_2016_10_21_s1_c11 bca.fes_wr_2016_10_21_s1_c11 Chart I-12Less Capacity Pressures In Europe Less Capacity Pressures In Europe Less Capacity Pressures In Europe In fact, this week, the ECB did little to dispel this notion. Beyond trying to squash ideas of a sudden end to the QE program or any imminent tapering, president Draghi communicated that December will be the month when the real action occurs. Based on current trends, we expect the ECB to extend its QE program beyond March, but to hint at a tapering of purchases later in 2017. The ECB will also make it very clear that rates will remain as low as they currently are for an extremely long time. Thus, while the ECB might be slowly moving away from its hyper-stimulative stance, it will not do so as fast as the Fed. Therefore, policy divergences should continue to weigh on EUR/USD. Technicals are also pointing toward a lower euro. Not only has EUR/USD broken down its 1-year old series of higher lows, the euro's capitulation index, the intermediate-term momentum indicator, and the euro's A/D line are forming negative divergences with EUR/USD (Chart I-13). An interesting way to play the euro's weakness is to go short EUR/CZK, a position championed by our Emerging Market Strategy service.1 A floor at 27 has been set under EUR/CZK since November 2013. Yet, this floor looks increasingly untenable. Speculators are beginning to pile in. This week, 2-year Czech yields temporarily dipped below those of Swiss 2-year bonds, the current holder of the world's lowest yield. To fight appreciation pressures, the Czech National Bank (CNB) is accumulating a lot of reserves by buying euros, which is fueling a surge in the money supply (Chart I-14, top panel). Chart I-13Worrying Euro ##br##Technicals Worrying Euro Technicals Worrying Euro Technicals Chart I-14CZK: Reserves Expansion##br## Leading To Inflation bca.fes_wr_2016_10_21_s1_c14 bca.fes_wr_2016_10_21_s1_c14 This accumulation of reserves, in turn, is fanning inflationary forces in the Czech economy. The output gap is closing and core inflation already is increasing at a rate of 1.8% p.a. Easy financial conditions and expanding credit growth are likely to boost already-accelerating unit labor costs and wages (Chart I-14, bottom panel). This means that the 2% inflation target is likely to be hit as early as Q2 2017 according to the CNB. We expect this goal to be handily surpassed if the floor stays in place. Thus, we expect the CNB to abandon the floor within the next twelve months and we are shorting EUR/CZK. Finally, while we are bearish EUR/USD, we do believe that the euro will outperform the pound and commodity currencies. Moreover, despite poorer fundamentals, the euro could also temporarily outperform the SEK and the NOK if the dollar strengthens. The latter two are more sensitive to the USD than the euro is. Bottom Line: EUR/USD is at risk from the broad dollar rally. It is also likely to suffer from the tepid state of the euro area's final domestic demand, fueling monetary-policy divergences with the U.S. A speculative opportunity to short EUR/CZK is emerging, as the CNB's peg is outliving its usefulness. Canada: Falling Pressure USD/CAD has become more correlated with movements in rate differentials than with the vagaries of oil prices (Chart I-15). This puts the actions of the Bank of Canada in sharper focus. As expected, this week, the BoC left policy rates unchanged at 0.5%. More interesting was the quarterly monetary report. The economy has rebounded from the slump induced by the Q2 Alberta wildfires, and many key gauges of the Canadian economy have improved (Chart I-16). Yet, the BoC is looking the other way. Chart I-15CAD: Now More Rates Than Oil bca.fes_wr_2016_10_21_s1_c15 bca.fes_wr_2016_10_21_s1_c15 Chart I-16The BoC Is Looking The Other Way... bca.fes_wr_2016_10_21_s1_c16 bca.fes_wr_2016_10_21_s1_c16 The BoC is now forecasting the Canadian output gap to close in mid-2018; in July, this was expected to happen in the second half of 2017. This is because the BoC cut the expected Canadian growth rate by a cumulative 0.5% over the next two years. There have been some worrying developments warranting a more cautious forecast. While the Trudeau government's new childcare benefits are currently being rolled out and new infrastructure spending is to be implemented in 2017, the Canadian private sector's finances are increasingly shaky. The aggregate debt-servicing costs of the non-financial private sector is at record highs, with generous contributions from both households and the corporate sector (Chart I-17). The aggregate credit impulse has responded to this handicap, contracting by 7% of potential GDP, a move driven by the corporate sector (Chart I-18). While not as dramatic, the pace of debt accumulation by the household sector has also weakened. Recent administrative measures to cool the housing market - put in place by various provincial entities as well as the