Developed Countries

The GAA DM Equity Country Allocation model is updated as of January 31, 2017. The model has shifted to an overweight position on Switzerland at the expense of a larger reduction in Sweden. Additionally, the model reduced its underweight position in Japan and France (Table 1). Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the non-U.S. model (Level 2) underperformed its benchmark by 90 bps in January, due to the underweight in Japan. The large overweight in the U.S. caused the Level 1 model to underperform by 14 bps. Overall, the GAA model underperformed its MSCI World benchmark by 36 bps in January. Since Inception, the GAA model underperformed its benchmark by 16 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. Table 2Performance (Total Returns In USD) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2) Chart 4Overall Model Performance GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of January 31, 2017. The momentum component has shifted Energy from overweight to underweight. It has also shifted Info Tech and Consumer Discretionary from underweight to overweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

Highlights The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia; The Trump Doctrine, as currently defined, has no room for transatlantic alliances; President Trump is pursuing both mercantilism and an isolationist foreign policy; This combination imperils the transatlantic alliance and thus the American anchor in Eurasia; If pursued to its logical conclusion, the Trump Doctrine will end American global hegemony. Feature "Who rules East Europe commands the Heartland; Who rules the Heartland commands the World-Island; Who rules the World-Island commands the world." - Sir Halford John Mackinder Geopolitics is parsimonious and predictive because it posits that states are imprisoned by their geography. For academia, geopolitics is too parsimonious. And the professors are correct! Mountainous terrain combined with ethno-linguistic heterogeneity has destined Afghanistan and Bosnia to centuries of conflict, but Switzerland seems to be doing just fine. As such, BCA's Geopolitical Strategy, despite our name, very rarely relies on pure geopolitics for its analysis. The world is just too complex and geopolitics operates on long time horizons that are rarely investment-relevant. Geography is not destiny. Rather, geography is the ultimate constraint, an immutable factor that can only be conquered with a massive effort or new technology that comes but once in a generation. To fight geography is folly, even for a hegemon. The Trump Doctrine, as it has taken shape thus far, looks to be just such a folly. In this analysis, we explain why and what the investment relevance may be for the U.S. and the world. We still think the U.S. is likely to regain power in relative terms, but Trump's "charismatic authority" and foreign policy pose a risk to this view. American Geopolitical Imperatives There are two notable "fathers" of geopolitics: Alfred Thayer Mahan and Sir Halford John Mackinder. They both dedicated their life to elucidating great power "Grand Strategy," the implicit but real geopolitical imperatives, rooted in geography, from which a country derives its day-to-day foreign policy. For Mahan, a U.S. Navy Admiral and lecturer at the Naval War College, the imperative of the U.S. was to build a navy to dominate the oceans, the global "commons" that is indispensable to modern trade, economy, and thus "hard power."1 A strong navy is the defining characteristic of a great power. It affords the hegemon military supremacy over vital trade routes and ensures that global commerce operates in its interest. If this sounds like present-day U.S. "Grand Strategy," it is because Mahan had a great influence on American policymakers in the early twentieth century. Theodore Roosevelt supported Mahan's thinking, which included building the Panama Canal. Mahan's The Influence of Sea Power Upon History, and similar work by British strategists, provided a historical and strategic framework for the naval race between the U.K. and Germany that ultimately contributed to the start of World War I.2 Mackinder, a British geographer and academic, focused on the Eurasian landmass, rather than the oceans.3 In his view - perhaps colored by Britain's history of fending off invaders from the continent - Eurasia had sufficient natural resources (Russia), population (China), wealth (Europe), and a geographic buffer from naval powers (the seas surrounding it) to become self-sufficient. Hence any great power that managed to dominate Eurasia, or "the World Island" as Mackinder coined it, would have no need for a navy as it would become a superpower by default (Map 1). Map 1The World According To Mackinder American Grand Strategy is today a combination of both Mahan's and Mackinder's thinking. The U.S. has had two explicit geopolitical imperatives since the end of World War II: Dominate the world's oceans (Mahan); Prevent any one power from dominating Eurasia (Mackinder). To accomplish the first, the U.S. has expended an extraordinary amount of resources to build and operate the world's greatest blue-water navy. To accomplish the second, the U.S. has entered two world wars, the Korean War, the Vietnam War, and spent a good part of the twentieth century containing the Soviet Union. In addition, Washington has fostered a close transatlantic alliance to ensure that Europe, its anchor in Eurasia, remains aligned with the U.S. These were not arbitrary decisions made by a corrupt, Beltway elite looking to enrich itself with the spoils of globalization. These were decisions made by American leaders looking to expand American power, establish global hegemony, and retain it against rivals for centuries to come. Both imperatives are necessary for the U.S. to remain a hegemon. And U.S. hegemony is the foundation of the global monetary and financial system. Not least, it underpins the role of the U.S. dollar as the world's reserve currency. Bottom Line: The U.S. has two geopolitical imperatives: domination of the world's oceans and ensuring the disunity of Eurasia. The Trump Doctrine: America First, Second, And Third Every U.S. president tries to enshrine a foreign policy "doctrine" during their presidency. There is no single document that does the job of elucidating the doctrine; scholars and journalists weave the ideas together from speeches, policy decisions, resource allocation, and rhetoric. This early in the Trump presidency, it is not fair to determine what his foreign policy doctrine will be. Already, with Trump's executive orders on immigration and refugees, it is clear that there is a process of trial and error underway, with the administration reversing its position on green card holders (U.S. permanent residents). We therefore take liberty in projecting the little information we have forward. Chances that we are wrong are high and our conviction level is low. Nevertheless, we have two broad conclusions. If the Trump Doctrine develops as these early clues suggest, then it will either be rejected by Congress and the American policy establishment, or it will initiate the collapse of the geopolitical and economic institutions of our era, ushering in something profoundly different. We see no alternatives. So what are the early outlines of the Trump Doctrine? We see three factors that stand out: Isolationism: Long-term alliances and commitments abroad must have a clear, immediate, and calculable benefit for the U.S. economic "bottom line." Therefore, Japan and South Korea should pay more for the benefits of U.S. alliance, and NATO is a drain on American resources. All alliances and American commitments are negotiable. Mercantilism: The U.S. has no permanent allies, only trade balances that must be positive. Trump has not only threatened China and Mexico with protectionism, but also longstanding allies like Germany and Japan.4 Any country that sports a significant trade surplus with the U.S. is in Washington's crosshairs (Chart 1). Chart 1Trump's Hit List Sovereignty: Trump said in his inaugural address, "it is the right of all nations to put their own interests first" and that America does "not seek to impose our way of life on anyone." This is a stark departure from ideologically-driven foreign policies of both the Bush and Obama White House. However, there is an ideology underpinning Trump's foreign policy: nationalism. Professor Ted Malloch, tipped as the next U.S. Ambassador to the EU, revealed in a BBC interview that the new U.S. President "is very opposed to supranational organizations, he believes in nation states." This statement makes explicit what many of Trump's speeches have implied. Under the tenets of this inchoate Trump Doctrine, NATO and the EU are not just nuisances, but are positively detrimental to U.S. interests. This marks a profound shift in U.S. foreign policy thinking, if it stands. First, both NATO and the EU break the ideological tenet of nationalism. They are international organizations that pool sovereignty for some predetermined common goal. Given that the common goal has nothing to do with the immediate, domestic and economic goals of the U.S., the two organizations are not worth supporting, under this interpretation of the emerging Trump Doctrine. Second, NATO demands a U.S. overseas commitment with little material gain in return. This is not a new argument. President Obama complained about the failure of NATO member states to pay their fair share (2% of GDP on defense) for collective self-defense (Chart 2). However, Obama's intention was to cajole European allies to boost defense spending; NATO's existence was not in question. Trump does not see a point in America paying for Germany's defense, especially when Germany sports a sizeable trade surplus with the U.S. Chart 2NATO States That Need To 'Pay Up' Third, the EU runs a large current account surplus in general and a trade surplus with the U.S. in particular (Chart 3). For the Trump administration, the EU is therefore a rival, perhaps more so even than Russia, which, when viewed through a purely mercantilist lens, is not a foe. Trump's foreign policy is based on an understanding that the world is multipolar and that the U.S. is in relative geopolitical decline. Our data supports President Trump's assertion (Chart 4). In that way, Trump's doctrine is similar to that of the Obama presidency. Both recognize that the U.S. can no longer act unilaterally and that it must retrench from its global responsibilities. But while Obama sought to enhance U.S. power by relying on allies and supranational organizations, Trump seeks to withdraw into Fortress America and geopolitically deleverage. Such a deleveraging, when combined with mercantilism, may cause America's traditional allies to try harder for its approval, like Trump assumes, or it may push America's traditional allies away from Washington's orbit. Chart 3Mercantilism Makes The EU A 'Bad Guy' Chart 4American Power In Relative Decline Bottom Line: President Trump believes in a "what can you do for me" world.5 This world has no room for twentieth-century alliances, which did not anticipate the disenchantment and polarization of the American public (or the benefit of Trump's wisdom!) in their original design. Transatlantic Drift The most important feature of the Trump Doctrine is that it seeks to replace transatlantic links between the U.S. and Europe with bilateral, ad-hoc alliances. The one such alliance that has received much media attention is the thaw between the U.S. and Russia. To be clear here, we are very much aware that many U.S. presidents have had deep disagreements with Europe and that every president since Reagan has tried to thaw relations with Russia early in his presidency. However, Trump is different in that he is the first U.S. president to: Openly question the very existence of NATO; Openly oppose European integration;6 Openly engage in mercantilist trade policies towards allies while simultaneously undermining geopolitical alliances with them. The problem with this course of action is that other countries will pursue alternative economic and security relationships to hedge against America's perceived lack of commitment, or outright hostility. Japan and South Korea, for example, concerned that they may face tariffs and a drop in U.S. military support, will need to turn more friendly toward China to avoid conflict and access new consumer markets. The same goes for Europe, with Germany and others eager to substitute for the U.S. by selling more to China amid U.S.