federal government - could accentuate this trend. Chart I-17...Rightfully So bca.fes_wr_2016_10_21_s1_c17 bca.fes_wr_2016_10_21_s1_c17 Chart I-18Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Collapsing Canadian Credit Impulse Another problem for Canada has been its loss of competitiveness. Non-oil Canadian exports have not responded as expected to the fall in the CAD. This is because many Canadian manufacturers have set up factories in Mexico and other EMs, or are competing with firms operating out of these nations. With these countries' currencies witnessing devaluations as deep as, or deeper than the loonie's, it is no wonder that Canada has lost market shares in the U.S. (Chart I-19). This means that Canadian rates will remain low for longer, making Canada another contributor to global monetary divergences vis-a-vis the U.S. The BoC is right to be worried that the Canadian economy will take longer than anticipated to close its output gap. With the pass-through to inflation of a lower CAD dissipating, the BoC expects Canadian core inflation to remain well contained for the next two years. We see little cause to disagree. This means that despite trading at a premium to PPP, USD/CAD has upside. Moreover, the Canadian dollar's A/D line is rolling over, another factor pointing to upside for USD/CAD (Chart I-20). At this point, the biggest risk to our view is oil. If WTI can breakout above $52 - perhaps in response to an as-yet negotiated OPEC/Russia oil-production cut or freeze - this could mitigate the downside for the CAD. Thus, while we like USD/CAD, we think the CAD has upside against the AUD and the NZD, especially as the loonie is less sensitive to the USD and EM spreads than the two antipodean currencies. Chart I-19Canada Is Losing Competitiveness Relative Pressures And Monetary Divergences Relative Pressures And Monetary Divergences Chart I-20Falling CAD A/D Line Falling CAD A/D Line Falling CAD A/D Line Bottom Line: The Canadian economy is showing surprising signs of underlying weakness. With the CAD having recently been more correlated to rate differentials than to oil, USD/CAD could rally on monetary divergences. That being said, on the back of a strong USD, CAD is likely to outperform the AUD and NZD. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Emerging Markets Strategy Weekly Report, "Central European Strategy: Two Currency Trades", dated September 28, 2016, available at ems.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_21_s2_c1 bca.fes_wr_2016_10_21_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_21_s2_c2 bca.fes_wr_2016_10_21_s2_c2 Policy Commentary: "The risks have changed in terms of overshooting what I think is full employment with implications for potential imbalances...Those imbalances might result in a reaction by the Fed that we end up having to tighten more quickly than I would like" - FOMC Voting Member Eric Rosengren (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_21_s2_c3 bca.fes_wr_2016_10_21_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_21_s2_c4 bca.fes_wr_2016_10_21_s2_c4 Policy Commentary: "An abrupt ending to bond purchases, I think, is unlikely...We remain committed to preserving a very substantial degree of monetary accommodation" - ECB President Mario Draghi (October 20, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_21_s2_c5 bca.fes_wr_2016_10_21_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_21_s2_c6 bca.fes_wr_2016_10_21_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_21_s2_c7 bca.fes_wr_2016_10_21_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_21_s2_c8 bca.fes_wr_2016_10_21_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_21_s2_c9 bca.fes_wr_2016_10_21_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_21_s2_c10 bca.fes_wr_2016_10_21_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_21_s2_c11 bca.fes_wr_2016_10_21_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_21_s2_c12 bca.fes_wr_2016_10_21_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_21_s2_c13 bca.fes_wr_2016_10_21_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_21_s2_c14 bca.fes_wr_2016_10_21_s2_c14 Policy Commentary: "Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_21_s2_c15 bca.fes_wr_2016_10_21_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_21_s2_c16 bca.fes_wr_2016_10_21_s2_c16 Policy Commentary: "[On the effects of low interest rates on the housing market]...If you look at the recent past, the dynamics have been a bit more reassuring...