-China trade conflicts.7 Thus, if we are to take the Trump Doctrine to its conclusion, we end up with an American foreign policy that pushes Eurasia towards the kind of integration - if not exactly alliance - that Mackinder feared. Since greater Eurasian coordination could eventually develop into a dynamic of its own, this process directly contravenes the second tenet of American grand strategy: Prevent any one power from dominating Eurasia. But wait, Trump supporters will cry, Trump is going to throw a wrench in Eurasian coordination by allying with Russia! No, he won't. Russia and America will not be allies. At best, they will be friends with benefits. The two countries have no shared economic interests. Russia sees both Europe and China as its economic partners. The former for supply of badly needed technology and investment (Chart 5), the latter as an energy market and another source of investment (Chart 6).8 Chart 5Russia Needs European Technology ... Chart 6... And Chinese Energy Demand Russian policymakers may be cheering Trump for the moment, but that is only because he brings relief from the extremely anti-Kremlin policies of the Obama (and potentially Hillary Clinton) presidency. The Kremlin will take advantage of the change in the White House. Bear in mind, all that Russian policymakers know of the U.S. in recent memory is conflict and realpolitik: It was the U.S. that pushed for NATO to expand into Ukraine and Georgia. Chancellor Angela Merkel, in fact, vetoed those plans at the 2008 NATO Summit; It was the Bush Administration that pushed for Kosovo's independence in 2008; Both the Bush and Obama administrations sought to construct a ballistic missile defense shield on Russia's doorstop in Central and Eastern Europe. If Trump stumbles in the next four years, who is to say that Moscow won't have to deal with an antagonistic Washington by the end of 2020? Trump's olive branches will not alter Russian thinking about the country's long-term interests. Russian President Vladimir Putin is going to do what is good for Russia, no matter how much he may think that Trump is a great guy to party with. And what is good for Russia is deeper economic integration with China and Europe. In fact, with the U.S. becoming an energy producer - and potentially a significant LNG exporter soon - America may become Russia's competitor for Europe's natural gas demand. Trump, his supporters and advisors, may believe that the twentieth century is over and that post-WWII American alliances have atrophied. They have! Russia is not the Soviet Union. It is no surprise that NATO is having an identity crisis when it no longer has a peer enemy to defend against. But geography has not changed. The U.S. is still far from Eurasia and Eurasia is still the "World Island." The Trump Doctrine ignores the entire twentieth century during which the U.S. had to intervene in Europe twice, and Asia three times, at a huge cost of blood and treasure, due to the threat of the continent unifying under a single hegemon. The international organizations that the U.S. set up after the Second World War, including NATO and the EU but also the UN, IMF, and others, were created to ensure that the U.S. did not have to intervene in Europe again. The security alliance and commercial system in Asia Pacific served a similar purpose. Bottom Line: Trans-oceanic alliances and organizations are not vestiges of a past that has changed, but vestiges of a geography that is immutable. The Trump Doctrine, such as it is, threatens to undermine an imperative of American hegemony. If pursued to its professed conclusion, it will therefore end American hegemony. Eurasian Alliance How can Europe, Russia, and China overcome their vast differences and unite in an anti-American alliance? It is not easy, but nor is it impossible. Russian point of view: The U.S. remains Russia's chief strategic threat. Sino-Russian distrust and tensions are overstated, as we discussed in a 2014 Special Report.9 Russia depends on China and Germany for 32% of its imports and 17% of its exports (Chart 7). It is deeply integrated with both economies. The U.S., meanwhile is about as relevant for the Russian economy as Poland in terms of imports and as Belarus in terms of exports. China's point of view: The U.S. is also China's chief strategic threat - and probably the only thing standing between China and regional hegemony over the course of this century. For China, integrating with the denizens of Eurasia makes a lot of sense. First, it would allow China to avoid the folly of competing with the U.S. in direct naval and maritime conflict. Overland transportation routes - which Beijing seeks to develop via its ambitious "The Silk Road Economic Belt" project - will bypass China's contentious and cramped South and East China Seas. Second, Europe has everything China needs from the U.S. (technology, aircraft, IT), and could offer them at discount rates due to a weak euro and general economic malaise (entire continent is for sale, at a discount!). Third, neither Europe nor Russia care what China does with its neighborhood in East Asia. If China wants to take some shoal from the Philippines, Berlin and Moscow will be okay with that. Europe's point of view: The European Union has never spent much time thinking seriously about the U.S. as a threat to its existence. The possibility, at very least, will promote efforts at economic substitution. Europe and Russia must overcome their differences over Ukraine in order to cooperate again. However, as we pointed out above, it was not Europe that sought to integrate Ukraine and Georgia into NATO, it was the United States. Europe needs Russian energy and Russia needs Europe's technology and investment. As long as they delineate where each sphere of influence begins and ends, which they have done before (in 1917 and 1939 if anyone is still counting!) they will be fine. Finally, trade with emerging markets is already more important for the EU than with the U.S. (Chart 8). And China remains a major potential growth market for EU products. Chart 7U.S. No Substitute For Russian Partners Chart 8Europe Relies On EM More Than U.S. We do not think that a formal EU-Russia-China axis is around the corner, or even likely. However, if the U.S. should pursue a policy of undermining its transatlantic and transpacific alliances, cheerleading the dissolution of the EU, and treating foes and allies equally when it comes to trade protectionism, the probability that it faces a united front from Eurasia increases. We are not sure that the Trump Administration understands this, or even cares. From what we can tell right now, the Trump White House is singularly focused on trade and commercial matters. It is mercantilist, pure and simple. But geopolitics is not a single dimension. It is like a game of three-dimensional chess. Foreign policy and security are on the top chess board, trade and economic matters are in the middle, and domestic politics are played on the bottom board. When the Trump administration threatens the "One China" policy or encourages EU dissolution because the bloc has "overshot its mark," it corners its counterparts on the geopolitical and political chess boards for the sake of trade and commercial interests. This is a mistake. Europe and China will give up chess pieces on the economic board to preserve their position on the geopolitical and political boards. In other words, Trump's strategy of tough-nosed negotiations - which he learned in the global real estate sector - will only strengthen opposition against the U.S. in the real world. We don't think that Trump is playing three-dimensional chess. He is singularly focused on America's economy and commercial interests and his own domestic political coalition. This is unique in post-World War Two American foreign policy. Ronald Reagan, who cajoled Japan and West Germany into the 1985 Plaza Accord, did so because both Berlin and Tokyo understood they owed their security to America. If Reagan threatened to withdraw America's security commitment to either, he would not have gotten the economic deal he wanted. Bottom Line: If pursued to its logical conclusion, the Trump Doctrine will end U.S. hegemony. Trump's foreign policy has raised a specter, however faint at present, which has not been seen since the Molotov-Ribbentrop Pact between Russia and Germany in 1939: a united Eurasian continent marshalling all its human, natural, and technological resources against the U.S. The last time that happened, 549,865 U.S. lives were needed to preserve American hegemony, not to mention the global cost in blood and treasure. Investment Implications In our 2017 Strategic Outlook we posited that investors should get used to the revival of charismatic authority.10 We borrow the concept from German sociologist Max Weber, who identified it in his seminal essay, "The Three Types of Legitimate Rule."11 Weber argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office. Today, we are seeing the revival of charismatic authority, which Weber defined as flowing from the extraordinary characteristics of an individual. Such leaders are difficult to predict as they often rise to power precisely because of their opposition to the institutions and laws that define the legal-rational authority. The Trump Doctrine is one example of how charismatic authority can lead to uncertainty. Twentieth century institutions may be flawed, but they have underpinned and continue to underpin American hegemony. The U.S. cannot, at the same time, maintain global hegemony, pursue mercantilist commercial policy, and seek to undermine its global alliances. The Trump White House threatens to push allies and foes, pursuing their own interests, to work in concert to isolate the United States. Perhaps President Trump and his advisors are comforted by the fact that the U.S. has always profited from global chaos. The U.S. benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 9). This is why Trump's election led us to believe that global multipolarity would peak in the coming year and set the stage for an American revival.12 Chart 9The U.S. Benefits From Global Chaos However, to maintain primacy while sowing global discord, the U.S. needs more than just Anglo-Saxon allies in the world. It needs an anchor in Eurasia, which is and always will be Europe. Without an anchor, Trump's policies will not sow discord, they will create concord, and unite the "World Island" against America. That is why it is important to see how the Trump Doctrine develops in terms of real policy, as opposed to a year's worth of mostly campaign statements. Already the administration has made some appropriate noises about standing "100% behind NATO" and having an "ironclad commitment" to Japan. But make no mistake, Trump's open doubts have reverberated farther and deeper than these minimal reassurances. It is critical to monitor how the Trump administration approaches NATO, the EU, and bilateral negotiations with key partners. We are already seeing evidence of serious coordination - particularly between Germany and China - that could be a counterweight to U.S. power in the marking. These two outcomes - renewed U.S. hegemony, or U.S. downfall - are essentially binary and it is too soon to know which will prevail. What is the probability of downfall? It is low, but rising. If Trump does not adjust his foreign policy - or, barring that, if the U.S. Congress or American foreign policy, defense, and intelligence establishment do not "correct" Trump's course - then U.S. hegemony will begin to unravel. And with it will go a range of "certainties" underpinning global economic growth and trade, including the U.S. dollar's reserve currency status. If America loses its hegemony, one victim may be the U.S. dollar's role as a safe haven asset. The notion that the greenback is a safe-haven asset even when the chief global risks emanate from the U.S. will be tested. We recommend that long-term investors diversify into other currencies, including the Swiss franc, euro, and, of course, gold. Marko Papic, Senior Vice President marko@bcaresearch.com 1 Alfred Thayer Mahan, The Interest Of America In Sea Power: Present And Future (Boston: Little, Brown and Co., 1918). 2 Mahan, The Influence Of Sea Power Upon History, 1660-1783, 15th ed. (Boston: Little, Brown and Co., 1949). 3 Halford John Mackinder, Democratic Ideals And Reality: A Study In The Politics Of Reconstruction, 15th ed. (Washington, D.C.: National Defense University Press, 1996). 4 Trump has surprised U.S. ally Japan by coupling it with China in some of his statements threatening tariffs. Meanwhile Peter Navarro, chief of the new National Trade Council, has recently accused Germany of currency manipulation and structural trade imbalances. Please see Shawn Donnan, "Trump's top trade adviser accuses Germany of currency exploitation," Financial Times, January 31, 2017 available at www.ft.com. 5 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?" dated January 25, 2017, available at gps.bcaresearch.com. 6 Trump has said that the U.K. was "smart" to leave the EU, and has expressed indifference to the existence of the EU and a belief that "others will leave" following the U.K. Please see "Full Transcript of Interview with Donald Trump," The Times of London, January 16, 2017, available at www.thetimes.co.uk. Also, the aforementioned Professor Malloch, potential U.S. Ambassador to the EU, said in his interview with the BBC that "Trump believes that the European Union has in recent decades been tilted strongly and most favorably towards Germany" and that "the EU has overshot its mark." 7 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 8 Please see Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 9 Please see Geopolitical Strategy Special Report, "The Embrace Of The Dragon And The Bear," dated April 11, 2014, available at gps.bcaresearch.com. 10 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 11 Please see Max Weber, "The Three Types Of legitimate Rule," Berkeley Publications in Society and Institutions 4 (1) (1958): 1-11. Translated by Hans Gerth. Originally published in German in the journal Preussiche Jahrbücher 182, 1-2 (1922). 12 Please see Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com.

Highlights Duration: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth, which is supported by accelerating corporate profits. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Country Allocation: Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporates: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Feature Optimism reigns supreme in the markets at the moment, particularly in the U.S. where bullish investors traded in their "Make America Great Again" hats for "Dow 20,000" ballcaps last week. The string of better-than-expected economic data across the world is continuing - a fact confirmed by the latest corporate profit releases showing that an earnings recovery was already underway before Donald Trump's election victory. We have been looking for a meaningful pullback in government bond yields, and a widening of credit spreads, before returning to a below-benchmark portfolio duration stance and raising corporate allocations. That opportunity may not come to pass as economic data remains solid and leading indicators are accelerating. With no major inflation hiccups likely in the near-term to force the major central banks to rapidly shift to a more hawkish stance, and with equity markets remaining supported by accelerating earnings growth, the current "sweet spot" for risk can continue. Return expectations must be tempered, though, as much of the recent growth improvements is already reflected in bond and equity valuations. Any sign that the optimism shown in confidence surveys is not translating into improving hard economic data could trigger an equity market correction and a risk-off move to lower government bond yields and wider credit spreads. Given our view that global growth will be faster than consensus expectations in 2017, however, we think that a pro-risk overshoot phase is more likely than a risk-off correction in the near term. Any upset in equity markets would represent a medium-term opportunity to increase credit risk and reduce duration. This week, we are adapting a more pro-growth, pro-risk stance in our recommended portfolio allocations this week, making the following changes: Reduce overall portfolio duration to below-benchmark Reduce U.S. Treasury exposure to below-benchmark (2 of 5) Upgrade U.S. Investment Grade corporate exposure to above-benchmark (4 of 5) Upgrade U.S. High-Yield corporate exposure to neutral (3 of 5), favoring B- & Ba-rated names Importantly, we are maintaining our current allocations to Euro Area corporates (above-benchmark) and Emerging Market sovereign and corporate debt (neutral for both), given that we see more potential for upside surprises in the U.S. economy relative to the rest of the world. Duration: Re-Establish A Cyclical Below-Benchmark Stance We moved to a neutral stance on our overall duration recommendation back on December 6th, which we viewed as a tactical profit-taking exercise on our previous successful bearish bond call dating back to last July.1 Our view at the time was that global bonds were still in a cyclical bear phase, led by rising inflation expectations and better economic growth prospects in the developed world (especially in the U.S.). Given the extreme bearish positioning in government bond markets, at a time of oversold momentum, our stated plan of attack was to look to move back to a below-benchmark stance after a meaningful pullback in yields. The likely trigger for that move was expected to be some disappointment on actual economic data, especially given the heightened growth expectations in the U.S. after Trump's electoral victory. Global economic data continues to trend in a positive direction, however, which is preventing any pullback in bond yields despite a deeply oversold market (Chart of the Week). The Citigroup Data Surprise index for the major developed economies is at the highest levels since early 2014. The Global ZEW indicator, one of our favorites, is at the highest level since mid-2015. The global leading economic indicator from the OECD is back to levels last seen in 2013, suggesting that the positive growth momentum can continue to put upward pressure on real bond yields. There are few signs of disappointment at the country level, with the Purchasing Managers Indices for all major developed markets, as well as for China, all pointing to expanding global activity (Chart 2). Chart of the WeekYields Supported By Faster Growth Chart 2A Broad Based Upturn It will be interesting to see if this uptrend can withstand the "bull in the China shop" approach of the new Trump administration with regards to U.S. trade policy. Already, in just the first week of his presidency, Trump has aggressively pushed to implement much of his protectionist campaign promises, like pulling out of the Trans-Pacific Partnership, pushing to renegotiate the North American Free Trade Agreement and threatening the imposition of tariffs or border taxes in an effort to reduce the U.S. trade deficit. Global confidence surveys will be critical to monitor in the next month or two for any sign that Trump uncertainty is having a detrimental effect on business optimism outside the U.S. Importantly, the starting point is strong, with both consumer and business confidence measures in Europe and China rising steadily, as are net earnings revisions for global equities (Chart 3). A combination of improving economic sentiment, confirmed by stronger corporate profits, may be enough for the global economy to withstand the shifting plate tectonics of U.S. economic policy. In the U.S. itself, the GDP report released last week showed that 2016 ended on a soft note, with annualized growth of only 1.9% in the 4th quarter. However, a sector-by-sector forecast for U.S. GDP presented last month by our colleagues at BCA U.S. Bond Strategy shows that there is upside risk for most major elements of the U.S. economy (Chart 4).2 Rising consumer confidence amid a tight labor market should help boost consumption, while the large drag from inventory destocking seen last year will not be repeated in 2017. Chart 3An Improving Corporate Profit Backdrop Chart 4Upside Risks For U.S. Growth The wild cards for U.S. growth will come from all the sectors most impacted by potential policies from the Trump administration: business investment, government spending and net exports. Trump has been going full steam ahead with his protectionist leanings in his initial days in office, but how much he can quickly implement remains to be seen. For now, the U.S. dollar is not rising rapidly enough to generate much of a drag on U.S. GDP growth, unlike the 2014/15 surge in the greenback (see the bottom panel of Chart 4). More importantly, the improving trend in U.S. corporate profit growth and post-election surge in business confidence should support faster growth in U.S. capital spending, which is already showing signs of perking up a bit (Chart 5). As we discussed in a Weekly Report earlier this month, the bigger upside surprise for the U.S. economy this year will come from capital spending, not government spending, as Trump will have a much easier time passing pro-growth corporate tax cuts than getting his infrastructure spending program green-lighted quickly through the U.S. Congress.3 U.S. growth will be much faster than the Fed's current forecast of 2.1%, which will embolden the Fed to deliver on additional rate hikes later this year. The Fed will likely want to see some sign of clarity on the fiscal policy outlook before contemplating the next rate hike, and we are not expecting a rapid acceleration of U.S. inflation in the next few months that would force to Fed to act more quickly. The next rate hike will come at the June FOMC meeting, with the Fed delivering at least the 50bps of rate hikes by year-end currently discounted in the market, and possibly the full 75bps of hikes shown in the latest FOMC projections if the economy delivers faster growth in 2017, as we expect. When looking at the other major bond yields in the "Big-4" developed markets, all elements of valuation have repriced higher (Chart 6): Chart 5U.S. Corporate Profits & Confidence Are Stronger, Capex Is Next Chart 6All Yield Components Are Rising Central bank policy rate expectations have shifted away from cuts in the Euro Area, Japan and the U.K., with a small hike from the Bank of England now discounted in the U.K. Overnight Index Swap (OIS) curve; Term premiums have risen from the mid-2016 lows, but remain negative in the countries where central banks are still actively engaging in asset purchase programs; Inflation expectations are well off the 2016 lows in all markets, but with higher levels in the U.K. and U.S. We see much higher upside risks for growth and inflation, and tighter monetary policy, in the U.S. and U.K. than the Euro Area or Japan. To reflect this in our model portfolio, we are downgrading our U.S. country allocation to below-benchmark (2 of 5) this week, while maintaining our underweight in the U.K. (also 2 of 5). We are keeping the Euro Area at above-benchmark (4 of 5) and Japan at benchmark (3 of 5). Government bond yield curves should see mild steepening pressure from rising inflation expectations before central banks are forced to turn more hawkish. We are focusing our decision to reduce overall portfolio duration more at the longer end of yield curves, especially in the U.S. and U.K. (Chart 7). A large headwind to any significant move higher in bond yields remains investor positioning, with only the "active client" portion of the JP Morgan duration survey showing a flip back to a net long duration stance in recent weeks (Chart 8). A full unwind of the large short positions in government bond markets is unlikely in the absence of much weaker economic data or a big correction in equity markets. The latter is impossible to time, but nothing that we are seeing in the forward-looking data is pointing to an imminent slowing of economic growth. Thus, we are choosing to shift back to our desired strategic below-benchmark duration stance this week. Chart 7Rising Inflation = Steeper Yield Curves Chart 8Large Short Positions Still An Issue Bottom Line: Rising political tensions in the U.S. will not offset the cyclical upward momentum in global growth and inflation. Bond yields are unlikely to fall much in the near term, despite significant bearish investor duration positioning. Shift back to a below-benchmark overall portfolio duration stance and position for bear-steepening of yield curves. Downgrade U.S. Treasuries to underweight (2 of 5) in global hedged bond portfolios. Corporate Bonds: A Cyclical Upgrade In The U.S., Despite Tight Valuations Global corporate debt has enjoyed solid relative performance versus government bonds over the past several months, driven by the improvements in economic growth and earnings. Credit spreads have narrowed in response, for both Investment Grade and High-Yield. In the Euro Area, the U.K. and Japan, central bank asset purchases of corporate bonds have also helped to keep spreads tight and help support the overall positive backdrop for credit markets. High levels of corporate leverage remain an issue, especially in the U.S., but an improving profit backdrop and faster nominal GDP growth will help paper over problems associated with high company debt. In the U.S., the items in our "Corporate Checklist" are providing a generally positive signal (Chart 9): Our Corporate Health Monitor (CHM) is starting to signal a slight improvement in corporate credit metrics after several years of deterioration; Bank lending standards are no longer tightening, according to the Fed's Senior Loan Officer Survey, after a brief period of more stringent standards in 2015 & 2016; Bank equities are outperforming the overall market, which in the past has been a positive signal for credit availability and corporate debt performance; Monetary conditions are still only just neutral, even with the U.S. dollar at very expensive levels. The monetary backdrop could become a concern later on in the year if Fed rate hikes lead to another period of rapid U.S. dollar appreciation. Until then, the more positive backdrop for profits will continue to boost balance sheet health, resulting in reduced equilibrium risk premiums (i.e. spreads) on corporate bonds. Already, U.S. corporate debt has priced in the better news (Chart 10). In High-Yield, the massive rally in energy-related names after the recovery in oil prices last year (top panel) has driven the spread on the Energy sub-component of the Barclays Bloomberg benchmark index back to levels last seen when oil was at $100/bbl ... even though the price of oil is still in the low $50s! Meanwhile, junk spreads ex-energy now reflect the benign macro volatility environment, as proxied by the VIX index (middle panel). Chart 9A Better Fundamental Backdrop Chart 10Corporate Valuations Are Not Cheap... In Investment Grade, spreads have also tightened alongside falling volatility, although spreads are still somewhat higher than during