[still]let's not forget, this disequilibrium that we have achieved remains very high" - SNB Vice-President Fritz Zurbruegg (October 12, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_21_s2_c17 bca.fes_wr_2016_10_21_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_21_s2_c18 bca.fes_wr_2016_10_21_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_21_s2_c19 bca.fes_wr_2016_10_21_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_21_s2_c20 bca.fes_wr_2016_10_21_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 27, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Recent U.S. economic data have surprised to the upside, raising the odds of a December rate hike. U.S. GDP growth is likely to accelerate further in 2017 on the back of stronger business capex, a turn in the inventory cycle, and a pickup in government spending. Faster wage growth should also support consumption. The real broad trade-weighted dollar will appreciate by 10% over the next 12 months, as the market prices in more Fed tightening. The stronger dollar will pose a headache for U.S. multinationals, as well as emerging markets and commodity producers. However, it will be a boon for Europe and Japan. Global equities are vulnerable to a near-term correction, but the longer-term outlook for developed market stocks outside the U.S. looks reasonably good. Investors should overweight euro area and Japanese equities in currency-hedged terms. Feature Why The Fed Hit The Pause Button When the FOMC decided to hike rates last December, it signaled to investors via its "dot plot" that rates would likely rise four times this year. Ten months later, the fed funds rate remains unchanged. What caused the Fed to stand down? External factors certainly played a role: Fears of a hard landing in China permeated the markets at the start of the year. And just as these worries were beginning to recede, the Brexit vote sent investors into a hurried panic. However, the more important reason for the Fed's decision to hit the pause button is that U.S. domestic activity slowed sharply, with real GDP growing by just 0.9% in Q4 of 2015 and by an average of 1.1% in the first half of 2016. Rays Of Light Fortunately, recent data suggest that the growth drought may be ending (Chart 1): Chart 1Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data Some Bright Spots In the U.S. Data The ISM non-manufacturing index jumped 5.7 points in September, the largest monthly increase on record. The ISM manufacturing index also surprised to the upside, with the new orders index jumping six points to 55.1. Factory orders increased by 0.2% in August, against consensus expectations for a modest decline. Initial unemployment claims continue to decline, with the four-week average falling to a 42-year low this week. The Conference's Board's consumer confidence index hit a nine-year high in September. The University of Michigan's index also rose. The key question for investors is whether the recent spate of good data is just noise or the start of a more lasting improvement in underlying demand growth. We think it's the latter. As we expand upon below, the adverse lagged effects on growth from the dollar's appreciation between mid-2014 and early this year should dissipate, pushing aggregate demand higher. Energy sector capex appears to be stabilizing after plunging nearly 70% since its peak in 2014. Stronger wage growth should also keep consumption demand elevated, even as employment growth continues to decelerate. In addition, fiscal policy is likely to loosen somewhat regardless of who wins the presidential election. Lastly, the inventory cycle appears to be turning, following five straight quarters in which falling inventory investment subtracted from growth. To what extent will better U.S. growth translate into a stronger dollar? To answer this question, we proceed in three steps: First, we estimate the magnitude by which U.S. growth will exceed its trend rate if the Fed takes no action to tighten financial conditions. Our answer is "by around one percentage point in 2017," which we think is considerably above market expectations. Second, we assess the degree to which the Fed will need to tighten financial conditions - via higher interest rates and a stronger dollar - in order to keep inflation from significantly overshooting its target. Third, we consider how developments abroad will affect the dollar. Our conclusion is that the real trade-weighted dollar will likely rise by around 10% over the next 12 months. How Quickly Will Aggregate Demand Grow If The Fed Does Not Raise Rates? As detailed below, a bottom-up analysis of the various components of GDP suggests that real GDP growth could reach 2.5% in the second half of 2016 and accelerate to 2.8% in 2017 if financial conditions remain unchanged from current levels. This would represent a significant step up in growth from the average pace of 1.6% experienced between Q1 of 2015 and Q2 of 2016. While growth of 2.8% next year might sound implausibly high, keep in mind that real final sales to private domestic purchasers - the cleanest measure of underlying private-sector demand - has grown by an average of 3% since Q3 of 2014 and increased by 3.2% in Q2 of this year, the last quarter for which data is available. Consumption Assuming that interest rates and the dollar remain unchanged, we project that