the previous period when the VIX was this low back in 2014 (bottom panel), suggesting that spreads could compress even further if the macro backdrop stays benign. We have maintained a generally cautious stance on U.S. corporate credit for much of the past year, given the combination of poor corporate health, contracting profits and slowly tightening monetary conditions. Now that the backdrop has changed, the case for upgrading U.S. corporates versus U.S. Treasuries is more compelling. This is especially so given the improvement in global economic growth momentum, which usually correlates with periods of positive excess returns for both Investment Grade and High-Yield versus Treasuries (Chart 11). Given our more optimistic tone on global economic growth, led by the potential for upside surprises in the U.S., this week we are upgrading our recommended stance on U.S. Investment Grade corporates to above-benchmark (4 of 5) and U.S. High-Yield to at-benchmark (3 of 5). Within High-Yield, we are focusing our exposure on the high-to-middle quality tiers, as both B-rated and Ba-rated spreads look far more attractive than Caa-rated debt. That can be seen in Chart 12, which shows the option-adjusted spread (OAS) for the overall U.S. High-Yield index and the three main credit tier buckets, divided by the 12-month trailing volatility of excess returns for each grouping. These "vol-adjusted" spreads are at the long-run median level for B-rated and Ba-rated debt, while Caa-rated bonds (which are dominated by the now-expensive debt of energy-related companies) offers poor value relative to their volatility. Chart 11...But The Growth Outlook Remains Supportive Chart 12Avoid The Lower Credit Tiers In U.S. Junk Differentiating within the credit tiers is important, as the overall U.S. High-Yield spread is not particularly cheap once expected default losses are taken into account (Chart 13). If U.S. economic growth surprises to the upside, as we expect, then the default outlook will look better and High-Yield spreads will look more attractive. For this reason, we would look to shift to an above-benchmark stance on any risk-off correction in global equities or corporates. With the business cycle improving, buying any dips in U.S. corporate credit markets should pay off in 2017. One final point: we have had a long-standing recommendation to overweight Euro Area Investment Grade corporate debt versus U.S. equivalents. That view was based on the underlying support for Euro Area corporates from ECB purchases, coming at a time when Euro Area balance sheets were improving in absolute terms, and relative to the U.S., as shown by our Euro Area Corporate Health Monitor (Chart 14). However, with our U.S. CHM now showing some modest improvement, and with U.S. likely to show more upside growth surprises in 2017, we are not upgrading Euro Area debt from the current above-benchmark (4 of 5) ranking, even as we boost our U.S. corporate allocation. Chart 13Expect Carry-Like Returns, Given Tight Spreads Chart 14A Bullish Case For Both U.S. and Euro Area IG Bottom Line: A better global growth outlook should continue to support U.S. corporate debt markets, despite tight valuations and a strong U.S. dollar. Upgrade allocations to U.S. Investment Grade to above-benchmark (4 of 5) and U.S. High-Yield to neutral (3 of 5), at the expense of U.S. Treasuries. Favor the higher quality tiers (i.e. above Caa) in U.S. junk. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "The Bond Vigilantes Take A Break For The Holidays", dated December 6, 2016, available at gfis.bcaresearch.com 2 Please see BCA U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see BCA Global Fixed Income Strategy Weekly Report, "A "Post-Truth" Economic Upturn?", dated January 17, 2017, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). Economy: U.S. GDP growth will be solidly above trend in 2017, driven in large part by accelerating consumer spending. Feature The divergence in economic growth between the U.S. and the rest of the world has been one of our key investment themes for much of the past two years. All else equal, the greater the divergence in growth between the U.S. and the rest of the world, the more the U.S. dollar comes under upward pressure. A strengthening dollar limits how far the Fed can lift rates and caps the upside in long-dated yields. In fact, in a report published last October titled "Dollar Watching: An Update"1 we wrote: Our continued expectation that the Fed will lift rates in December leads us to maintain below-benchmark portfolio duration and a neutral allocation to spread product until a December rate hike has been fully discounted by the market. Beyond December, our investment strategy will depend largely on how the dollar responds to an upward re-rating of rate expectations. Strong dollar appreciation would likely cause us to reverse our below-benchmark duration stance and become even more cautious on spread product. Conversely, a tame dollar could mean that the sell-off in bonds and rally in spreads have further to run. With the December rate hike now in the rearview mirror, global growth divergences do not appear to be a strong headwind for bond yields. In fact, the trade-weighted dollar has flattened off since the Fed lifted rates and bullish sentiment toward the dollar has plunged even though rate hike expectations remain elevated (Chart 1). This suggests that the dollar is so far not having much of an impact on the U.S. growth outlook or the expected path of monetary policy. Digging a little deeper, it appears we are witnessing a synchronized upturn in global growth led by the manufacturing sector (Chart 2). The Global Manufacturing PMI is in a clear uptrend, while the diffusion index suggests the improvement is broad based. Similarly, our Global Leading Economic Indicator is once again expanding, while its diffusion index is holding steady above the 50% line. Chart 1Dollar Sentiment: A Key Indicator Chart 2Synchronized Global Recovery Although the extremely high level of economic policy uncertainty increases the odds of a near-term selloff in risk assets and related flight-to-quality into Treasury securities, the strength of the global growth impulse and sustainability of the U.S. economic recovery (see section titled "U.S. Economy: A Healthy Consumer Leads The Way" below) means we would view any risk-off episode as an opportunity to reduce portfolio duration and increase exposure to spread product. As such, given our 6-12 month investment horizon and the inherent difficulty in forecasting near-term market riot points, this week we begin the process of shifting our portfolio in this direction. Specifically, we move from an "At Benchmark" back to a "Below Benchmark" duration stance and we also upgrade spread product from neutral (3 out of 5) to overweight (4 out of 5), while downgrading Treasuries from neutral (3 out of 5) to underweight (2 out of 5). Within spread product we upgrade investment grade corporates from neutral (3 out of 5) to overweight (4 out of 5) and upgrade high-yield from underweight (2 out of 5) to neutral (3 out of 5). We expand on the rationale for each move below. Portfolio Duration Chart 3Treasuries Now Expensive Two weeks ago,2 we detailed our bearish 6-12 month outlook for U.S. bonds, while also pointing to three factors that had so far prevented us from adopting a below-benchmark duration stance. The three factors were: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation Two weeks ago the 10-year Treasury yield was trading 9 basis points cheap on our 2-factor model based on Global PMI and bullish dollar sentiment. Since then, bullish sentiment has declined and Flash3 PMI readings from the U.S., Eurozone and Japan were all strong. If we assume that final PMIs from these regions are in line with the Flash numbers and that the PMIs from all other countries remain flat, then we calculate that the 10-year Treasury yield is actually 4 basis points expensive relative to fair value (Chart 3). In short, valuation argues even more in favor of reducing portfolio duration than it did two weeks ago. Factor 2: Uncertainty Economic policy uncertainty remains elevated and, unusually, has de-coupled from surveys of consumer and business confidence (Chart 4). Certainly, there is a risk that confidence measures relapse in the near-term if it appears as though some of the new President's promises related to tax cuts and deregulation will not be delivered. However, this risk needs to be weighed against the bond-bearish combination of protectionism and fiscal stimulus favored by the new administration, especially at a time when the economy is close to full employment. Factor 3: Sentiment & Positioning Bond sentiment and positioning remain decidedly bearish according to our Bond Sentiment Indicator and net speculative positioning in Treasury futures, although the J.P. Morgan client survey shows that clients' duration positioning is close to neutral (Chart 5). It is likely that some further capitulation of short positions is necessary before Treasury yields can move decisively higher. However, these shifts in positioning can occur very quickly and given the reading from our valuation model we feel that now is the appropriate time to reduce duration exposure. Chart 4Elevated Uncertainty Remains A Near-Term Risk... Chart 5...As Does Bearish Positioning Bottom Line: Treasuries are now slightly expensive relative to global growth indicators, and the global economic recovery appears sustainable. Despite lingering concerns about policy uncertainty and bearish bond positioning, we recommend shifting back to a below-benchmark duration stance. Spread Product In last week's report,4 we explored the performance of spread product throughout the four phases of the Fed cycle (Chart 6), which are defined as follows: Chart 6Stylized Fed Cycle Phase I represents the early stage of the withdrawal of monetary stimulus. This phase begins with the first hike of a new tightening cycle and ends when the fed funds rate crosses above its equilibrium level. Phase II represents the late stage of the tightening cycle, when the Fed hikes its target rate above equilibrium in an effort to slow the economy. Phase III represents the early stage of the easing cycle. It begins with the first rate cut from the peak and lasts until the Fed cuts its target rate below equilibrium. Phase IV represents the late stage of the easing cycle. It encompasses both the period when the fed funds rate descends to its cycle trough and the subsequent adjustment period when the Fed remains on hold in an effort to kick start an economic recovery. Based on the fact that core PCE inflation remains below the Fed's target and the view that its uptrend will proceed only gradually, we concluded that we are presently in Phase I of the Fed cycle and would probably remain there for the balance of the year. Historically, spread product has performed well in Phase I of the Fed cycle, with only Phase IV producing higher average monthly excess returns. However, the Fed cycle is only part of the story. Our Corporate Health Monitor (CHM) - a composite measure of balance sheet health for the nonfinancial corporate sector - has been in "deteriorating health" territory since late 2013. Historically, this measure has an excellent track record of flagging periods of spread widening (Chart 7). Chart 7The Corporate Health Monitor And Credit Spreads To augment our analysis, this week we re-examine average monthly excess returns for investment grade corporate bonds in the four phases of the Fed cycle but this time we also split each phase into periods of improving and deteriorating corporate health (Table 1). Table 1Investment Grade Corporate Bond Excess Returns* Given Reading From ##br##BCA Corporate Health Monitor And The Phase Of The Fed Cycle (July 1989 To Present) Table 1 shows there have been 14 months since 1989 when Phase I of the Fed cycle coincided with deteriorating corporate health, according to the CHM. Conversely, Phase I of the Fed cycle coincided with improving corporate health in 25 months. However, 13 of the 14 months when Phase I of the Fed cycle coincided with deteriorating corporate health are the most recent 13 months. In other words, the current combination of tightening (but still-supportive) monetary policy and weak corporate balance sheets is unprecedented. The other factor we have not yet considered is valuation, as measured by the starting level of corporate spreads. In Table 2 we present average monthly excess returns for investment grade corporate bonds split by both the phase of the Fed cycle and the investment grade corporate option-adjusted spread. At present, the average option-adjusted spread for the Bloomberg Barclays investment grade corporate index is 120 bps. Table 2Investment Grade Corporate Bond Excess Returns* Given Previous Month Option-Adjusted Spread** ##br##And The Phase Of The Fed Cycle (July 1989 To Present) In Table 2 we observe that usually spreads are much lower in Phase I of the Fed cycle, typically between 50 bps and 100 bps, and that periods when spreads are above 100 bps generally coincide with higher excess returns. However, we must also recall that corporate health is typically still improving in Phase I of the Fed cycle, so today's higher spread levels might be justified by worse credit quality. Chart 8Value Is Stretched In Junk It goes without saying that the unusual combination of deteriorating corporate health and still-supportive Fed policy is a complicated environment for credit investors to navigate. Our view is that accommodative Fed policy will prevent material spread widening, at least until inflation breaks above the Fed's target and we shift into Phase II of the Fed cycle, but it is also probably not reasonable to expect spreads to tighten much further from current levels. We are looking for low, but positive, excess returns from spread product, consistent with the available carry. Bottom Line: The combination of an improving global growth back-drop and still-accommodative Fed policy will be positive for spread product. As such, we increase our allocation to investment grade corporate bonds - and spread product more generally - from neutral (3 out of 5) to overweight (4 out of 5). We also upgrade our allocation to high-yield bonds from underweight (2 out of 5) to neutral (3 out of 5). We retain only a neutral allocation to high-yield due to the longer-run risks posed by poor corporate health, and tight valuations for high-yield bonds (Chart 8). U.S. Economy: A Healthy Consumer Leads The Way U.S. GDP growth decelerated to 1.9% in Q4 from 3.5% in Q3. Growth in consumer spending slowed to 2.5% from 3.0%, while fixed investment spending picked up to 4.2% from 0.1%. The headline 1.9% GDP print also includes a -1.7% contribution from net exports and +1.0% contribution from inventories. Taking a step back from the quarterly data, we see that the growth in real final sales to domestic purchasers - a measure of growth that strips out the volatile trade and inventory components - has clearly shifted into a higher range during the past couple of years (Chart 9). Further, leading indicators for each individual component of growth all suggest that further acceleration is in store (Chart 10). Chart 9Growth Finds A Higher Gear Chart 10Contributions To GDP Growth But crucially, it is the fundamental drivers underpinning the outlook for consumer spending that lead us to believe that U.S. economic growth will maintain an above-trend pace throughout 2017. As was observed by our U.S. Investment Strategy service in a recent report,5 income growth - the main driver of consumption trends - appears poised to accelerate, driven by accelerating wage growth that is starting to kick in now that the economy has finally reached full employment (Chart 11). The boost in consumer confidence could also lead to a lower savings rate, further increasing the impact on spending (Chart 11, bottom panel). Chart 11Consumer Spending = Income + Confidence Bottom Line: A healthy consumer is the back bone of the U.S. economy, and elevated consumer demand will also lend support to corporate fixed investment and the housing market. We expect that U.S. growth will be solidly above trend in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Weekly Report, "Dollar Watching: An Update", dated October 25, 2016, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, titled "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 3 The flash estimate is typically based on approximately 85%-90% of total PMI survey responses each month and is designed to provide an accurate advance indication of the final PMI data. 4 Please see U.S. Bond Strategy Weekly Report, "Inflation: More Fire Than Ice, But Don't Sound The Alarm", dated January 24, 2017, available at usbs.bcaresearch.com 5 Please see U.S. Investment Strategy Weekly Report, "U.S. Consumer: The Comeback Kid", dated January 16, 2017, available at usis.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Table 1Recommended Allocation The Reflation Trade Continues It is wrong to think that the recent rally in risk assets is mainly due to the election of President Donald Trump. Yes, since November 8, U.S. equities have risen by 7% and global equities by 3%. But the rally began as long ago as February last year, and since then U.S. and global equities have risen by 25% and 20% respectively. A more useful narrative is that the U.S. went through a "mini-recession" in late 2015/early 2016 (as indicated by the manufacturing ISM and credit spreads, Chart 1). Since then, assets have moved as they typically do in the first year of a cyclical recovery: small caps, cyclicals and value stocks have outperformed, bond yields risen, and equity multiples expanded in anticipation of a recovery in earnings. Expectations of Trump's fiscal stimulus and deregulation merely gave that momentum an extra boost. Our view is that global economic growth is likely to continue to accelerate. With the U.S. now at full employment, wage growth should rise further (Chart 2). Trump's policies are igniting animal spirits among companies, whose capex intentions have jumped sharply (Chart 3). U.S. real GDP growth this year could be 2.5-3%, somewhat above the consensus forecast of 2.3%. Meanwhile, Europe is growing above trend, and China will continue for a while longer to see the effects from last year's massive monetary stimulus (Chart 4). Chart 1One Year On From A Mini Recession Chart 2Wage Growth Is Set To Accelerate Chart 3Comapanies' Animal Spirits On The Rise Chart 4China's Reflation Still Coming Through In the short term, a correction is possible: the rally looks technically over-extended, and investors have begun to notice that in addition to "good Trump" (tax cuts, deregulation and infrastructure spending), there is also a "bad Trump" (market unfriendly measures such as immigration control, confrontation with China, and arbitrary interference in companies' investment decisions). But, on a 12-month view, our expectations of accelerating growth and only a moderate rise in inflation imply that the "sweet spot" for risk assets will continue, and so we maintain the overweight on equities and underweight on bonds we instituted in late November. What could end the reflation trade? The main risks we see (and the reasons we don't think they are serious enough to derail the rally for now) are: Extreme moves by the new U.S. administration. The biggest risk is a confrontation with China over trade. Our view is that Trump will use the threat of recognizing Taiwan to force concessions out of China. A precedent is the way the U.S. handled its trade deficit with Japan in the 1980s (note that new U.S. Trade Representative Robert Lighthizer was deputy USTR at the time). China is unlikely to accept significant currency appreciation, understanding how this caused a bubble in Japan. But it might agree to voluntary export restrictions, to increasing investment in the U.S., opening the Chinese market more to foreign companies, and to stimulating domestic consumption, as Japan did in the 1980s (Chart 5). This may even chime with how Xi Jinping wants to reform the economy, though missteps by the U.S. could force him into a nationalistic position. Fiscal policy fails. The details of tax cuts are complex: alongside lowering the headline rate of corporate tax to 15% or 20%, for example, Republicans are discussing a border-adjustment tax, one-year depreciation, and an end of the tax offset for interest payments. Infrastructure spending won't happen quickly either, not least since it is disliked by Republican fiscal hawks (who are much less averse to tax cuts). BCA's geopolitical strategists, however, believe that Trump will able to get a program of personal and corporate tax cuts through Congress by August. Economic (and earnings) growth stumble. While corporate and consumer sentiment have picked up recently, hard data has not yet. U.S. 4Q GDP growth of only 1.9%, for example, was disappointing. Earnings growth will need to recover this year to justify elevated multiples. EPS growth for the S&P500 stocks in Q4 2016 looks to have been around 4% YoY according to FactSet. Stocks might fall if earnings do not come in somewhere close to the 12% that the bottom-up consensus forecasts for 2017. Inflation risks rise, triggering the Fed and the European Central Bank to rush to tighten monetary policy. Core U.S. PCE inflation, at 1.7% YoY, is not far below the Fed's 2% target and inflation could accelerate as fiscal policy stimulates an economy where slack has already disappeared. However, it is likely to take some time for inflation expectations to rise, and over the past few months core PCE inflation has, if anything, slowed (Chart 6). We expect the Fed to raise rates three times this year (compared to market expectations of twice) but not to move faster than that. German inflation, at 1.9% YoY, is starting to get uncomfortably high too, but the ECB will probably continue to set policy with more focus on the periphery, especially Italy. Chart 5When U.S. Pushed Japan In The 1980's Chart 6Inflation Has Been Slow To Pick Up Equities: We prefer U.S. equities over European ones in common currency terms. This is partly because we expect further U.S. dollar appreciation. But we also remained concerned about the structural weakness in the European banking system, and by the higher volatility of eurozone equities. Moreover, European earnings will not be boosted by currency depreciation as much as will Japanese earnings, since the euro has hardly weakened on a trade-weighted basis (Chart 7). We continue to like Japanese equities (with a currency hedge). The Bank of Japan remains committed to an overshoot of its 2% inflation target, which should weaken the yen and boost earnings. We are underweight Emerging Market equities: structural vulnerabilities remain, and the inverse correlation with the U.S. dollar is intact. Chart 7Euro Hasn't Weakened Much Fixed Income: For now, U.S. 10-year Treasury bonds are at around fair value. But we expect the yield to rise moderately further, as growth and inflation pick up, to about 3% by year-end. Yields on eurozone government bonds will also rise, but not by as much. This means that global sovereigns could produce a YoY negative return for the first time since 1994. In the U.S. we continue to prefer TIPS over nominal bonds: inflation expectations are still 30-40 bps below a normalized level (Chart 8). With risk assets likely to outperform, we recommend exposure to spread product, but find investment grade bonds more attractively valued than high-yield. Currencies: Short term, the dollar has probably overshot and could correct. But growth and interest rate differentials (Chart 9) suggest that the dollar will appreciate further until such time as Europe and Japan can contemplate raising rates. Additionally, if the proposal of a border-adjustment tax looks like becoming reality, the dollar could appreciate sharply: a BAT of 20% would theoretically be offset by a 25% rise in the dollar. The yen is likely to depreciate further (perhaps back to JPY125 against the dollar) as the Bank of Japan successfully maintains its target of a 0% 10-year government bond yield. The euro will fall by less, especially if the market begins to worry about ECB tapering in the face of rising inflation. Chart 8TIPS Have Further to Go Room To Rise Chart 9Interest Rate Differentials Suggest Stronger Dollar Commodities: The supply/demand picture for industrial metals looks roughly balanced for the year, with Chinese demand likely to remain robust, suppliers more disciplined, but the stronger dollar acting as a headwind. In the oil market, Saudi Arabia and Russia seem to be sticking to their commitment to cut supply, but U.S. shale oil producers are filling the gap, with the rig count up 23% in Q4 over the previous quarter. We continue to expect crude oil to average US$55 a barrel for the next two years. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com Recommended Asset Allocation Model Portfolio (USD Terms)