real personal consumption will grow by an average of 2.7% in Q4 of this year and over the course of 2017. This is equivalent to the average growth rate of real PCE between Q1 of 2015 and Q2 of 2016, but below the 3% pace recorded in the first half of this year. Granted, employment growth is likely to slow over the coming quarters, as labor market slack is absorbed. Nevertheless, real income growth should remain reasonably robust, as real wages accelerate in response to a tighter labor market. A rough rule of thumb is that a 1% increase in real wage growth boosts real household income by the equivalent of 120,000 extra jobs per month over one full year. Thus, it would not take much of a pickup in wage growth to ensure that consumption keeps rising at a fairly solid pace. In fact, one could see a virtuous circle emerging, where accelerating wage growth pushes up consumption, leading to a tighter labor market, and even faster wage growth. At some point the Fed would raise rates by enough to cool the economy, but not before the dollar had moved sharply higher. This may explain why there is such a strikingly strong correlation between the dollar and labor's share of national income (Chart 2). Households may also end up spending a bit more of their incomes. Faster wage growth, rising consumer confidence, continued home price appreciation, and negative real deposit rates have all given households even more incentive to spend freely. While we do not expect the savings rate to fall anywhere close to the rock-bottom levels seen before the financial crisis, even a 0.5 percentage point decline from the current level of 5.7%, spread out over six quarters, would add 0.4% to GDP growth. Residential Investment Real residential investment dropped 7.7% in Q2 after growing by an average of nearly 12% over the preceding six quarters. The Q2 dip was mainly due to the warm winter, which pulled forward home-improvement spending. Housing activity has recovered since then, with new home sales, single-family housing starts, and the NAHB homebuilders index all at or near post-crisis highs (Chart 3). Chart 2The Dollar Is Redistributing Income bca.gis_wr_2016_10_14_c2 bca.gis_wr_2016_10_14_c2 Chart 3U.S. Housing Remains Robust U.S. Housing Remains Robust U.S. Housing Remains Robust The underpinnings for housing continue to look good. The ratio of household debt-to-GDP has declined nearly 20 points from its 2008 high - the lowest figure since 2003 - while the debt- service ratio is back to where it was in the early 1980s (Chart 4). Excess inventories have also been absorbed. The homeowner vacancy rate has fallen to 1.7%, completely reversing the spike experienced during the Great Recession (Chart 5). With household formation picking up and housing starts still 20%-to-25% below most estimates of how much construction is necessary to keep up with population growth, it is likely that housing activity can increase at a reasonably brisk pace over the next two years. We assume that real residential investment will expand by 4% in both Q4 and 2017. Chart 4Household Debt Burdens Have Declined bca.gis_wr_2016_10_14_c4 bca.gis_wr_2016_10_14_c4 Chart 5The Excess Supply In Housing Has Cleared bca.gis_wr_2016_10_14_c5 bca.gis_wr_2016_10_14_c5 Business Capex Growth in business capital spending has been falling since mid-2014 and turned negative on a year-over-year basis in the first quarter of this year. Initially, the deceleration in capital spending was largely confined to the energy sector. Since late last year, however, non-energy capex has also weakened sharply (Chart 6). Chart 6Easing In Energy Sector Retrenchment Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen The recent slowdown in business capex reflects three factors. First, the disaggregated data on corporate investment spending indicate that lower energy prices generated a second-round effect on businesses that are not officially classified as being part of the energy space, but that are nonetheless major suppliers to the sector. Second, the stronger dollar hurt the manufacturing sector more broadly, leading to a lagged decline in capital spending. Third, the backup in corporate borrowing spreads that began in May 2014 and the associated tightening in bank lending standards put further downward pressure on business capex. All three of these headwinds have waned over the past few months (Chart 7). The oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. The dollar and corporate credit spreads have also come down, while loan growth remains robust (Chart 8). Reflecting these developments, core capital goods orders have risen for the past three months. Corporate capex intentions have also perked up (Chart 9). We project that real business capex will increase by 2.5% in Q4 and 3.5% in 2017 if the dollar and interest rates remain unchanged. Chart 7Borrowing Costs Have Fallen bca.gis_wr_2016_10_14_c7 bca.gis_wr_2016_10_14_c7 Chart 8Solid Loan