Highlights Portfolio Strategy Pricing power has improved across a number of industries, with the exception of technology, a necessary development to sustain an overall profit recovery. The S&P railroads index has surged to the point where it will take massive upside earnings surprises to drive additional gains. Profit-taking is appropriate. Telecom services profit drivers have deteriorated significantly of late, and a full shift to underweight is recommended. Recent Changes S&P Railroads Index - Take profits of 22% and downgrade to neutral. S&P Telecom Services Index - Take profits of 6% and downgrade to underweight from overweight. Table 1 Feature Chart 1Pricing Power Is Profit Positive... Momentum remains the dominant market force. Fear of missing out is pulling sidelined cash into the market, supported by a decent earnings season to date and rising economic confidence. While consumer inflation expectations remain very low, market-derived inflation expectations have moved up markedly since the U.S. election (Chart 1), a surprising development given the surge in the U.S. dollar. Inflation expectations are back to levels that existed prior to the 2014 kickoff to the U.S. dollar rally. A shift away from deflation worries is supporting a re-pricing of stocks vs. bonds. That trend could continue until the U.S. economy begins to disappoint, potentially causing inflation expectations to retreat. Our pricing power update shows that while deflation remains prevalent, its intensity is fading. We have updated our industry group pricing power (Table 2), which compiles the relevant CPI, PPI, PCE or commodity-data for 60 S&P 500 industry groups. The table also compares those pricing power trends with overall inflation rates to help determine which areas are at a profit advantage or disadvantage. Based on our analysis, the number of groups suffering deflation in selling prices has shrunk to 19 from 23 in our update last September, and 32 last March. In all, 34 out of 60 groups are still unable to raise prices by more than 1%, but that is also an improvement from the 40 out of 60 industries that couldn't keep a 1% price hike pace last September. The bad news is that less than 1/3 have a rising selling price trend, even if the absolute level is negative, down from 50%, and another third has a flat trend. The implication is that upward momentum in pricing power may already be fading. Where is the pricing power improvement? Deep cyclical sectors such as energy and materials account for the lion's share, reflecting higher commodity prices. However, as discussed previously, 6-month growth rates have rolled over (Chart 2), signaling that the unwinding of the negative rate of change shock has run its course. The technology sector is also notable, as several groups are cutting selling prices at a faster clip. Table 2Industry Group Pricing Power Defensive sectors such as consumer staples, health care and utilities remain well represented in the positive category, while a reacceleration in consumer discretionary and financials sector selling price increases has boosted interest rate-sensitive sector pricing power (Chart 2). This would suggest that profit advantages continue to reside in these areas, rather than in cyclical sectors. That is confirmed by the uptrend in developed vs. developing market PMIs. This manufacturing gap would presumably widen further if the U.S. ever imposes import taxes. The latter would weaken developing country exports, thereby forcing currency devaluation and hurting capital inflows. Regardless, the PMI divergence reinforces that, in aggregate, cyclical sectors are not as fundamentally well supported as other sectors, and that a highly targeted and selective approach is still the right strategy (the PMI ratio is shown advanced, Chart 3). Even external factors warn against chasing lingering cyclical sector strength. Using the options market, the SKEW index provides a good read on perceived tail risk for the S&P 500. A rise toward 150 indicates significant worries about potential outlier returns. The SKEW has soared in recent weeks, which is often a harbinger of increased equity volatility and defensive vs. cyclical sector strength (Chart 4). Chart 2... But Is Not Broad-Based Chart 3Global PMIs Are Signaling Defense First... Chart 4... As Are Market-Based Indicators In sum, the broad market has a powerful head of steam and it could be dangerous to stand in its way, but the rally continues to exhibit signs of a late stage blow-off, vulnerable to sudden and sharp corrections. Maintain a healthy dose of non-cyclical exposure to protect against building and potentially sudden downside overall market risks, while being careful in terms of cyclical industry coverage. This week, we are taking advantage of exuberance in the rail space, and reversing our call on the telecom services sector in response to broad-based erosion in profit indicators. Rails Are Now Priced For Perfection For such a mundane and staid industry, railroad stocks have garnered considerable attention of late. Most recently, rumors that railroad maven Hunter Harrison will be installed at CSX to engineer yet another corporate turnaround have spurred a massive buying frenzy. We upgraded the S&P railroads index to overweight on August 1, 2016. Our analysis suggested that analysts and investors had made a full bearish capitulation, slashing long-term growth estimates to deeply negative territory and pushing valuations decisively into the undervalued zone. That pessimism overlooked efforts to cut costs and stabilize profit margins in the face of waning freight growth, setting the stage for a re-rating. While that thesis has worked out, we are concerned that the needle has now swung too far in the other direction, much like what occurred in the air freight industry. The latter had a steep run up only to disappoint newly buoyant expectations. We took air freight profits in late-November, as the soaring U.S. dollar was an anti-reflationary threat to the anticipated recovery in global trade that both investors and the industry had positioned for. Indeed, industry hiring has expanded rapidly (Chart 5). However, hours worked are contracting (Chart 5). Ergo, the hoped for increase global revenue ton miles has not materialized to the extent that was expected (Chart 5). Over-employment is a productivity and profit margin drag, and we were fortunate to take profits before the payback period. We can envision a similar scenario for railroads. There has no doubt been an improvement in freight activity, and there is more in the pipeline. The question is one of degree. Total rail shipment growth has climbed back into positive territory, and our rail shipment diffusion index, which measures the number of freight categories experiencing rising vs. falling growth, is near the 80% level (Chart 6). The key consumer-driven intermodal segment, which accounts for over half of total freight volumes, has finally begun to recover. Rising personal incomes should underpin credit availability and demand, and therefore, spending. The increase in business sales-to-inventories and growth in Los Angeles port traffic also augur well for intermodal shipments (Chart 6). One caveat is that autos represent a large portion of this segment, and pent-up demand has been fully realized at the same time that auto credit quality is beginning to crack. That could keep a lid on the magnitude of the intermodal shipment recovery. Coal volumes have also shown signs of life after a brutal contraction. Coal is a high margin product and another large freight category, and any sustained recovery would provide a meaningful profit boost. Rising natural gas prices typically bode well for coal volumes (Chart 7), via increasing the cost of competing fuels to burn for power generation. However, it is premature to celebrate, because the abnormally warm North American winter may mean that the rebound in electricity production is passed its peak. That would slow the burn rate and keep coal (and natural gas) supplies higher than otherwise would be the case. Chart 5Stay Grounded Chart 6Broad-Based Freight Recovery Chart 7Coal Is Critical History shows that pricing power and coal shipment growth are tightly linked. Selling prices have firmed in recent months, but are not at a level that heralds meaningful improvement in return on equity (Chart 8, third panel). True, rising oil prices typically lead to rail companies reinstituting fuel surcharges. But that is profit margin protective, not expansionary, as true pricing power gains come on the back of increased demand and the creation of bottlenecks. It is not clear that such a point has been reached. The Cass Freight Expenditures Index has been flat for several months, signaling that companies do not intend to raise transportation outlays. This series correlates positively with relative forward earnings estimates (Chart 8). That will make it difficult for rail freight to grow faster than GDP (Chart 9), a necessary development to drive earnings outperformance. Meanwhile, productivity gains may be slow to accrue if freight only grows modestly. Weekly train speeds have been stuck in neutral (Chart 8), and the industry may be in the early stages of a capital spending reacceleration. Rail employment growth has jumped in recent months, which is often a leading indicator of investment (Chart 9). If capital spending begins to take a larger share of sales in the coming quarters, then recent investor excitement may ease, leading to a prolonged consolidation phase. After all, valuations are stretched. Over the past two decades, whenever the relative forward P/E has crossed above a 10% premium, relative forward 12-month returns have averaged -4%, and been negative in 4 out of 5 cases. Overheated technical momentum also warns against extrapolating the latest price gains (Chart 10). Chart 8Earnings Will Only Improve Slowly... Chart 9... If Capital Spending Re-Accelerated Chart 10A Profit Recovery Is Discounted Bottom Line: Take profits of 22% and downgrade the S&P rails index (BLBG: S5RAIL - UNP, CSX, NSCX, KSU) to neutral, as the index appears to be setting up for a 'buy the rumor, sell the news' scenario. Stay neutral on the S&P air freight index (BLBG: S5AIRF - UPS, FDX, CHRW, EXPD). Telecom Services: Can You Hear Me Now? The niche S&P telecom services sector (comprising 3% of the S&P 500) has served our portfolio well, up 6% since inception. However, operating conditions have downshifted and we recommend lightening up a notch and reducing weightings to underweight. There are five factors driving this downgrade: the relative spending profile, sales outlook, margins pressure, interest rates and capital spending trends. First, telecom services personal consumption expenditures (PCE) have sunk anew after a brief attempt to stabilize last year. While consumer spending on telecom services has increasingly become a discretionary item, the improvement in consumer finances and vibrant labor market appear to be generating even more outlays on non-telecom goods and services (top panel, Chart 11). Second, this spending backdrop has undermined the sector sales outlook. Top line growth has retreated to nil, and BCA's telecom services sales-per-share model is signaling that a contraction phase looms (middle panel, Chart 11). Worrisomely, the latest producer price index release revealed that industry pricing power has taken a turn for the worse, which will sustain downward pressure on revenue growth. Third, profit margins are under stress. Selling prices are deflating at a time when the wage bill is still expanding at a mid-single digit rate. The implication is that margins, and thus earnings, are unlikely to improve much in the coming quarters (Chart 12). Chart 11Sales Prospects Have Dimmed Chart 12Ditto For Profit Fourth, telecom services is a high yielding sector and the recent sell-off in 10-year Treasurys (UST) is an unwelcome development. When competing investments rise in yield, the allure of telecom carriers diminishes, and vice versa. Chart 13 shows that relative performance momentum and the change in UST yields are inversely correlated, underscoring that as long as the bond market selloff persists relative share price pressures will remain intact. Finally, industry capital expenditures are reaccelerating, which is a short-term negative for profitability. This message is corroborated by the government's construction spending release, which shows a pickup in telecom facilities construction (bottom panel, Chart 13). Taken together with the deteriorating sales backdrop, higher capital spending would be negative for profit margins. While we would normally be reluctant to move an attractively valued sector all the way to underweight (Chart 14), the marked deterioration in these five drivers of relative profitability warrants such an extreme move, regardless of our reticence about the sustainability of the broad market's recent gains. Chart 13Higher Bond Yields Aren't Helping Chart 14Technical Breakdown Our Technical Indicator has crossed decisively into the sell zone, and the share price ratio has failed to break back above its 40-week moving average, providing technical confirmation of a breakdown (Chart 14). Bottom Line: Lock in profits of 6% in the S&P telecom services sector since the Nov 9th, 2015 inception and downgrade exposure all the way to underweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Special Report

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 Chart 2U.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 Chart 4Tight Labor Market Will Boost ##br##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 Chart 6Corporate Sector Has Yet ##br##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 Chart 8Government 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.

Highlights The DXY correction has a bit more to run as G10 economic surprises are likely to roll over. EM-related plays like commodity currencies can rally for a few more months, but the outlook for 2017 is troublesome. China is at risk of a deceleration. Global liquidity is tightening. Protectionism is rising. Feature Dollar Correction: It Ain't Over 'til It's Over Can the dollar correction advance further, or is the dollar bull market about to resume? We prefer to position ourselves for additional dollar weakness in the coming months. Despite persistently high bond yields, the DXY is still softening. It is being dragged down by a euro supported by strong economic news such as this week's Belgian business confidence, our favorite bellwether for the euro area. The pound too continues to show some vigor, which is also a byproduct of economic data pointing toward better growth (Chart I-1). We expect the support for the greenback from higher Treasury yields to be temporary. Momentum in U.S. 10-year government bond yields is driven by G10 economic surprises (Chart I-2). Currently, economic surprises are flirting with the upper end of their distribution of the past 12 years. Chart I-1The British Economy Is Picking Up Chart I-2G10 Economic Surprises Drive Treasury Yields Accentuating the odds of a rollover in surprises are two factors: First, as bond yields and risk-asset prices attest, investors are revising their growth expectations upward, lifting the hurdle for data to surprise to the upside. Second, having expanded for 10 months, the global credit impulse has experienced its longest upswing in a decade. Yet, the increase in global borrowing costs, along with the widening in cross-currency basis swap spreads, points to tightening global liquidity conditions, a poison for the credit cycle (Chart I-3). As credit slows, the economy will deteriorate. Chart I-3The Credit Cycle Is Stretched This means that the key factor that has supported the stronger dollar in recent months - higher U.S. yields - will begin to dissipate, putting downward pressure on the USD. Finally, our dollar capitulation index, after hitting overbought conditions, is now falling. Moreover, it currently stands below its 13-week moving average, conditions under which the greenback has recorded an average 8.1% annualized weekly loss since 1994, and an average 5.3% annualized weekly loss since 2011 (Chart I-4). Chart I-4Negative Momentum For The Dollar We continue to play this correction by shorting USD/JPY. As we have pointed out before, USD/JPY remains a function of the level of global bond yields (Chart I-5). Additionally, a negative surprise in global growth is likely to hurt risk assets. To conclude with the favorable backdrop for the yen, the high degree of uncertainty created by the seemingly erratic policy changes of the new Trump administration suggests that equity implied volatility remains too low. After all, we do not know what changes will hit global tax regimes, what the Fed policy will look like, nor how protectionist Trump will really be. Imbedding a premium for these risks will require higher equity implied vols. A higher VIX tends to support the yen against the USD (Chart I-6). Chart I-5USD/JPY And G10 Bond Yields Chart I-6The Yen Likes Uncertainty Bottom Line: The correction in the dollar should continue, as bond yields still have downside on a one- to three-month basis. The yen remains the best-placed currency to take advantage of these dynamics, especially if risk assets experience a correction. Focus - Emerging Markets and Liquidity: A March To The Scaffold This week, we re-examine our bearish view on emerging markets, a key theme underpinning our bearish stance on commodity currencies. EM assets, and therefore commodity currencies, have outperformed our expectations, reflecting the percolation of previous positive economic surprises in EM relative to the U.S. (Chart I-7). EM and commodity currencies are priced for perfection, with the risk-reversals on EM currencies displaying elevated levels of optimism (Chart I-8). For EM and commodity currencies to rally further, EM economies need to continue to outperform durably. This requires the Chinese economy and the global liquidity backdrop to only improve further. Can this happen? Chart I-7Surprise Beat In EM Versus The U.S. Has ##br##Helped EM And Commodity Currencies Chart I-8EM And Commodity Currencies ##br##Priced For Perfection While the next month or two may continue to generate generous returns for EM-related plays, the rest of 2017 may not prove as kind. The China Syndrome Let's begin with China. The recent upsurge in metal prices has reflected an improvement in Chinese economic activity (Chart I-9). As we have pinpointed before, the Keqiang index is near cycle highs, and, Chinese railway freight volumes have been growing at their fastest pace since 2010. This situation is unlikely to continue much longer. The upsurge in Chinese commodity intake - metals in particular - has been fueled by a vigorous rebound in Chinese real estate construction. However, Chinese real estate price appreciation has hit dangerous levels, and the authorities are already leaning against it, with the PBoC increasing rates by 10 basis points this week. The roll-over in Chinese real estate activity should deepen Chart I-10), hurting commodity prices - particularly iron ore, steel and copper - and commodity currencies along the way. Chart I-9China's Rebound Explains ##br##The Metals Rally Chart I-10The Risk Of A China Real Estate ##br##Slowdown Is Growing Moreover, some of the upswing in Chinese economic activity was also related to large amounts of fiscal stimulus in that nation. In mid-2015, the Middle Kingdom was inching ever closer to a hard landing, prompting a panicked Beijing to boost fiscal support and to speed up the roll-out of US$1.2 trillion of infrastructure public-private partnerships. Today, this fiscal hand-out is fading (Chart I-11). This could once again cause industrial activity and investments to weaken as Chinese capacity utilization remains near recession troughs. The recent disappointing investment growth reading in the latest Chinese GDP release could be a harbinger of this reality. Finally, as we have highlighted last week, Chinese monetary conditions have massively improved as Chinese producer-price inflation rebounded, pushing down Chinese real rates in the process. However, with commodity price inflation set to slow - courtesy of a dissipating base effect and of last year's dollar rally - Chinese PPI should roll over, pulling up real rates and tightening monetary conditions (Chart I-12). A tightening in Chinese monetary conditions represents a big problem for EM as it portends a slowdown in economic activity (Chart I-13). This will ultimately lead to a big drag on DM commodity producers, as EM commodity intake decreases, pushing down the likes of the AUD, CAD, and NZD as their terms of trade suffer. Chart I-11Fading Chinese##br## Fiscal Stimulus Chart I-12Commodity Inflation Will Peak, ##br##So Will Chinese Inflation Chart I-13Tightening China Monetary Conditions##br## Will Hurt EM Economic Activity Bottom Line: In early 2016, global markets were not positioned for a rebound in Chinese economic activity. Yet, Chinese industrial activity improved, resulting in a rebound in EM assets, commodity prices, and commodity currencies. The crackdown on real estate activity, the removal of Chinese fiscal stimulus, and the expected tightening in Chinese monetary conditions should result in a reversal of these trends, hurting commodity producers and their currencies in the process. Global Liquidity In Retreat While China represents a problem for EM plays and commodity currencies, deteriorating global liquidity could prove an even stronger hurdle. Our tactical expectation of a lower dollar and lower rates may support EM plays temporarily, but the cyclical outlook remains grim. To begin with, EM economies are dependent on global liquidity as they run a current account deficit expected to hit US$140 billion in 2017, or US$400 billion if China is excluded. Moreover, they sport large external debts of US$4.8 trillion, excluding Taiwan and China. Especially worrisome are the large funding requirements of many EM countries, especially for Turkey, Malaysia, and Colombia. (Chart I-14). Chart I-14EM Debt Vulnerability Ranking Why is this a problem? Two reasons: Global Interest rates and the dollar. Global Interest rates, driven by higher Treasury yields, are rising as the U.S.'s economic slack vanishes, suggesting that the current tightening campaign by the Fed will be durable (Chart I-15). Higher U.S. rates lift the U.S. dollar against EM currencies, tightening EM liquidity conditions. But an unrelated shock is also putting exogenous upward pressure on the dollar. This force is the widening in LIBOR spreads (Chart I-16). This is the result of the regulation-related 90% melt down in the asset under management of U.S. prime money-market funds, an important source of global dollar liquidity. Moreover, U.S. banks, with their balance sheets under pressure by the binding constraints of Basel III, have not been able to fill the gap. Chart I-15The Fed has A Green Light To Hike Chart I-16Stresses In The Libor Market Remain The end result has been a widening of cross-currency basis swap spreads, which usually tends to boost the dollar (Chart I-17). This phenomenon increases the hedging costs to foreign investors of holding U.S. dollar assets. These investors become increasingly tolerant of purchasing U.S. assets unhedged, pushing up the value of the dollar in the process. This is best illustrated by the fact that net portfolio investments in the U.S. moved from a deficit of US$300 billion in Q1 2015 to a surplus of more than US$550 billion. Yet, hedges put in place, as approximated by the BIS's volume of OTC FX derivatives, have flat-lined since 2013 (Chart I-18). Chart I-17Widening Cross-Currency Basis Swap Spreads Equals A Higher Dollar Chart I-18Hedging Activity is Receding A rising dollar and LIBOR stresses are tightening global dollar liquidity, creating a big problem for EM. Wider-than-normal cross-currency basis swap spreads have been associated with declining global trade (Chart I-19). The stronger dollar plays a role, as it hurts the price of globally-traded good prices. Also, higher borrowing costs result in a mild disintermediation of global trade flows. As physical exports are 26% of EM GDP versus 13% for the U.S., this represents a huge drag on EM currencies, especially versus the USD. As a corollary, it is also a problem for the small open commodity producing DM economies like Australia, Canada, or New Zealand. Furthermore, the strength in the dollar associated with LIBOR shocks further hurts EM domestic economies by impeding EM credit growth (Chart I-20). The combined assault of a stronger dollar and higher rates increases the cost of EM foreign debt. Also, according to the BIS, between 2002 and 2014, 55% of EM commodity producers' debt issuance has been in USD.1 When the dollar rises, they see both their borrowing costs rise and the prices of the products they sell fall. Altogether, these forces preempt capex and credit accumulation in EM nations. Chart I-19Tightening Global Liquidity##br##Is Bad For Trade Chart I-20A Stronger Dollar Will Hamper##br## EM Credit Growth Bottom Line: The global liquidity backdrop is deteriorating. DM rates are rising cyclically, which is lifting the dollar. Moreover, a global dollar shortage is also supporting the greenback, further hurting EM liquidity conditions. Thus, we expect EM growth to deteriorate, hurting EM assets and commodity currencies. Protectionism The final issue affecting EM economies is the rise of protectionism, especially in the United States. EM - Asia and China in particular - have been the main beneficiaries of globalization (Chart I-21). Currently, they are in the line of sight of President Trump. Thus, we expect that any potential trade war between the U.S. and the rest of the world