Growth bca.gis_wr_2016_10_14_c8 bca.gis_wr_2016_10_14_c8 Chart 9Recent Signs Of Improving Corporate Capex Spending Intentions bca.gis_wr_2016_10_14_c9 bca.gis_wr_2016_10_14_c9 Inventories Lower inventory investment shaved 1.2 percentage points off Q2 growth. This marked the fifth consecutive quarter that inventories have been a drag on growth - the first time this has happened since 1956. Real inventory levels fell by $9.5 billion at a seasonally-adjusted annualized pace in the second quarter and are likely to be flat-to-slightly down again in Q3. However, since it is the change in inventory investment that affects growth, this should translate into a modestly positive contribution to Q3 GDP growth. Looking further out, firms are likely to start slowly rebuilding inventories as we head into 2017. The economy wide inventory-to-sales ratio is now back near its trend level (Chart 10). Durable goods inventories excluding the volatile aircraft component rose in the third quarter, as did the inventory component of the ISM manufacturing index (Chart 11). We expect inventory restocking to boost growth by 0.1 percentage points in Q4 and 2017, a big improvement over the drag of -0.6 percentage points between Q2 of 2015 and Q2 of 2016. Chart 10Room To Stock Up Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 11Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Inventory Rebuilding Has Commenced Government Spending Real government consumption and investment declined by 1.7% in Q2 on the back of lower state and local spending and continued weakness in defense expenditures. The drop at the state and local levels should be reversed, given that tax revenues are trending higher. Federal government spending should also pick up regardless of who wins the presidency. There is now bipartisan support for removing the sequester and increasing infrastructure spending. We are penciling in growth in real government expenditures of 1.5% in Q4 and 2.5% in 2017. Net Exports Net exports shaved 0.8 percentage points off growth in the five quarters spanning Q4 of 2014 to Q4 of 2015. Net exports made a slight positive contribution to growth in the first half of this year. Unfortunately, this was mainly a consequence of sluggish import growth against a backdrop of decelerating domestic demand. Looking out, assuming no change in the dollar index, a rebound in import demand will lead to a modest widening in the trade deficit, which will translate into a 0.2 percentage-point drag from net exports over the remainder of this year and 2017. Putting It All Together The analysis above suggests that the U.S. economy will grow by around 2.5% in Q4 - close to the pace that Q3 growth is currently tracking at - with growth accelerating to 2.8% in 2017. This is a point above the Fed's estimate of long-term real potential GDP growth based on the latest Summary of Economic Projections. How Will The Fed React To Faster Growth? We tend to agree with most FOMC officials who think that the economy is now close to full employment. We also concur that the relationship between inflation and spare capacity is not linear. When spare capacity is high, even large declines in unemployment have little effect on inflation. In contrast, when the labor market becomes quite tight, modest declines in the unemployment rate can cause inflation to rise appreciably. As Chart 12 illustrates, the existence of such a "kinked" Phillips Curve is consistent with the data. Where this publication's view differs with the Fed's is over the question of how much of an inflation overshoot should be tolerated. Considering that the Fed has undershot its inflation target by a cumulative 4% since 2009, a strong case can be made that it should aim for a sizable overshoot in order to bring the price level back to its pre-crisis trend. Most FOMC members do not see it that way, however. This point was reinforced by Chair Yellen at her September press conference when she said that "We don't want the economy to overheat and significantly overshoot our 2 percent inflation objective."1 Chart 13 shows that many measures of core inflation are already above 2%. This suggests that the Fed is unlikely to stand pat if aggregate demand growth looks set to accelerate to nearly 3% next year, as our analysis suggests it will. Chart 12The Phillips Curve Appears To Be Non-Linear Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen Chart 13Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% Some Measures Of U.S. Core Inflation Are Already Above 2% How high will rates go? This is a tricky question to answer because it requires us to know the value of the so-called neutral rate - the short-term interest rate consistent with full employment. Complicating the matter is the fact that changes in interest rate expectations will affect the value of the dollar, and that changes in the value of the greenback, in turn, will affect the level of the neutral rate. This is because a stronger dollar means a larger trade deficit, which necessitates a lower interest rate to keep the economy at full employment. It is a "joint estimation" problem, as economists call it. One key point to keep in mind is that currencies tend to be more sensitive to changes in interest rate differentials when those differentials are expected to persist for a long time. Chart 14 makes this point using a visual example.2 The implication is that most of the tightening in financial conditions that the Fed will need to engineer is likely to occur through a stronger dollar rather than through higher interest rate expectations. Chart 14The Longer The Interest Rate Gap Persists, The Bigger The Exchange Rate Overshoot Better U.S. Economic Data Will Cause The Dollar To Strengthen Better U.S. Economic Data Will Cause The Dollar To Strengthen A back-of-the-envelope calculation suggests that the level of aggregate demand would exceed the economy's supply-side potential by 2% of GDP by end-2019 in the absence of any effort by the Fed to tighten financial conditions.3 We estimate that in order to keep the output gap at zero, the real trade-weighted dollar would need to appreciate by 10% and the fed funds rate would need to rise to 2% in nominal terms, or 0% in real terms. Despite this month's rally, the real broad trade-weighted dollar is still down more than 2% from its January high. Thus, a 10% appreciation would leave the dollar index less than 8% above where it was earlier this year, and well below past peaks (Chart 15). Chart 15Still Far From Past Peaks Still Far From Past Peaks Still Far From Past Peaks In terms of timing, a reasonable baseline is that the Fed will raise rates in December and twice more in 2017. This would represent a more rapid pace of rate hikes than what is currently discounted by markets, but would only be roughly half as fast as in past tightening cycles. How quickly the dollar strengthens will depend on how fast market expectations about the future path of short-term rates adjust. In past episodes such as the "taper tantrum," they have moved quite rapidly. This suggests that the dollar could also rise at a fairly fast clip. The Impact From Abroad Chart 16A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads A Stronger Dollar Could Push Up EM Spreads Exchange rates are nothing more than relative prices. This means that developments abroad have just as much of an effect on currencies as developments at home. Given the size of the U.S. economy, better U.S. growth would likely benefit the rest of the world. Could this impart a tightening bias on other central banks that cancels out some of the upward pressure on the dollar? For the most part, the answer is no. Both the euro area and Japan have more of a problem with deflation than the U.S. The neutral rate is also lower in both economies. This implies that neither the ECB nor the BoJ are likely to raise rates anytime soon. Thus, to the extent that stronger U.S. growth buoys these economies, this will translate into somewhat higher inflation expectations and thus, lower real rates in the euro area and Japan. This is bearish for their currencies. The possibility that the ECB will start tapering asset purchases next March, as many have speculated, would not alter our bullish view on the dollar to any great degree. Granted, if the ECB did take such a step without introducing any offsetting measures to ease monetary policy, this would cause European bond yields to rise, putting upward pressure on the euro. However, anything that strengthens the euro would weaken the dollar, giving the U.S. a competitive boost. This, in turn, would prompt the Fed to raise rates even more than it otherwise would. The final outcome would be that the dollar would still appreciate, although not quite as much as if the ECB kept its asset purchases unchanged. As far as emerging markets are concerned, a hawkish Fed is generally bad news. Tighter U.S. monetary policy will reduce the pool of global liquidity that has pushed down EM borrowing costs (Chart 16). And given that 80% of EM foreign-currency debt is denominated in dollars, a stronger greenback could cause distress among some over-leveraged borrowers. To make matters worse, a stronger dollar has typically hurt commodities - the lifeblood for many emerging economies. All of this is likely to translate into weaker EM currencies, and hence, a stronger dollar. Investment Conclusions Today's market climate is similar to the one around this time last year. Back then, the Fed was also gearing up to hike rates. Initially, stocks held their ground even as bond yields edged higher. But then, shortly after the Fed raised rates, the floodgates opened and the S&P 500 fell 13% within the course of six weeks (Chart 17). We are nearing such a precipice again. And, in contrast to earlier this year when the 10-year Treasury yield fell by 70 basis points, there is less scope for the bond market to generate an easing in financial conditions in response to plunging equity prices. The 10-year Treasury yield stood at 2.30% on December 29, just before the stock market began to sell off. Today it stands at 1.74%. Investors should position for an equity correction that sends the S&P 500 down 10% from current levels. Looking out, if U.S. growth does begin to accelerate, that should provide some support to stocks. Nevertheless, a stronger dollar and faster wage growth will weigh on corporate earnings, while stretched valuation levels will limit any further expansion in P/E multiples (Chart 18). Investors should underweight U.S. stocks relative to their global peers, at least in local-currency terms. Chart 17Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Beware Of A Replay Of The Last Correction Chart 18U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High U.S. P/E Ratios: High, Very High Turning to bonds, while an equity market correction would not cause Treasurys to rally as much as they did in January, the 10-year yield could still touch 1.5% if risk sentiment were to deteriorate. Once the dust settles, however, bond yields will resume their upward grind. Lastly, a stronger dollar will pose a significant headwind for commodities. That said, as we discussed in last week's Fourth Quarter Strategy Outlook, recent cuts to capital spending are likely to generate supply shortages in some corners of the commodity complex.4 BCA's commodity strategists prefer energy over metals and are particularly bullish on U.S. natural gas heading into 2017. Peter Berezin, Senior Vice President peterb@bcaresearch.com 1 Please see "Transcript of Chair Yellen's Press Conference September 21, 2016," Federal Reserve, September 21, 2016. 2 To understand this concept in words, consider two countries: Country A and Country B. Suppose rates in both countries are initially the same, but that Country A's central bank then proceeds to raise rates by one percentage point and pledges to keep them at this higher level for five years. Why would anyone buy Country B's short-term debt given that Country A's debt yields one percent more? The answer is that people would be indifferent between investing in Country A and Country B if they thought Country A's currency would depreciate by 1% per year over the next five years. To generate the expectation of a depreciation, however, Country A's currency would first have to appreciate by 5%. Now modify the example with the only difference being that Country A's central bank pledges to keep rates higher for ten years, rather than five. For interest rate parity to hold, Country A's currency would now have to overshoot its fair value by 10%. The implication is that the longer interest rates in Country A are expected to exceed those in Country B, the more "expensive" Country A's currency must first become. 3 For the purposes of this calculation, we assume that the output gap this year will be -0.5% of GDP and that aggregate demand growth will exceed potential GDP growth by 1% in both 2017 and 2018, with the gap between demand and supply growth falling to 0.5% in 2019 and stabilizing at zero thereafter. The New York Fed's trade model suggests that a 10% appreciation in the dollar would reduce the level of real GDP by a cumulative 1.2 percentage points over a two-year period. A slightly modified Taylor Rule equation implies that an 80 basis-point increase in interest rates on average across the yield curve would reduce the level of real GDP by 0.8 percentage points after several years. We assume that Fed tightening would lead to a flatter yield curve so that short-term rates rise more than long-term yields. 4 Please see Global Investment Strategy Strategy Outlook, "Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

India's agricultural output per capita has not increased at all. Thus, food and headline inflation will remain structurally high, which will negatively impact savings and investment dynamics in the years ahead. With respect to cyclical growth, household spending is very strong, but investment expenditures are stagnant. Fixed-income traders should bet on yield curve steepening in India. A section <i>Brazil's Business Cycle Illustrated</i> highlights the cyclical profile of this economy.

This month's <i>Special Report<i/> looks at the Fed's policy options in the event that there is a negative economic shock while the policy rate is still very depressed. The Fed's "Plan A" is more QE and forward guidance, which are not up to the task. There is no "Plan B", which means that risk assets will be hit hard during the next downturn.

A playable pair trade opportunity has emerged on the back of shifting capital spending patterns: long communications equipment/short machinery.

This week, we are sending a <i>Special Report </i>written by BCA's Chief Global Strategist Peter Berezin, discussing the end of the 35-year global bond bull market.