will focus on EM economies and China. Chart I-21EM And Asia Are In Trump's Line Of Sight EM are much more dependent on the U.S. than the other way around. As an example, China's exports to the U.S account for 3.5% of Chinese GDP, while U.S. exports to China account for less than 1% of U.S. GDP. EM economies have a lot more to lose from a trade war than the U.S. Because of this imbalance in relative trade-exposures, EM economies are at risk from the border-adjustment tax being discussed in the U.S. These taxes would be very deflationary for EM economies as they could force a downward adjustment in EM labor costs and further depress capex in these nations. To ease these adjustments, falling EM exchange rates would be required. Once again, commodity currencies would suffer from these developments. First, lower capex in EM hurts Australian, New Zealand, or Canadian terms of trade. Second, lower EM exchange rates means that that exports from the dollar bloc to EM would suffer. Finally, and most perversely, lower EM exchange rates will give EM commodity producers an advantage versus DM producers, in that a stronger U.S. dollar means their local-currency costs are falling. EM commodity producers would keep producing more than warranted, putting additional downward pressure on commodity prices and stealing market shares from the dollar bloc producers. This is not a pretty picture. Bottom Line: EM should bear the brunt of the pain of any rise in U.S. protectionism. The tight link between EM economies and DM commodity producers suggests that this pain should adversely affect the AUD, the CAD, and the NZD. Risks To Our View Chart I-22Chinese Tariffs Are Falling The biggest risk to our view is a redoubling of Chinese fiscal stimulus. The threat of U.S. tariffs and trade sanctions is obviously deflationary and negative for the Chinese economy. We know this, as do the relevant powers in Beijing. A tool to mitigate any of these negative repercussions on the Chinese economy might be for Beijing to press on the gas pedal once more. Additionally, as our colleague Yan Wang wrote in this week's China Investment Strategy, key members of the new U.S. administration have been on record saying that the threat of tariffs is not an end game, but rather a negotiating tool to extract concessions from U.S. trade partners, implying a potentially more pragmatic stance from the U.S. than current rhetoric suggests.2 Moreover, the Chinese side of the negotiation table is also more open minded than most observers fear. China has been cutting its own tariffs and could continue to do so (Chart I-22). Moreover, Premier Li Keqiang has made a new pledge to move faster toward opening and liberalizing Chinese markets for access by foreign companies. A deal may be less elusive than feared. Finally, regarding the global liquidity deterioration, the recent rebound in gold and silver prices may be a harbinger of improving liquidity conditions globally. We doubt that the economic situation will let this rally be durable, but it remains something to monitor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Bruno Valentina, and Hyun Song Shin, "Global Dollar Credit And Carry Trades: A Firm-level Analysis", BIS, Working Papers, August 205. 2 Please see China Investment Strategy Special Report, "Dealing With The Trump Wildcard", dated January 6, 2017, available at cis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 U.S. data was mixed this week. The labor market saw both continuing and initial jobless claims rise above expectations. However, the economy is still near full employment and the Fed will not respond to this news. Furthermore, the Beige Book, released last week, also highlights that the U.S. economy remains resilient with employment and pricing activity particularly strong. This week the DXY broke through the key 100 level, as the market continues to reprice capricious assumptions of Trump's policies. Nevertheless, it has rebounded since then. The dollar is unlikely to see any real movement until the administration releases concrete information about its policies. For the time being, the Fed also seems to be on the sidelines in anticipation of more information. Report Links: U.S. Border Adjustment Tax: A Potential Monster Issue For 2017 - January 20, 2017 Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Although the euro area has seen a brighter economic environment as of late, this week's data has been mixed: German and overall euro area services and composite PMI underperformed, while manufacturing PMI outperformed consensus. The IFO Business Climate and Expectations both underperformed consensus, while the Current Assessment remained in line with consensus. All measures still remain over 100. Finally, Belgian Business Confidence accelerated sharply. The ECB is unlikely to change its dovish stance. The euro will therefore see little upside. The recent uptrend in EUR/USD is due to dollar weakness, but the recent downtrend in EUR/GBP and EUR/SEK indicate that the market is not necessarily hopeful that the ECB will reach its inflation target anytime soon. Report Links: GBP: Dismal Expectations - January 13, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data indicates that last year's sharp depreciation of the yen is helping the Japanese economy: Exports increased by 5.4% YoY, crushing expectations of 1.2% growth. Nikkei Manufacturing PMI reached 52.8, also beating expectations. In November machinery orders grew by more than 10% YoY. The BoJ will be more resolute on its radical monetary measures, as recent data shows that their approach is working. This will prove very bearish for the yen on a cyclical basis, given that the cap in Japanese rates will cause the rate differential between the U.S. and Japan to widen. In the short term, USD/JPY will resume its correction. We estimate that USD/JPY will cease to be attractive as a short opportunity at around 110. Report Links: Update On A Tumultuous Year - January 6, 2017 Outlook: 2017's Greatest Hits - December 16, 2016 Party Likes It's 1999 - November 25, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Tuesday, the Supreme Court upheld the decision of the High Court, requiring a parliamentary vote to authorize the exit of the U.K. from the European Union. This news is an added boon for cable, which has surged by almost 5% after bottoming at 1.20 about 10 days ago. As political risks start to dissipate, and the currency trades more on economic fundamentals, the pound should become a more attractive buy, particularly against the euro, given that the U.K. economy should outperform the market's dismal expectations. Recent data supports this view: Average earning growth outperformed expectations in November. GDP growth was 2.2% YoY in Q4, also outperforming expectations. Furthermore, short-term technicals point to a stronger pound. EUR/GBP has broken through its 100-day moving average, which indicates that momentum should continue to drive this cross downwards for the time being. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Two weeks ago, we argued that the rally in AUD lacks fundamental domestic causes. This week, the momentum of the recent AUD rally, caused by rising iron ore and copper prices, has seemingly paused. Exacerbating this change of pace is recent data which indicates a weak economic backdrop: the RBA trimmed mean CPI, and the more common CPI measure, underperformed consensus at both a quarterly and yearly pace. This could be due to depressed consumer sentiment, as the labor market remains mired in a slump, with the unemployment rate increasing to 5.8%, and total hours worked falling. Given recent data, it is likely that markets reprice growth prospects in Australia. U.S. trade policies could also potentially curtail global trade, painting a bearish picture for AUD. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The Kiwi has appreciated 4.4% since the start of 2017. Although this rally might eventually be limited against the U.S. dollar, the NZD will likely have more upside against its crosses, particularly the AUD. Indeed it seems that low inflation, one of the only sore spots for the RBNZ in an otherwise stellar kiwi economy, has turned the corner, surging to 1.3% on the latest reading Wednesday. More importantly, not only did inflation beat expectations but it also surpassed 1% for the first time since 2014. This is a significant development, given that persistently low inflation in New Zealand was keeping the dovish bias of the RBNZ. With this hurdle gone, and an economy that continues to be the best performing in the G10, this dovish bias should disappear, which will ultimately lift the NZD against its crosses. Report Links: Outlook: 2017's Greatest Hits - December 16, 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 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Despite the dissipating oil slump, potential risks may weigh on Canada's future. These risks are likely to emanate from an international sphere. Key concerns revolve around U.S. policies: recent statements have increased yields and tightened financial conditions, but global trade worries are not fully priced in. Recent news indicates that Trump has no ill-intentions aimed at Canada, however, protectionist policies could hurt global trade, indirectly curtailing Canadian exports. A U.S. corporate tax cut can also deviate investment from Canada to the U.S. The recent appreciation in the CAD against major currencies can also hurt Canadian competitiveness going forward. As oil is likely to remain relatively stable in the near future, we may again see a disassociation of CAD with oil, and a continued tight relationship with interest rate spreads. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Yesterday, EUR/CHF fell below the crucial 1.07 level. As we have recommended many times, any time that this cross falls below this threshold, it becomes an excellent buying opportunity. The SNB has not been shy to intervene in the currency markets, and they have been very clear that they will not tolerate any currency strength past a certain threshold as it could add additional deflationary pressures to an economy that has not had a positive inflation rate since 2014. We have identified a level of 1.07 for EUR/CHF as this threshold. Moreover given that the euro is the currency of reference for interventions, the behavior of USD/CHF should roughly mirror the behavior of the dollar against the Euro. Report Links: Outlook: 2017's Greatest Hits - December 16, 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 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Norwegian Krone has rallied along other commodity currencies so far this year, in spite of the meek performance of oil over this timeframe. This surge might prove unsustainable in the short term, as USD/NOK is very close to oversold territory. In the long term, the outlook for the NOK is more positive, particularly against other commodity currencies. Rising oil prices resulting from the OPEC cuts should supercharge the already high inflationary pressures in the Norwegian economy. This factor will eventually push the Norges Bank off its dovish bias, and the NOK higher in the process. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy seems to be finally benefitting from last year's weaker krona; PPI numbers came in at 2.1% MoM, and 6.5% YoY, higher than previous numbers. This will feed into CPI in the near future. Additionally, 1-year, 2-year, as well as the important 5-year Prospera Inflation Expectations have all picked up, with the 5-year at 2%, in line with the Riksbank's target. The bank is aware of the krona's recent strength against major currencies, and realizes that it is important that the appreciation slows. In the short term, the SEK could continue to rally on the back of the dollar's correction and the Swedish economic outperformance vis-à-vis the euro area. Report Links: Outlook: 2017's Greatest Hits - December 16, 2016 One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades