Economic Growth

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

Highlights Duration: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. USTs vs. Bunds: U.S. Treasury yields will remain under upward pressure from a hawkish Fed with the U.S. economy operating at full employment. The opposite is true in Europe, at least until Euro Area inflation is much higher. Stay overweight core Europe versus the U.S. in global hedged bond portfolios Feature Chart of the WeekCan The Bond Selloff Continue? Can The Bond Selloff Continue? Can The Bond Selloff Continue? Last week brought the first serious test of the bond bear phase that has been in place since last July. The 10-year U.S. Treasury yield dipped as low as 2.33% after a benign January U.S. Payrolls report that substantially reduced the odds of a March Fed rate hike. German Bund yields also dipped as renewed worries about the upcoming French election triggered a flight to quality out of French and Peripheral sovereign debt. Even the chartists got in on the act, talking of an imminent breakdown below the "head & shoulders neckline" on the 10-year U.S. Treasury that would herald a 25bp decline in yields. Adding to the growing sense of nervousness among investors is a fear that the "Trumpflation" trade could soon run out of gas, with a correction of both elevated equity prices and bond yields likely in the absence of concrete economic news from the White House. Yet all it took was for Trump to simply mention that a "phenomenal" announcement on his tax plan was coming in the next few weeks to restart the Trump trades, pushing equity indices to new highs and driving up bond yields. Given all the conflicting forces at play in developed bond markets - accelerating growth, rising inflation, fiscal and political uncertainties, bearish bond investor positioning - we believe it is important to stay grounded by focusing only on the most relevant factors while trying to sift out the signal from the noise. This week, we are introducing a new "Duration Checklist" for both U.S. Treasuries and German Bunds, highlighting the key economic and market indicators that we are watching to assess whether we should maintain our current below-benchmark portfolio duration stance. From this checklist, we can confirm that the bond-bearish backdrop remains intact, with more indicators pointing to higher yields in the U.S. relative to core Europe. Describing The Elements Of Our Checklist The individual components of bond yields that we typically monitor - term premia, inflation expectations and shifts in the market-implied path of policy rates - have all contributed to the rise in U.S. and European bond yields since last July (Chart of the Week). Some of the factors that have driven yields higher are global in nature, like faster economic growth and rising energy prices, while others are more country-specific, like rising wage inflation in the U.S. To account for those different factors, we need to include a variety of indicators in our new GFIS Duration Checklist. The goal of list is to answer the specific question: "what should we watch to maintain a below-benchmark duration stance in the U.S. and core Europe?" The items in the Checklist are shown in Table 1, broken down into the following groupings: Table 1Stay Bearish On Treasuries & Bunds A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Accelerating Global Growth: Here, we are looking at indicators that are pointing to a quickening pace of global economic growth that would put upward pressure on all developed market bond yields. Specifically, we are looking to see if: a) the annual growth in the global leading economic indicator (LEI) is accelerating; b) our diffusion index for the global LEI is above 50 (suggesting a majority of countries with an expanding LEI) and rising; c) the global ZEW economic sentiment index is increasing; d) the global data surprise index is moving higher; and e) our measure of the global credit impulse (the 6-month change in credit growth among the major economies, one of BCA's favorite leading economic signals) is expanding. These global indicators are all shown in Chart 2. The global LEI growth rate, the global ZEW index and global data surprises are all moving higher, consistent with upward pressure on bond yields, and thus warrant a "check" in our GFIS Duration Checklist. The LEI diffusion index is well above 50, but has hooked down slightly in the past few months, as has the global credit impulse. These moves are relatively modest, and it is not yet certain whether they represent a change in trend in these series. For now, we are giving these indicators a "check", but with a question mark attached. If we see additional declines in the diffusion index and the global credit impulse in the next few months, we would interpret that as a sign that the cyclical global upturn is in danger of losing momentum, thus reducing the upward pressure on bond yields. Accelerating Domestic Growth: These are economic data that are specific to each country that would be consistent with higher yields; a) manufacturing purchasing managers' indices (PMIs) that are above 50 and rising; b) expanding consumer confidence; c) rising business confidence; d) faster growth in corporate profits. The relevant data for the U.S. are shown in Chart 3, which shows that all elements are increasing in a fashion that is bearish for U.S. Treasuries. The popular perception is that the recent surge in business confidence (both for corporate CEOs and small business owners) is simply a "Trump effect" from the new president's pro-business economic platform. However, the acceleration in corporate profit growth, which our own models are suggesting will continue in the coming quarters, is a sign that there is a more fundamental reason for firms to feel more optimistic. Chart 2Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Global Growth Still Pointing To Higher Yields Chart 3U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid U.S. Domestic Upturn Is Solid We give all the U.S. domestic growth indicators a "check" pointing to a need to stay below-benchmark U.S. duration. The specific Euro Area growth data is shown in Chart 4. Similar to the U.S., all the indicators are moving higher in a bond-bearish direction, warranting a "check" on the Euro Area Duration Checklist. The political tensions stemming from the busy election calendar in Europe this year represent a potential negative shock to confidence. As we discussed in our Special Report published last week, however, we do not foresee a populist election shock in France akin to Brexit or Trump that would derail the Euro Area economic expansion.1 Rising Domestic Inflation Pressures: These are data that are specific to each country that would be consistent with faster inflation and higher yields: a) the annual growth in the oil price, in local currency terms, is accelerating; b) wage inflation is rising; c) the unemployment gap (the difference between the unemployment rate and the full employment NAIRU rate) is closed or nearly closed; The U.S. inflation data is shown in Chart 5, with all the indicators warranting a bond-bearish "check" in our U.S. Duration Checklist. The rising trend in oil prices continues to put upward pressure on headline U.S. inflation, even with the strong U.S. dollar. Meanwhile, the unemployment gap is now closed and U.S. wage inflation is grinding higher. This should be consistent with additional modest gains in core inflation that will put upward pressure on the inflation expectations component of U.S. Treasury yields (bottom panel). Chart 4Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Euro Area Domestic Upturn Is Solid Chart 5U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs U.S. Inflation Trends Still Bearish For USTs It is a different story in the Euro Area, as can be seen in Chart 6. While the rapid acceleration in the Euro-denominated price of oil is starting to feed through into faster headline inflation, there still exists a positive unemployment gap that is helping keep wage growth, and core inflation, muted. A continuation of the recent economic upturn will likely put more downward pressure on Euro Area unemployment, but, for now, only the oil price acceleration justifies a "check" in the Euro Area Duration Checklist. Chart 6Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Euro Area Inflation Is A Mixed Bag Central Bank Policy Stance: Here, we are not including any charts, but are only stating whether the central bank has a bias to tighten monetary policy. That is certainly the case in the U.S., where the Fed has already delivered a 25bp hike in December and continues to signal that up to three more hikes will occur in 2017 if the FOMC growth forecasts are realized. So we put a "check" in this box on the U.S. side of the checklist. The European Central Bank (ECB) continues to maintain an unusually accommodative monetary stance, using a combination of asset purchases, negative policy rates and dovish forward guidance. We continue to see a potential shift away from this super-easy policy bias in the latter half of the year - in response to the upturn in economic growth and acceleration of Euro Area inflation towards the ECB's 2% target - as the biggest risk for both Euro Area bonds, in particular, and global bonds, in general. For now, however, the ECB is signaling no imminent shift to a more hawkish stance, so we are placing an "x" in the central bank portion of the Euro Area checklist. Risk-Seeking Behavior In Financial Markets: Here, we are checking to see if pro-growth, pro-risk asset classes are outperforming and whether market volatilities are rising. Risk asset outperformance and stable vol suggests that investors are less interested in risk-free government bonds: a) the domestic equity index is rising but is not yet 10% above the 200-day moving average (a level that has coincided with post-crisis equity market and bond yield peaks); b) domestic corporate bond spreads are either flat or falling rapidly; c) domestic equity market volatility is low and falling rapidly. The U.S. indicators are shown in Chart 7, while the Euro Area data is shown in Chart 8. The story is the same in both regions, with equity markets in a bullish trend but not yet at a fully-stretched extreme, credit spreads (both for Investment Grade and High-Yield) tight, and equity market volatility at multi-year lows. We view these indicators as signs that investors are less interested in owning U.S. Treasuries and German Bunds than owning equities and corporate debt. This will help bond yields drift higher on the margin as economic growth and inflation rise in the coming months. Thus, we place a "check" on all three elements in both the U.S. and Euro Area Duration Checklists. Chart 7Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Risk-Seeking Behavior In The U.S. Chart 8Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Risk-Seeking Behavior In Europe Contrarians may look at those same charts and say that this is more of a sign that investors are too optimistic and are now exposed to any negative growth shock, potentially representing a trigger for a selloff of risk assets and a move into government debt. We prefer to view the bullish performance of growth-sensitive assets as a sign of underlying investor risk appetite. Domestic Bond Market Technicals: Here, we are simply looking at measures of price momentum and market positioning in government bonds, to assess if there is room for additional yield increases as investors reduce exposure: a) the domestic 10-year bond yield is not stretched to the upside versus the 200-day moving average; b) the domestic Treasury index total return momentum (26-week rate of change) is not stretched to the downside; c) bond investor positioning is not already short. The 10-year U.S. Treasury technicals are shown in Chart 9, while the German Bund technicals are shown in Chart 10. The story is quite simple here - the rapid run-up in global bond yields late last year has led to stretched, oversold conditions on both sides of the Atlantic. Sentiment remains bearish in U.S. Treasuries, with massive net shorts in bond futures, suggesting that an overhang of positions remains a major headwind to higher yields. While we do not have positioning data for Euro Area bond investors, the momentum charts for German Bunds look very similar to the U.S. Treasury charts. Clearly, we must place an "x" in all these boxes on both Duration Checklists. Chart 9Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Stretched Technicals In U.S. Treasuries... Chart 10...And In German Bunds ...And In German Bunds ...And In German Bunds So What Are The Checklists Telling Us? Adding it all up, and the vast majority of the indicators in both checklists are pointing to continued upward pressure on bond yields, justifying a below-benchmark duration stance. The lack of core inflation pressure in the Euro Area, however, suggests that there is less upward pressure on German Bund yields relative to U.S. Treasuries, thus we continue to recommend an overweight stance on Bunds versus Treasuries in global hedged bond portfolios. Oversold conditions suggest that yields will have a tough time rising quickly from here while the market continues to consolidate the late 2016 bond selloff. However, a major bond market reversal is unlikely given the solid upturn in global growth. Bottom Line: Growth, inflation & investor risk-seeking behavior remain bond-bearish in both the U.S. & the Euro Area. Market technicals, both in terms of oversold momentum and heavy short positioning, are the biggest headwind to higher yields in the near-term. Maintain a below-benchmark portfolio duration stance in the near term, favoring German Bunds over U.S. Treasuries. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Our View On French Government Bonds", dated February 7, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Duration Checklist For U.S. Treasuries & German Bunds A Duration Checklist For U.S. Treasuries & German Bunds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Chart I-1No Recovery In Domestic Demand A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Feature Today we are publishing charts on cyclical economic conditions within developing economies. The aim of this report is to aid investors in gauging the business cycle profiles of these individual emerging economies. Global trade and manufacturing have recovered, driven by an acceleration in U.S. and euro area demand. Chinese imports have also recovered, supporting global trade amelioration. Although there has been improvement in EM manufacturing PMIs (diffusion indexes), "hard" EM economic data have not recovered (Chart I-1). This is especially true for EM domestic demand measures such as consumer spending and real gross fixed capital formation. Given the still-lingering credit excesses in many EM countries, credit growth is likely to decelerate further, leaving little chance of domestic demand recovering. Bottom Line: Continue underweighting EM equities and credit markets versus their DM peers. China Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 Chart I-2C2 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-3C3 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-4C4 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-5C5 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-6C6 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-7C7 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Korea Chart I-8, Chart I-9, Chart I-10, Chart I-11 Chart I-8C8 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-9C9 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-10C10 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-11C11 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Taiwan Chart I-12, Chart I-13 Chart I-12C12 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-13C13 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies India Chart I-14, Chart I-15, Chart I-16, Chart I-17 Chart I-14C14 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-15C15 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-16C16 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-17C17 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Indonesia Chart I-18, Chart I-19 Chart I-18C18 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-19C19 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Malaysia Chart I-20, Chart I-21 Chart I-20C20 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-21C21 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Thailand Chart I-22, Chart I-23, Chart I-24 Chart I-22C22 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-24C24 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-23C23 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Philippines Chart I-25, Chart I-26 Chart I-25C25 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-26C26 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Brazil Chart I-27, Chart I-28, Chart I-29, Chart I-30, Chart I-31, Chart I-32 Chart I-27C27 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-28C28 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-29C29 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-30C30 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-31C31 C31 C31 Chart I-32C32 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Mexico Chart I-33, Chart I-34, Chart I-35, Chart I-36, Chart I-37 Chart I-33C33 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-34C34 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-35C35 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-36C36 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-37C37 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Colombia Chart I-38, Chart I-39, Chart I-40, Chart I-41 Chart I-38C38 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-39C39 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-40C40 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-41C41 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Peru Chart I-42, Chart I-43, Chart I-44 Chart I-42C42 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-43C43 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-44C44 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chile Chart I-45, Chart I-46, Chart I-47, Chart I-48 Chart I-45C45 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-46C46 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-47C47 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-48C48 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Argentina Chart I-49, Chart I-50, Chart I-51, Chart I-52, Chart I-53 Chart I-49C49 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-50C50 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-51C51 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-52C52 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-53C53 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Russia Chart I-54, Chart I-55 Chart I-54C54 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-55C55 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Turkey Chart I-56, Chart I-57, Chart I-58, Chart I-59 Chart I-56C56 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-57C57 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-58C58 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-59C59 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies South Africa Chart I-60, Chart I-61, Chart I-62, Chart I-63 Chart I-60C60 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-61C61 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-62C62 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-63C63 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Central Europe Chart I-64, Chart I-65 Chart I-64C64 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Chart I-65C65 A Cyclical Growth Profile Of EM Economies A Cyclical Growth Profile Of EM Economies Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Rate Volatility: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Treasury Yields: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. MBS: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Feature Low interest rate volatility has been a constant feature of the investing landscape during the past few years. In fact, you need to go back to the 1970s to find another period when interest rate volatility was consistently at or below its current level (Chart 1). Not surprisingly, the implied volatility priced into Treasury options is also as low as it has been during the past 30 years, with the exception of the period just prior to the financial crisis in 2007 (Chart 2). Chart 1Yield Volatility: Lowest Since The 70s Yield Volatility: Lowest Since The 70s Yield Volatility: Lowest Since The 70s Chart 2Implied And Realized Yield Volatility Move Together Implied And Realized Yield Volatility Move Together Implied And Realized Yield Volatility Move Together This begs the question of whether the current low-vol environment can be sustained, or whether overly complacent investors are in for a shock. At the very least, we believe that rate volatility has already passed its cyclical trough and will start to move up this year. Investors should prepare themselves for higher volatility. In this week's report we examine the key macro drivers of interest rate volatility and discuss the implications of rising vol for both Treasury yields, and crucially, mortgage-backed securities. Macro Uncertainty & Rate Volatility Chart 3Macro Drivers Of Rate Volatility Macro Drivers Of Rate Volatility Macro Drivers Of Rate Volatility In a Special Report published in 2014,1 we posited that the long-term trends in volatility across all asset classes are largely driven by common macroeconomic factors. Specifically, investor uncertainty regarding the outlook for economic growth and monetary policy. A 2004 paper by Alexander David and Pietro Veronesi2 provides some theoretical justification for this view, as the authors observed that investors tend to overreact to new information when macro uncertainty is high, and underreact when uncertainty is low. To test the linkage between interest rate volatility and macro uncertainty we consider three measures of uncertainty. The first two measures, shown alongside the MOVE index of implied Treasury volatility in Chart 3, are measures of GDP growth and T-bill rate forecast dispersion. We measure dispersion - the disagreement among forecasters - by looking at individual forecasts of GDP growth and T-bill rates and calculating the difference between the 75th and 25th percentiles. The series shown in Chart 3 are equal-weighted averages of the forecast dispersion calculated for five different time horizons, ranging from the current quarter to four quarters ahead. As can be seen in the top two panels of Chart 3, implied interest rate volatility is higher when the disagreement among forecasters is greater, consistent with our thesis. The third measure of uncertainty we consider is the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index tracks uncertainty about the macro environment by counting the number of mentions of certain key words in major global newspapers. Elevated readings from this index have also coincided with high rate volatility in the past (Chart 3, bottom panel). GDP Growth Forecast Dispersion Chart 4Forecast Dispersion & Corporate Lending Forecast Dispersion & Corporate Lending Forecast Dispersion & Corporate Lending Disagreement among GDP growth forecasts reached an all-time low in the fourth quarter of 2016, but has since recovered to slightly more typical levels. Historically, we have found that C&I lending standards and corporate sector balance sheet health correlate most closely with GDP growth forecast dispersion (Chart 4) and both measures suggest that forecast dispersion is biased upward. T-Bill Rate Forecast Dispersion T-bill rate forecast dispersion was abnormally low between 2011 and 2014 for two reasons. The first reason is quite simply the zero-lower-bound on interest rates. A short rate bounded at zero necessarily trimmed the distribution of possible T-bill rate forecasts, since forecasters logically assumed that further interest rate cuts were not possible. This impact will gradually dissipate the further the fed funds rate moves off zero. Chart 5Fed Says March Meeting Is Live Fed Says March Meeting Is Live Fed Says March Meeting Is Live The second reason for extremely low T-bill rate forecast dispersion was the Fed's forward guidance. During this timeframe the Fed was actively trying to convince the public that interest rates would remain low. The most obvious example being the "Evans Rule", where the Fed promised not to lift interest rates at least until the unemployment rate had fallen below a specific threshold. This activist forward guidance limited the range of conceivable T-bill rate forecasts and crushed interest rate volatility. Nowadays, the Fed is engaged in a different sort of forward guidance, trying to convince markets that every FOMC meeting is live and that rate hikes could occur at any moment. Essentially, the Fed is trying to inject volatility into the rates market. Just a few weeks ago, when asked about the low probability markets are assigning to a March rate hike (Chart 5), San Francisco Fed President John Williams replied flatly: "I don't agree. All our meetings are live." Global Economic Policy Uncertainty We have written a lot about the policy uncertainty index in recent reports,4 focusing specifically on how it has diverged from its historical relationships with many asset prices. At the very least, we expect that sustained elevated policy uncertainty will place upward pressure on asset price volatility at the margin. Bottom Line: Forecast disagreement about GDP growth and T-bill rates will increase over the course of the year. This, alongside elevated policy uncertainty, will translate into higher interest rate volatility. Rate Volatility & Treasury Yields Long-dated nominal Treasury yields can be decomposed in a few different ways. In recent reports we have focused on the decomposition of the nominal 10-year Treasury yield into its real and inflation components. By identifying different macro drivers for each component we concluded that nominal Treasury yields will increase this year, driven by a rising inflation component and relatively stable real yields.5 Alternatively, we can think of the nominal 10-year Treasury yield as consisting of an expectations component equal to the market's expected path of short rates over the next ten years, and a term premium that reflects all of the other market imbalances and uncertainties associated with taking duration risk. This second approach is complicated by the fact that it requires a model of ex-ante interest rate expectations and every commonly used model is fraught with its own unique difficulties.6 Setting that aside, if we use the Kim & Wright (2005)7 estimate of the 10-year term premium we observe an expectations component that generally tracks the fed funds rate and a term premium component that is correlated with implied Treasury volatility (Chart 6), although the latter correlation is less than perfect. This decomposition also suggests that nominal Treasury yields should rise. The Fed is much more likely to hike rates than cut them and we have concluded that rate volatility is likely to trend higher from current depressed levels. However, the relationship between rate volatility and the term premium is complicated. The main reason for the complicated relationship between interest rate volatility and the term premium is the fact that elevated interest rate volatility also tends to be correlated with high equity volatility (Chart 7). So while higher rate volatility puts upward pressure on the term premium, the associated increase in equity volatility tends to raise investor risk aversion and increase the perceived value of bonds as a hedge against equity positions. This mitigates some (or often all) of the impact of rising rate volatility on the term premium. Chart 6Which Way For The ##br##Term Premium? Which Way For The Term Premium? Which Way For The Term Premium? Chart 7MOVE & VIX Have Opposing##br## Impacts On Bond Yields MOVE & VIX Have Opposing Impacts On Bond Yields MOVE & VIX Have Opposing Impacts On Bond Yields Bottom Line: Higher rate volatility should cause the term premium in the Treasury curve to increase at the margin. However, this impact could be offset if rate volatility and equity volatility rise in concert. An increase in equity vol would encourage flight-to-safety flows into bonds. Rate Volatility & MBS The relationship between rate volatility and MBS is much more straightforward than for Treasury yields. We observe a tight correlation between nominal MBS spreads and the MOVE implied volatility index (Chart 8). Chart 8 suggests that, even in the near-term, MBS spreads are too low for current levels of rate vol. The relationship between MBS spreads and rate volatility is easily explained. The defining characteristic of a negatively convex asset, such as MBS, is that its duration is positively correlated with the level of interest rates (Chart 9). This correlation leads to increased losses when yields rise and lower gains when yields fall. It's not surprising that negatively convex assets perform best in low volatility environments. Chart 8MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol MBS Spreads Are Linked To Vol Chart 9MBS Duration Moves With Yields MBS Duration Moves With Yields MBS Duration Moves With Yields We maintain an underweight allocation to MBS given that spreads are already low and that the volatility environment is poised to become less favorable. Further, if the Fed continues along its planned normalization path it is likely to cease the reinvestment of its MBS portfolio at some point in 2018. There are two reasons why this poses a risk for MBS. The first reason is that the unwinding of the Fed's MBS portfolio is likely to place upward pressure on implied volatility. While private investors often hedge their MBS positions by purchasing volatility, the Fed has no incentive to do so. It follows that by removing a large stock of MBS from private hands the Fed has also removed a large source of demand for volatility. When this supply is re-introduced into the market, demand for volatility is likely to increase. The second reason relates more directly to the supply and demand balance for MBS. In years when net MBS issuance (adjusted for Fed purchases) has been negative, excess MBS returns have tended to be positive (Chart 10). Further, while negative net MBS issuance (adjusted for Fed purchases) has been the norm since Fed asset purchases began in 2009 (Chart 11), this state of affairs will change once the Fed starts to unwind its MBS portfolio. Chart 10Annual MBS Excess Returns ##br## Vs. Net Supply Since 1989 The Road To Higher Vol Is Paved With Uncertainty The Road To Higher Vol Is Paved With Uncertainty Chart 11Net Issuance Will Turn##br## Positive In 2018 Net Issuance Will Turn Positive In 2018 Net Issuance Will Turn Positive In 2018 During the past three years the Fed has been buying between $20bn and $40bn MBS per month, just to keep its balance sheet stable. Net new MBS issuance will not be strong enough to overcome this hurdle in 2017, but net MBS issuance (adjusted for Fed purchases) will swing quickly into positive territory in 2018 if the Fed decides to let its MBS portfolio run down. Bottom Line: Higher interest rate volatility and the unwinding of the Fed's mortgage portfolio will lead to wider MBS spreads during the next two years. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, "Volatility, Uncertainty And Government Bond Yields", dated May 13, 2014, available at usbs.bcaresearch.com 2 "Inflation and earnings uncertainty and volatility forecasts", Alexander David and Pietro Veronesi, Manuscript, Graduate School of Business, University of Chicago (2004). 3 Please see www.policyuncertainty.com for further details. 4 Please see Theme # 4 in U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Is It Time To Cut Duration?", dated January 17, 2017, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, "Bond Volatility - The Unwelcome Guest That Will Not Leave", dated June 16, 2015, available at usbs.bcaresearch.com 7 Don H. Kim and Jonathan H. Wright, "An Arbitrage-Free Term Structure Model and the Recent Behavior of Long-Term Yields and Distant-Horizon Forward Rates", FEDS 2005-33. https://www.federalreserve.gov/econresdata/feds/2005/index.htm Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Brazilian growth will recover modestly in 2017, but it will be insufficient to stabilize the public debt-to-GDP ratio. With interest rates still at double digits, public debt dynamics will become unsustainable as the ratio reaches or surpasses 85-90% of GDP over the next couple of years. The central bank has been financing the government by buying local currency bonds. Going forward, the path of least resistance, and most likely scenario, is direct or indirect public debt monetization by the central bank of Brazil. This will allow the nation to avoid fiscal stress/crisis but the price for it will be large exchange rate depreciation. In the end, investors will lose capital in Brazilian financial markets in U.S. dollar terms. Feature Brazil's financial markets have rallied sharply over the past 12 months, even as the economy has continued to disappoint. Growth has fallen short of even our downbeat expectations, yet the tremendous rally in its financial markets had sent our bearish strategy wide of the mark. In the past year, we have argued that even if the Brazilian economy recovers, it is likely headed towards a public debt trap because the recovery will be muted and the starting point of fiscal accounts/government debt is already quite poor. So, has Brazil achieved escape velocity - i.e., has growth gained enough momentum to thwart concerns about public debt sustainability? Escape Velocity Chart I-1Despite A Strengthening Global Economy, ##br##Brazilian Growth Is Relapsing Despite A Strengthening Global Economy, Brazilian Growth Is Relapsing Despite A Strengthening Global Economy, Brazilian Growth Is Relapsing It is tempting to conclude that the rally in Brazilian markets has been so powerful that the country has broken away from its five-year bear market, and hence that public debt sustainability is not an issue at all. In other words, financial markets seem confident that Brazil has achieved escape velocity. We do not think so. Notably, in recent months Brazil's economy has surprised to the downside, despite the ongoing improvement in global growth: Brazil's manufacturing PMI overall index has rolled over decisively, despite broad-based strength in the global business cycle (Chart I-1). More importantly, export prices in general, and iron ore and soybean prices in particular, have rallied a lot in the past year. Hence, the external sector has been a positive force for the economy, yet the latter has failed to revive. Having appreciated dramatically, the currency is no longer cheap. This is confirmed within Brazil's trade dynamics since export volumes are slipping relative to import volumes. As fiscal spending growth has until now been decent, the epicenter of the retrenchment has clearly been household consumption and business investment (Chart I-2 and Chart I-3). Chart I-2Brazilian Households Are ##br##Still Feeling Massive Pain... Brazilian Households Are Still Feeling Massive Pain... Brazilian Households Are Still Feeling Massive Pain... Chart I-3...As Is The ##br##Business Sector ...As Is The Business Sector ...As Is The Business Sector Household debt-service costs remain elevated at 22% of disposable income (Chart I-4). This, and ongoing job losses, are keeping a lid on consumer spending. Manufacturing production is still collapsing, and capacity utilization is at a 20-year low (Chart I-3, bottom panel). This is not a sign of a competitive exchange rate or vibrant manufacturing sector. Due to the economic contraction, Brazil's primary and overall fiscal deficits have reached 2.5% and 8.9% of GDP (Chart I-5), respectively, despite the authorities' attempts to secure considerable one-off revenues. Chart I-4Brazil: Elevated Household Indebtedness ##br##Will Prevent A Consumption Rebound Brazil: Elevated Household Indebtedness Will Prevent A Consumption Rebound Brazil: Elevated Household Indebtedness Will Prevent A Consumption Rebound Chart I-5Brazil's Fiscal Accounts Brazil's Fiscal Accounts Brazil's Fiscal Accounts Remarkably, the level of Brazil's real GDP has already contracted by 7.6% from its peak in 2014, producing the worst depression in more than 116 years (Chart I-6). Bottom Line: Not only has Brazil failed to achieve escape velocity, but also its growth dynamics have underwhelmed even the most pessimistic of forecasts. As a result, public debt dynamics have become unsustainable. Fiscal And Credit Impulses In 2017 Going forward the outlook for Brazil's economy will hinge on credit and fiscal impulses: If government spending rises by 6.3% in 2017, which is equivalent to the 2016 IPCA inflation rate as mandated by the fiscal spending cap (known as PEC 55), the federal fiscal spending impulse in 2017 will be 79 billion BRL, or 1.23% of GDP (calculated using our 2017 nominal GDP estimate) (Chart I-7, top panel). Chart I-6Brazil's Worst Recession In 116 Years Brazil's Worst Recession In 116 Years Brazil's Worst Recession In 116 Years Chart I-7Fiscal And Credit Impulses Fiscal And Credit Impulses Fiscal And Credit Impulses The impact of fiscal policy on growth is defined by government spending and taxes. Odds are that taxes need to be hiked to achieve the 2017 budget targets. Unless growth recovers strongly, doubtful in our view, there are non-trivial odds of impending tax hikes. The latter will counteract the positive fiscal impulse from government expenditures. The credit impulse is calculated as an annual change in credit growth, or the second derivative of the outstanding stock of credit. If we assume private and public banks' credit growth will be 0% and -5%, respectively, in 2017 overall loan growth will contract by 2.5%, and the credit impulse will be 0.54% of GDP (Chart I-7, middle panel). Even though interest rates are declining, real (inflation-adjusted) rates remain high at 5.4%, and banks' balance sheets are impaired by mushrooming NPLs following the credit boom years. This will preclude a revival in loan growth in the banking system. Aggregating the fiscal spending and credit impulses together, there will be about a 2% boost to nominal GDP growth in 2017 (Chart I-7, bottom panel). However, as it is likely that taxes will rise, the overall combined effect on the economy will be less than that. Bottom Line: Odds are that the aggregate fiscal and credit impulse will be only mildly positive in 2017 - assuming no tax hikes. This portends only moderate nominal GDP growth in 2017. Government Debt Simulation Revisited The Brazilian economy will probably recover and our baseline view assumes real GDP growth will be modestly positive for 2017. However, the recovery will not be vigorous enough to halt the exponential rise in the public debt-to-GDP ratio. Table I-1 presents a scenario analysis for Brazil's public debt. Table I-1Brazil: Public Debt Sustainability Scenarios 2016-2019 Has Brazil Achieved Escape Velocity? Has Brazil Achieved Escape Velocity? We considered three scenarios: base case, optimistic and pessimistic. For each scenario, we have made assumptions for nominal GDP growth, nominal government revenue growth, nominal government expenditure growth (based on the fiscal spending cap), and on the average (or blended) interest rate on all local currency public debt. Chart I-8Brazil's Is Headed Towards ##br##A Public Debt Crisis Brazil's Is Headed Towards A Public Debt Crisis Brazil's Is Headed Towards A Public Debt Crisis In our base case scenario, the public debt-to-GDP ratio reaches 84% in 2018 and 91% in 2019 (Chart I-8). With double-digit interest rates, the 91% public debt load spirals out of control. In short, even in our base case scenario, which assumes a return to modest growth in 2017 and a decent recovery in economic activity in 2018 and 2019, Brazil is unlikely to avoid a debt trap. For the base case, we use the following assumptions For nominal GDP growth in 2017 we use the most recent Brazilian Central Bank Survey year-end forecast of real GDP growth of 0.5% plus our estimate of 5% inflation to arrive at 5.5%. In 2018, we assume real GDP growth of 2.5% plus 4.5% inflation to arrive at 7%. And in 2019 we also assume growth of 7%. For nominal government revenue growth, we use 5% in 2017 and 8% for both 2018 and 2019, as we assume government revenue reasonably tracks nominal GDP growth. A caveat: the actual 2016 federal government revenue growth number of 4.3% was heavily boosted by non-recurring revenues such as privatization revenue, repayment by the national development bank (BNDES) of 100 billion BRL, tax amnesty/repatriation programs, and so on. In brief, the government used all means at its disposal to boost its revenue via one-off items. As these are non-recurring and impossible to predict, we did not attempt to account for them. Yet, in future, these non-recurring sources of fiscal revenue will be harder to come by. To be consistent, we do not incorporate one-off expenditures, such as financial support for local governments, or recapitalization of public banks and state-owned companies. In a nutshell, we assume potential one-off public sector revenues will offset one-off expenditures. With the dire state of the economy, and likely need for bailouts and financial assistance from the federal government, this is a reasonable assumption. Besides, with most states and local governments near bankruptcy, staving off insolvency remains a much more urgent matter that will likely drain central government coffers in the near term. As to nominal government expenditures, since these are capped by the previous year's inflation rate due to the fiscal spending cap (or PEC 55), we use 6.3% growth in 2017 (i.e. 2016 IPCA inflation), and 5% in both 2018 and 2019, respectively. Investors, however, should keep in mind that the spending cap only applies to primary expenditures. Critically, it does not include interest on public debt, spending on education and health in 2017, and nonrecurring expenditures. If anything, federal government spending will likely exceed the 2017 cap as the government may spend more on healthcare and education to offset overall fiscal austerity. Table I-2Composition Of Brazilian Federal Debt Has Brazil Achieved Escape Velocity? Has Brazil Achieved Escape Velocity? For the average, or blended, interest rate on public debt, we used calculations by Dr. Jose Carlos Faria, Chief Brazil Economist at Deutsche Bank.1 We use Dr. Faria's assumptions for local currency average interest rate on public debt in 2017, 2018 and 2019, for our pessimistic scenario. The impact of lower policy interest rates (i.e. the central bank's SELIC rate) on the public debt service is a drawn out process because not all debt is rolled/re-priced over every year. Table I-2 illustrates the breakdown of Brazil's public debt by type. Therefore, the impact of declining interest rates on public debt dynamics will be slow. Bottom Line: With interest rates still in the double digits, Brazil's public debt dynamics will become unsustainable if the ratio reaches or surpasses 85-90% of GDP. The odds are substantial that this limit will be breached in the next few years. The best cure for debt sustainability is growth. So far, however, Brazil has failed to achieve growth strong enough to stabilize its public debt trajectory. A Word On Social Security Reform It is widely accepted that pension (social security) reform is desperately needed to help keep Brazil's public debt on a sustainable path. It does appear that reforms will be passed this year, as they have good momentum in Congress. That said, it will take many years for the positives of pension reforms to kick in and help the fiscal accounts, and in turn improve Brazil's public debt profile. According to the IMF,2 it will take roughly until 2020-2025 to see any decrease in social security expenses as a percentage of GDP, even if the reforms involve an increase in the retirement age, a benefits freeze, and a removal or change of the indexation of pensions to the minimum wage (and/or a change to the minimum wage formula). Bottom Line: The benefits of social security reform will only come into effect after 2020-30 or so, if passed in full. Therefore, they will not prevent Brazil's public debt-to-GDP ratio from surpassing the 85-90% mark in 2019. A Way Out: Debt Monetization? Chart I-9Brazil's Central Bank Has Been ##br##Expanding Its Local Currency Assets Brazil's Central Bank Has Been Expanding Its Local Currency Assets Brazil's Central Bank Has Been Expanding Its Local Currency Assets Being strangled by economic contraction, high debt/fiscal deficits, and a lack of political capital to embark on painful fiscal austerity, the path of least resistance for any country in general and Brazil in particular is debt monetization. That would lead to a considerable exchange rate depreciation. There are already hints that the central bank has been funding the government since 2014. In particular: The Brazilian central bank's domestic currency assets have expanded dramatically - by 640 BRL billion, or 10% of GDP - since January 2015 (Chart I-9). Most of this balance sheet expansion - 460 BRL billion or 7% GDP has been due to the rise in the central bank's holdings of federal government securities (Chart I-10). On the liability side of the central bank's balance sheet, a considerable rise has occurred in Banco Central do Brasil repos with commercial banks and deposits received from financial institutions. The amount of outstanding repos and these deposits has risen by 220 BRL billion since January 2015 (Chart I-11). Chart I-10The Central Bank Has Been ##br##Accumulating A Lot Of Public Debt... The Central Bank Has Been Accumulating A Lot Of Public Debt... The Central Bank Has Been Accumulating A Lot Of Public Debt... Chart I-11....But Withdrawing Liquidity Via ##br##Repos & Deposits Received ...But Withdrawing Liquidity Via Repos & Deposits Received ...But Withdrawing Liquidity Via Repos & Deposits Received Essentially, the central bank has purchased 460 BRL billion of government securities since January 2015 and, hence, injected a lot of liquidity into the banking system. Then, Banco Central do Brasil simultaneously withdrew liquidity via repo agreements and deposits received from financial institutions. This has basically sterilized half of the central bank's government bond purchases, i.e. the operation withdrew half of the liquidity expansion that was first made. Without the central bank intervention to buy 460 BRL billion of government securities in the past two years, the 626 BRL billion and 557 BRL billion overall fiscal deficits in 2015 and 2016, respectively, would not have been financed and local bond yields would have risen. Chart I-12The BRL Is Expensive Again The BRL Is Expensive Again The BRL Is Expensive Again Looking ahead, as the fiscal accounts continue bleeding, public debt burden will rise to around 85% of GDP and the banking system - wounded by non-performing loans - will struggle to expand its balance sheet further. In turn, the central bank might be tempted to continue monetizing the government's debt without, however, sterilizing its operations. In such a scenario, the currency will depreciate meaningfully. Markedly, Brazil's real effective exchange rate has risen above its historical mean and is somewhat expensive (Chart I-12). Brazil needs lower interest rates, more abundant banking system liquidity and a cheaper currency to embark on a sustainable recovery. The latter is required to avoid the fiscal debt trap. The exchange rate depreciation is an important relieve valve. Given that only 4% of government debt is denominated in foreign currency, a deprecation of the Brazilian real is the least painful solution. Bottom Line: Going forward, the only way for Brazil to stabilize the public debt-to-GDP ratio is to boost nominal GDP growth. This can be achieved by reducing interest rates aggressively, injecting large amounts of liquidity into the wounded banking system and devaluing the currency. Unless financial markets in Brazil sell off, there is a non-trivial probability that the authorities will embark on outright or covered public debt monetization. This would allow the country to avoid fiscal stress/crisis. Yet, the price will be large exchange rate depreciation. Chart I-13Stay Underweight Brazil ##br##Versus The EM Equity Benchmark Stay Underweight Brazil Versus The EM Equity Benchmark Stay Underweight Brazil Versus The EM Equity Benchmark Investment Implications We have been wrong on Brazilian markets in the past 12 months, but we do not see a reason to alter our view. The currency will plunge due to the ongoing debt monetization, and foreigners will not make money in Brazilian financial markets in U.S. dollar terms. We reiterate our short positions in the BRL versus the U.S. dollar, ARS and MXN. Stay long CDS and underweight Brazilian credit within EM sovereign and corporate credit portfolios. Continue underweighting this bourse within an EM equity portfolio (Chart I-13). Interest rate cuts will continue, but with the BRL set to depreciate considerably versus the U.S. dollar in the next 12 months - as we expect - buying local bonds for the U.S. dollar based investors is not the best strategy. Santiago E. Gomez, Associate Vice President santiago@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 These figures come from the appendix on page 9 of the Deutsche Bank report titled, "Brazil at a Debt Crossroad - Again", dated January 23, 2017. 2 Please refer to the following IMF report on Brazil, available at http://www.imf.org/external/pubs/ft/scr/2016/cr16349.pdf Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights In this report, we outline our tactical, cyclical and long term views on French government bonds, linked to France's political situation, cyclical dynamics, and structural outlook. Tactical View: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds. Cyclical View: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Secular View: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Feature Chart 1Fade The France Spread Widening Fade The France Spread Widening Fade The France Spread Widening After the stunning political victories in the U.K. and U.S. last year, there has been considerable speculation as to which country will fall next to the "populist wave." With a major political party aiming to take the country out of the Euro Area, France has naturally popped up on investors' radar screens. While it is easy to draw a parallel from Brexit to Trump to a possible "Frexit", the political and economic realities in France are very different from those in the U.K. and U.S. The upcoming presidential election will not provide a similar surprise, but could impact the economy's long trajectory. Meanwhile, this economy should beat expectations in the next twelve months. In this Special Report, we lay out our views on France from a political, cyclical and structural perspective and introduce two French bond trade ideas to benefit in the short and medium term. Tactical View: No Political Shocker Ahead In the short term (3-6 months), the domestic political landscape will dictate a large part of France's bond market price action leading up to the two-round French presidential election in April and May. Lately, political uncertainty surrounding the election has had a clear negative impact on French government bond yields (Chart 1). The spread between the benchmark 10-year French OAT and German Bund has widened 46bps off of the 2016 lows and is now close to levels seen during the Global Financial Crisis in 2008-9. The spread is still well below the wides seen during the European debt crisis in 2011-12, when markets were pricing in a serious Eurozone break-up risk. The current more moderate level seems reasonable to us, as a significantly wider spread to compensate for the political risk of a potential "Frexit" is not required, given the long odds of a Trump/Brexit-like upset victory. Last week, our colleagues at the BCA Geopolitical Strategy and Foreign Exchange Strategy services published a joint Special Report updating their view on the election, and concluded that Le Pen's odds of victory now stand at 15%.1 Either Francois Fillon (who is currently embroiled in a corruption scandal) or Emanuel Macron will win the French presidency, both of whom are running on structural reform platforms that should be market friendly. Moreover, Marine Le Pen has only a long-shot possibility to win the French presidential election, for several reasons:2 Assuming Le Pen becomes one of the final two candidates in the run-off election after the first round of voting in April, her probability of winning is low, as she continues to trail her centrist opponents by a massive 20% in the polls. That lead would have to fall to 3-5%, within the margin of error of the polling data, before investors would have to worry seriously about a Le Pen victory. Le Pen's personal approval rating peaked in 2012 (Chart 2). It fell despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, all of which should have helped boost her popularity. The problem for Le Pen is that 70% of the French support the euro (bottom panel), and she is running on an explicit campaign promise to try and pull France out of the euro if she wins the presidency. Leaving the euro area would mean a redenomination cost for Baby Boomer retirees, higher interest rates, higher inflation, and a likely economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks. Given BCA's relatively sanguine view of the true political risks of the French election, the recent spread widening represents a tactical trade opportunity to go the other way and position for French outperformance. A Le Pen defeat will cause French policy uncertainty to recede and French bond yields will converge back to German levels. Vanishing uncertainty and lower bond yields will further fuel the current economic recovery, as explained in the next section. Bottom Line: Marine Le Pen does not stand a realistic chance of winning France's presidency. As policy uncertainty recedes, the government bond yield differential between France and Germany will narrow. Go long French OATs versus German Bunds on a tactical basis (a trade we are adding to our Overlay Trades list on Page 20). Cyclical View: An Outperforming Economy Over the medium-term (6 to 12 months), the cyclical dynamics of French growth and inflation, as well as potential shifts in Euro Area monetary policy, will drive the evolution of French bond yields. On this basis, there is room for French yields to rise in absolute terms. Current pricing in the French forward curve has the 10-year government bond yield reaching 1.40% by the end of 2017, up 26bps from the current level. That yield target will be easily exceeded based on the budding upturns in French economic growth and inflation. A low growth hurdle to overcome The Bloomberg survey of economists currently pencils in a French GDP growth forecast of 1.3% in 2017, almost unchanged from 1.2% in 2016. That figure should be surpassed, in our view. The current situation component of the French ZEW economic sentiment survey has spiked recently but still sits far from previous peaks (Chart 3). As this unfinished economic cycle progresses, growth will drift inevitably higher. Chart 2Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Le Pen Is Not So Well-Liked Chart 3An Un-finished Cycle An Un-finished Cycle An Un-finished Cycle More specifically, the business sector could positively surprise in 2017. Business sentiment and industrial production already started to hook upward toward the end of 2016, and the December surge in the French Manufacturing PMI signals that the economy is accelerating. Even the previously lagging French service sector PMI has now caught up to the Euro Area average (Chart 4). This upturn looks very well supported. Firms' order books have been replenished, and corporations are now in a position to hike prices, indicating that pricing power has returned (Chart 5). This is a crucial development, it will allow for further increases in corporate profit margins, and, in turn, give them some leeway to lift wages, hire more workers and/or invest anew. Chart 4A Solid Economic Upturn A Solid Economic Upturn A Solid Economic Upturn Chart 5Improving Business Sector Outlook Improving Business Sector Outlook Improving Business Sector Outlook Moreover, business cycle dynamics should then boost consumption. An improving labor market has already translated into confidence-building momentum among households. Consumers' disposable income growth has risen steadily, while households' intentions to make important purchases have reached levels not seen since before the Global Financial Crisis (Chart 6). Also, labor slack is diminishing in France, with the number of job seekers falling for the first time in a decade (bottom panel). If French households remain upbeat, the broader economy should do well. Historically, the INSEE survey of households' assessment of the future economic situation has been closely linked to GDP growth. Advancing that series by three months clearly shows that France's growth is set to accelerate. Using a simple regression, growth could reach a 1.7% year-over-year pace in the first half of 2017 (Chart 7). Chart 6Better Fundamentals For French Consumers Better Fundamentals For French Consumers Better Fundamentals For French Consumers Chart 7GDP Will Beat Expectations GDP Will Beat Expectations GDP Will Beat Expectations One note of caution on this optimistic French economic outlook comes from capital spending. The elevated political uncertainties from the upcoming election, as well as the potential U.K.-E.U. Brexit negotiations, have left French firms less inclined to expand business through increased investments. However, robust activity in the housing market should support overall gross fixed capital formation, as housing permits sprang to life in 2016 (Chart 8). To ensure that this economic expansion gains momentum, ample credit growth will be paramount. This could be a potential headwind, as France's non-financial private sector credit has reached high levels, especially compared to its European peers (Chart 9). These excesses could act as a speed limit on the overall economy, at some point. Chart 8Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Housing To Support Overall Capital Formation Chart 9Private Non-Financial Leverage: High Private Non-Financial Leverage: High Private Non-Financial Leverage: High However, in the current cycle, this doesn't seem to be the case. Both money and loan growth are accelerating after several years of weakness (Chart 10, top panel). The ECB's Bank Lending Survey, which shows slowly increasing demand for credit (middle panel) and no tightening of lending standards (bottom panel) will help fuel this trend.3 The central bank's loose overall monetary stance will keep this positive credit impulse alive over the course of the year, while also helping exports by keeping the Euro weak. Finally, on the fiscal side, the IMF projects France's cyclically-adjusted primary budget balance to go from -0.6% of potential GDP in 2016 to -0.7% in 2017, representing a fiscal thrust of +0.1% (Chart 11). This modest number will obviously not supercharge the current cycle, but does represent a big change from the years of austerity since the last recession. Chart 10A Positive Credit Impulse A Positive Credit Impulse A Positive Credit Impulse Chart 11No More Austerity No More Austerity No More Austerity Building inflationary pressure The Bloomberg consensus forecast calls for French consumer price inflation to reach 1.2% in 2017, a modest advance from the current rate of 0.7%. That level should be reached, and likely surpassed, as most inflation measures have already entered an expansionary phase (Chart 12). That trend should persist in 2017 for several reasons: First, French unemployment will soon fall below the non-accelerating inflation rate of unemployment (NAIRU), which typically results in a rise in French underlying CPI inflation soon afterward (Chart 13). Chart 12Inflation Moving Higher Inflation Moving Higher Inflation Moving Higher Chart 13France Is Close To Full Employment France Is Close To Full Employment France Is Close To Full Employment Second, current French inflation appears about half a percentage point too low relative to the unemployment rate, based on the Phillips curve relationship since 2000 (Chart 14). Chart 14Inflation Should Be Higher Our Views On French Government Bonds Our Views On French Government Bonds Third, our French CPI diffusion index is well off the cyclical lows and points towards higher underlying inflation in the months ahead (Chart 15).4 In sum, French inflation will follow, and likely exceed, the current consensus expectation of 1.2%. This is important to appreciate, as inflation was a more important driver of higher nominal bond yields, relative to the real yield component, last year (Chart 15, bottom two panels). There is more to come in 2017. How to position for this view? In terms of valuation, French government bonds still appear quite expensive. Our bond valuation indicator shows that yields remain well below fair value, even after the recent backup (Chart 16). Combine this with our optimistic view on French growth and inflation, and investors should move to reduce duration within the French component of hedged global bond portfolios. Today, we open a new position in our model fixed income portfolio: reducing the exposure in the longest duration (+10 years) bucket in France, and placing the proceeds in the 1-3 year France bucket. This combination will lower our overall French duration exposure by one full year. If yields finish the year higher than currently priced on the forward curve, as we expect, this position will contribute positively to the excess return versus our benchmark. Bottom Line: French GDP growth should surprise to the upside, while inflation will at least match the consensus expectation in 2017. Both of those trends will force French bond yields higher this year. To express that view, move to a below-benchmark duration stance within the French component of global hedged bond portfolios. Chart 15Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Rising Inflation Will Push Yields Even Higher Chart 16French Bonds: Still Expensive French Bonds: Still Expensive French Bonds: Still Expensive Secular View: A Structural Ceiling On French Yields In the very long run (5 to 10 years), structural considerations are needed to forecast bond yields. Ten years ago, the French forward yield curve was implicitly forecasting that the 10-year French bond yield would be close to 4% today. Currently standing at 1.13%, the market missed the mark by 287bps! The forwards are now priced for the 10-year bond yield to reach 2.84% in ten years, possibly making the same mistake of over-estimating future bond yields. To gauge a fair value of the 10-year bond yield, using nominal potential GDP growth has proved to be useful in the past. From 2004 to 2014, and before the deflationary shock experienced since, France's 10-year bond yield was indeed trading very close to growth in French nominal potential GDP (Chart 17, shaded portion). Chart 17Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields Low Potential Growth Is A Long-Term Cap On French Yields As inflation will most likely return to more "normal" levels in the next few years, the relationship between the two should be reestablished soon. If so, the current 2.84% level on the 10-year French government bond yield, 10-years forward should translate to a nominal potential growth rate of around 2.8% in ten years' time (Chart 17). This outcome would represent an 80bp increase in the rate of trend French nominal potential growth from current levels, which could be difficult to achieve, in our view. Lots of work to do... Most likely, France's nominal potential growth will only slowly grind lower. Faster potential growth could be achieved either through increasing demographic growth or improving productivity. Unfortunately, neither outcome appears imminent. Since the French working age population is already expanding at a very slow pace, and is projected to decelerate in the years ahead, productivity increases are the only candidate to improve potential growth. On that front, a lot needs to be done; many structural weaknesses in the French economy have to be addressed. For years, France has been plagued by weak productivity, which has constrained growth. Compared to its European peers, inefficient use of available capital has led to a loss of competitiveness through higher unit labor costs. Clearly, France needs to improve workers' skills to lift total factor productivity growth (Chart 18). This will become increasingly difficult as France now faces - more than ever - difficulty attracting and retaining talent due to the recent turmoil that has hit the country such as the terrible rise in terrorist attacks. At the source, the poor productivity performance in France is grounded in the overly protective employment system. Like other European countries, high employment costs have led to misallocation of capital, potentially affecting the optimal capital labor input mix and total factor productivity.5 Indeed, friction in the labor market is often cited as the source of the problem. We tend to agree. French workers work too few hours, even fewer than in the Peripheral European economies. As the divide between the unemployment rate of persons under and over 25 years old gets larger, resolving the growing generational disparities has become paramount. Plus, upward mobility opportunities are scant - not everyone gets an equal chance to rise in status in French society (Chart 19). Chart 18Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Productivity Unlikely To Lift Potential Growth Chart 19Friction In The Labor Market Friction In The Labor Market Friction In The Labor Market Recent reforms have the potential to fix some problems. The Pacte de Responsabilité et Solidarité (PRS) and the Crédit d'impôt compétitivité emploi (CICE) should help reduce unit labor costs through a reduced labor tax wedge.6 The Macron Law could raise real GDP growth by 0.3 percent per year through 2020, according to the OECD. However, the effectiveness might be fleeting in some other cases. For example, studies by the IMF suggest that the El Khomri Law - aimed at making the labor market more flexible - might have little impact on overall French unemployment, potentially reducing it by only 0.14 percentage points.7 Meanwhile, France's enormous public sector continues to crowd out the private sector. At 54% of GDP, government expenditures are simply too big, forcing the government to tax profits at a whopping 63% rate. This leaves little space for national savings - which now sit at a lowly 21.4% of GDP - to increase (Chart 20). Additionally, France ranks 115th out 136 countries in the Global Competitiveness Report in terms of the burden of government regulation, which further constrains productivity-enhancing investments.8 In sum, boosting potential GDP growth will remain an uphill battle. Everyone agrees that reforms are necessary. But will they happen? ...and France still has a tough crowd to win over It is not impossible that the next president will have a serious structural reform agenda. For example, the most reformist presidential contender, Francois Fillon, has made these proposals in his campaign platform: Abandon the national limit on weekly hours worked and leave that decision to individual companies; Decrease corporate taxation; Allow companies to fire employees when undergoing structural/managerial changes; Extend the retirement age; Cut public spending; Reduce the size of the state by cutting government employees. From a structural perspective, these measures would surely be promising for the future, and would lift French potential GDP growth over time. However, in the populist world we live in, we are skeptical that the electorate will give him an unambiguous mandate of this sort. That kind of mandate usually comes after a crisis, not before. More pain might be needed. Chart 20France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector France's Government: Crowding Out The Private Sector Chart 21"Silent Majority" Wants Reform Our Views On French Government Bonds Our Views On French Government Bonds Moreover, reforming France has always proved very challenging. As such, will Mr. Fillon (or Mr. Macron) really be able to comply with his campaign promises, if elected? Winning a majority at the parliamentary election would be a necessary precondition. Although every President has been given a parliamentary majority since 2002, the elections have not happened yet. Confronting the unions on these measures will prove difficult for the next French president. The latest labor market reform push unveiled last year was met with massive resistance. Surely, deregulation that makes it easier to fire workers will inevitably dissatisfy insiders that benefit from high barriers to entry for new employees. This obstacle will be difficult to remove. In any case, it has always been puzzling why things have to be this way in France. According to economists Yann Algan and Pierre Cahuc, one possible response might lie in the French tendency to distrust their fellow citizen. Their theory, introduced more than ten years ago, posits the following: ...the French people's lack of trust gets in the way of their ability to cooperate, which brings the State to regulate work relations in minute detail. By emptying social dialogue of its content, these interventions prevent the adoption of favorable reforms to improve the function of the job market. Distrust even induces a fear of competition, leading to the set-up of regulatory barriers-to-entry, that create rent-seeking which favors corruption and mutual distrust. The French social model fosters a truly vicious circle. Corporatism and state intervention undermine the mechanisms of solidarity, destroy social dialogue and reinforce mutual distrust - that which in turn feeds categorical demands and the constant call for regulation, and thereby favors the expansion of corporatism and state intervention.9 Of course, their angle on things could sound somewhat extreme. But it might also explain why the issues discussed ten or twenty years ago concerning France's predicament remain mostly the same today. There might be something else besides pure rational thinking at play behind the French citizenry's propensity to stiff-arm reforms. Nonetheless, if these authors are correct, true changes will continue to be hard to come by in France. Meaning this invisible hand of distrust will continue to lead potential GDP growth lower, and, as history dictates, will represent a ceiling on how high long-term French bond yields can ever rise. That said, maybe our view could prove to be too backward looking. The new report co-written by our Geopolitical Strategy and Foreign Exchange Strategy teams takes a more optimistic view on the chances of French economic reform. They argue that France's recent economic underperformance will motivate its citizens to demand real action from their politicians, as occurred in Australia during the mid-1980s and 1990s and Germany in the 2000s - episodes of real structural reform occurring without any dramatic crisis to prompt them. A desire to compete with Germany economically, combined with government spending excesses and protest fatigue, could be leading France to elect a pro-reform government. As the French polling data shows, there is a "silent majority" in France that would favor supply side reforms (Chart 21). Plus, even those that traditionally favor the status quo, like "blue collar" and "left leaning" employees, are opposing reforms by extremely narrow margins. Undoubtedly, our colleagues raise very good points. As such, we will be watchful to see if reforms gain a greater chance of meaningfully transforming France in the next few years. The onus will be on the reformers to change the system. Bottom Line: France has been, and will probably continue to be, difficult to reform. While a pro-reform government is our expectation from the upcoming election, boosting French productivity growth will be an uphill climb. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy/Foreign Exchange Strategy Special Report, "The French Revolution", dated February 3, 2017, available at gps.bcaresearch.com and fes.bcaresearch.com 2 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?", dated November 16, 2016, available at gps.bcaresearch.com 3 https://www.ecb.europa.eu/stats/pdf/blssurvey_201701.pdf?6c44eff3bac4b858969b9cb71bd4a8fa 4 The diffusion index is the percentage of sectors within the French Consumer Price Index that are growing faster than their 24-month moving average. This indicator leads underlying inflation by 10 months. 5 For further details on this idea, please see "Employment Protection Legislation, Capital Investment and Access to Credit: Evidence from Italy", available at https://ideas.repec.org/p/sef/csefwp/337.html 6 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44080.0 7 https://www.imf.org/external/pubs/cat/longres.aspx?sk=44081. 8 http://www3.weforum.org/docs GCR2016-2017/05FullReport TheGlobalCompetitivenessReport2016-2017_FINAL.pdf 9 http://voxeu.org/article/france-price-suspicion and more on these authors theory on the impact of trust on economic development can be found here: http://econ.sciences-po.fr/sites/default/files/file/yann%20algan/HB_FinalVersion1.pdf The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Our Views On French Government Bonds Our Views On French Government Bonds Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights France is on the verge of pro-market structural reforms; Marine Le Pen will not win the presidency. Her odds are 15%; The French economic upswing will continue to surprise; Overweight French stocks relative to German; Buy the euro on any election-related dip. Feature Le courage consiste à savoir choisir le moindre mal, si affreux soit-il encore. - Stendhal La France ne peut être la France sans la grandeur. - Charles de Gaulle Every decade, a country defies stereotypes and surprises investors with ambitious, pro-market and pro-business, structural reforms (Chart 1). Margaret Thatcher's laissez-faire reforms pulled Britain out of the ghastly 1970s and into the wild 1980s. Sweden surprised the world in the 1990s when voters turned against the generous social welfare system under the stewardship of the center-right Moderate Party. At the turn of the century, Germany's Social Democratic Party (SPD) defied its own label and moved the country to the right of the economic spectrum. Finally, this decade's reform surprise is Spain, which undertook painful labor and pension reforms that have underpinned its impressive recovery. What do all of these episodes have in common? Investors - and the public at large - didn't see them coming. Our favorite example is the Hartz IV labor reforms in Germany. The SPD government of Gerhardt Schröder completely re-wired Germany's labor market, leading to the export boom that has lasted to this day (Chart 2). And yet The Economist welcomed the Schroeder government with a scathing critique that is a textbook example of how the media often confuses stereotyping for data-driven analysis.1 Chart 1Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Each Decade Has A Reform Surprise Chart 2The German Miracle The German Miracle The German Miracle We think that this decade will belong to France. Yes, France. While the dominant narrative today is whether Marine Le Pen will win the presidential elections on April 23 (with a possible runoff on May 7), we think the real story is that the two other serious candidates are pro-growth, pro-reform, pro-market candidates. François Fillon and Emmanuel Macron are both running platforms of structural reforms. They are not hiding the fact that the reforms would be painful. On the contrary, their campaigns revel in the self-flagellation narrative. Most of our clients either politely roll their eyes when we present this view or counter that the French are ______ (insert favorite stereotype). We welcome the pessimism! It shows that the market is not yet pricing in a pro-market revolution that guillotines a long list of French inefficiencies. In this analysis, we present what is wrong with France, whether the presidential candidates running in the election plan to fix the problems, and our view of who is likely to win. Forecasting elections is a Bayesian process, which means that the probabilities must be constantly updated with new information. As such, we intend to keep a very close eye on the developments in the country over the next four months. What Is Wrong With France? France has a growth problem. While this is partly a cyclical issue, the reality is that its real per-capita GDP growth has been closer to Greek levels than German over the last two decades (Chart 3). In addition, France has lost competitiveness in the global marketplace, judging by its falling share of global exports relative to peers (Chart 4). Chart 3France's Lost Millennium The French Revolution The French Revolution Chart 4Export Performance Is A Disaster Export Performance Is A Disaster Export Performance Is A Disaster Three issues underpin the French malaise of the past two decades: The state is too large; The cost of financing the large state falls on the corporate sector; The labor market is inflexible. First, the French state relative to GDP is the largest in the developed world. In 2016, public spending was estimated to be 56% of GDP, compared with 44% of GDP in Germany and just 36% in the U.S. (Chart 5)! What is most concerning is that the state has actually grown in the past two decades from already unsustainable levels (Chart 6). Government employment as share of total employment is naturally very high (Chart 7). Chart 5The French State Is Large... The French Revolution The French Revolution Chart 6... And Continues To Be In Charge The French Revolution The French Revolution Chart 7French Talent Is Wasted In The Public Sector The French Revolution The French Revolution Such a large public sector requires very high levels of taxation. Government tax revenues are also second-largest in the developed world at 45% of GDP (Chart 8) and, like the size of the overall public sector, continue to grow (Chart 9). Chart 8French Tax Burden Is Large... The French Revolution The French Revolution Chart 9...And Growing The French Revolution The French Revolution Part of the problem is the labyrinth of administrative layers beneath the central government. France has 13 regional governments, 96 departments, 343 arrondissements, 4,058 cantons, and 35,699 municipalities.2 What do they all do? We have no idea. Reforms in 2015 have sought to reduce the number of sub-federal layers, but the process ought to go much further and faster. The French social welfare state is also inefficient. To be fair, it has kept income inequality in check, which has not been the case in more laissez-faire countries (Chart 10). This is an important part of our political analysis. French "socialism" is what keeps populism at bay, which was the intention of the expensive welfare state in the first place.3 However, there is a lot of room to trim the fat. The French welfare state is essentially an "insurance program" for the middle class, with more transfers going to the households in the top 30% income bracket than in the bottom 30% (Chart 11)! France could cut its massive social spending by means-testing the benefits that accrue to the upper middle class.4 Somebody ultimately must pay for the enormous public sector. In France, a large burden falls on employers. The French "tax wedge" - the difference between the cost of labor for the employer and the take-home pay of the employee as a percent of total remuneration - is one of the largest in the OECD (Chart 12). The heavy tax burden on employers, combined with a relatively high minimum wage, means that business owners are wary of hiring new workers. The tax wedge is ultimately passed on to the consumer by businesses, which hurts competitiveness and contributes to the poor performance of French exports.5 Chart 10A Positive: ##br##No Income Inequality A Positive: No Income Inequality A Positive: No Income Inequality Chart 11French Welfare State##br## Protects...The Rich! The French Revolution The French Revolution Chart 12Employees Are Too Expensive ##br##For Employers The French Revolution The French Revolution The French labor market remains inflexible and overprotected (Chart 13), which not only hurts competitiveness but also discourages youth employment (Chart 14). According to the OECD Employment Protection Index, both regular and temporary contracts have some of the highest levels of protection in the developed world. Germany actually has a higher level of protection in regular contracts, but not in temporary employment, thanks to ambitious reforms. Chart 13French Labor Market##br## Is Too Rigid The French Revolution The French Revolution Chart 14French Youth Underperforms ##br##OECD Peers The French Revolution The French Revolution Chart 15Starting A Business In France? ##br##Bonne Chance! The French Revolution The French Revolution Finally, France suffers from too much red-tape (Chart 15), too much regulation (Chart 16), high wealth taxes that force capital out of the country, and too many barriers to entry for medium-sized enterprises, the lifeblood of innovation and productivity gains (Chart 17). Part of the reason that France suffers from a lack of German-styled Mittelstand (small and medium-sized enterprises) is that the effective tax rate of the medium-sized businesses is greater than that of large enterprises (Chart 18). This is a problem given the already high levels of corporate tax rates in the country (Chart 19).6 Chart 16Too Much Regulation The French Revolution The French Revolution Chart 17France Needs A Mittelstand The French Revolution The French Revolution François Hollande's government tried to address many problems facing France. However, Hollande largely spent his term treating the symptoms and not trying to cure the disease. France can reduce regulatory barriers and tinker with labor flexibility. It can even shift the tax burden from employers to consumers. But the fundamental problem is the large state, which forces the government to raise lots of taxes one way or another. Chart 18French SMEs Are Punished ##br##With High Taxes The French Revolution The French Revolution Chart 19French Corporate Taxes ##br## Are High By European Standards The French Revolution The French Revolution Bottom Line: The French state is too big. Up to this point, reforms have largely focused on tinkering with how the government raises funds for the welfare state. But what France needs is to alleviate the tax burden in the first place. The state, therefore, must be cut. Why Will France Reform? Our clients and colleagues challenge our view on France by rightly pointing out that painful structural reforms are easiest following a "market riot" or deep recession. Neither has befallen France. It actually did remarkably well in weathering the 2008 Great Recession, compared to OECD peers, and it has not faced the extraordinary housing or unemployment busts of neighboring Spain. Yet crises are not necessarily a must for successful reforms. Australia, starting in the mid-1980s and throughout the 1990s, pursued broad-based reforms due to a prolonged period of mediocre growth.7 So did Germany in the 2000s. We think that it is precisely this underperformance that is today motivating France. In particular we see three broad motivations: Competition with Germany: France did not lead the creation of European institutions in the twentieth century in order to cede leadership to Germany. As Charles de Gaulle said, "France is not France without greatness." The economic underperformance versus Germany is not geopolitically sustainable (Chart 20). If France continues to lose economic ground to Germany, it will continue to play second-fiddle to Berlin in the governing of the EU. At some point, but not likely in 2017, this will reinforce the populist logic that France should go it alone, sans the European institutions. Change impetus: It is difficult to imagine how François Fillon and Emmanuel Macron can run on an anti-establishment, "change" platform. Fillon proudly calls himself a Thatcherite (in 2017!) and Macron is a former Rothschild investment banker. And yet they are doing so. This is especially astonishing after the successes of Donald Trump and the Brexit campaign, which specifically targeted elitist policymakers like Fillon and Macron. But in France, the status quo is a large state, dirigiste economy, and a generous welfare system. In other words, the French are turning against their status quo. Laissez-faire is change in France. Social welfare fatigue: Our colleague Peter Berezin argued in a recent Special Report that Europeans will turn against the welfare state due to the breakdown in social cohesion. Significant populations of immigrant descent - as well as recent arrivals - fail to properly integrate in countries where the welfare state is large.8 Resentment against immigrants, and citizens of immigrant descent, could therefore be fueling resentment against the expensive welfare state. Chart 20France Is Not France Without Greatness France Is Not France Without Greatness France Is Not France Without Greatness Chart 21"Silent Majority" Wants Reform The French Revolution The French Revolution Polls suggest that we are on to something. Chart 21 illustrates that there may be a Nixonian "silent majority" in France favoring supply side reforms. Per January 2017 polling, "blue collar" and "left leaning" employees oppose reforms. But surprisingly by extremely narrow margins (Chart 21, bottom panel)! Thus, there is demand for structural reforms, but is there supply? According to a review of the platforms of Macron and Fillon, we think the answer is a resounding yes (Table 1). Generally speaking, François Fillon's proposed reforms are the deepest, but Macron would also pursue reforms aimed at reducing the size of the state. Marine Le Pen, too, promises to reduce the size of the public sector, suggesting that the narrative of reform is now universal. However, it is not clear how she would do so. Her views on the EU and the euro are also not positive for growth or the markets, as they would precipitate a recession and an immediate redenomination crisis. As we discuss below, it is likely that her opposition to European integration is precisely what is preventing her from being a much more competitive opponent against Fillon and Macron in the second round. Table 1French Presidential Election: Policy Positions Of Chief Contenders The French Revolution The French Revolution What of implementation? In France, several reform efforts - the 1995 Juppé Plan, 2006 labor reforms and 2010 Sarkozy pension reforms in particular - prompted significant social unrest. However, unrest is having diminishing returns for unions and left-wing activists. While unrest forced the government to fully reverse both the 1995 Juppé Plan and the 2006 labor reforms, it did not manage to hold back retirement reforms in 2010. The Sarkozy government made some concessions, but the core of the reforms remained in place despite severe unrest that brought the country to a standstill. Most recently, in spring 2016, the El Khomri law - proposing modest changes to the French labor code - was rammed through by Prime Minister Manuel Valls using Article 49.3 of the French constitution. Despite significant unrest, the law passed and became law in August. Protests remained peaceful - unlike the 2010 unrest - and eventually fizzled out. Investors should not be afraid of unrest. Unrest is a sign that reforms are being enacted. We would be far more concerned if the election of Fillon or Macron did not lead to strikes and protests! That would be a sign that their reform efforts are not ambitious. But our review of the unrest and strikes in France since 1995 suggests that the last two events - in 2010 and 2016 - ultimately did lead to reforms. In addition, most significant international reform efforts lead to protests. The U.K. miners' strike (1984-85) led to over 10,000 arrests and significant violence. German labor reforms in the 2000s led to a spike in strikes. And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, who ultimately gave the world Occupy Wall Street. When it comes to reforms, the adage "no pain, no gain" rings true. Most effective reforms, however, will come right after the election. The incoming president will have about 12 months to convince investors that he is serious about reforms, as this is when the new government has the most political capital and legitimacy for reforms. In addition, much will depend on whether Fillon and Macron have parliamentary majorities with which to work to enact reforms. France's parliamentary election will follow the presidential (two rounds, June 10 and 17). Every president has managed to gain the majority in parliament since the two elections were brought to the same year (2002). Macron's new third party - En Marche! - will likely struggle to gain a foothold in the parliament, even if he wins. However, we suspect that both Les Républicains and centrist members of the Socialist Party will support his reforms. Macron's reforms are more modest than Fillon, at least according to Table 1 and his rhetoric, but they would still be a net positive. Ultimately, investors will have plenty of opportunity to reassess the reform efforts as the new government proposes them. In this analysis, we have sought to simplify what we think is wrong with France. If the government does not address our three core issues - how big is the state, how the state is funded, and the flexibility of the labor market - then we will know that our optimism was misplaced. Bottom Line: We believe that the support for reform exists. A review of electoral platforms reveals that all three major candidates are promising reforms that reduce the size of the French state. This can only mean that French politicians recognize that the "median voter" wants it to be reduced.9 Can Le Pen Win? Although Marine Le Pen, leader of National Front (FN), wants to reduce the size of the state as much as her counterparts, her broader approach poses an obvious risk to the stability of France, Europe, and potentially the world. Her position on the EU and the euro is extreme. She seeks to replace the EU with a strategic alliance with Russia, that she thinks would then include Germany. In the process, the euro would be abandoned. The extreme nature of Le Pen's proposals may ironically increase the likelihood of pro-market reforms in France. François Fillon's problem - aside from the ongoing corruption scandal involving his wife - is that 62% of the French public believes that "his program is worrisome."10 He may therefore win purely because Le Pen's proposal of dissolving the EU and the euro is even more worrisome. What are Le Pen's chances of overcoming the population's fear of abandoning the euro and EU institutions? We think they are very slim. Fillon's corruption scandal could grow, but we think that it is too little too early. With three months ahead of the first round, the spotlight on Fillon may have come too soon. Meanwhile, Le Pen's FN is not without skeletons in her closet. The party's main financial backer has been a Russian bank whose license was revoked by Russia's central bank in June. Le Pen refuses to disclose the details of her campaign funding, unlike Fillon and Macron.11 So what are the chances of a Le Pen presidency? Following the U.S. election, many of our clients wonder where populism will triumph next. In meetings and at conference panels, clients ask whether Marine Le Pen can replicate the success of Donald Trump and the anti-establishment Brexit campaign. Our view has not changed since our Client Note on the topic last November: Le Pen has a very low probability of winning.12 Our subjective figure is 15%. This view is not necessarily based on the strength of her opponents. In other words, if François Fillon stumbles in the first round, we believe that Emmanuel Macron will win in the second round. Our view is focused more on the structural constraints that Le Pen faces. There are three reasons for this view: The Euro The French support the euro at a high level. Marine Le Pen wants to take France out of the euro. Thus, her popularity is inversely correlated with the support for the euro (Chart 22). Euro support bottomed in France in 2013 at 62%, the same year when Le Pen's popularity peaked at 36%. The populist and nationalist Le Pen has not regained her 2013 levels of support despite a massive immigration crisis in Europe and numerous terrorist attacks against French citizens. This is surprising and important. Chart 22The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The Euro Is Le Pen's Foil The only way we can explain her lackluster performance in the face of crises that should have helped her popularity is her ideological and rhetorical consistency on the euro. For several different reasons,13 the French public supports the common currency as well as the EU - like most Europeans. Le Pen's insistence on "Frexit" is a major hurdle to her chances of winning. The Polls Before we dive into the French presidential polls we should remind our readers of our view that polls did not get Brexit and Trump wrong. Pundits, the media, and data-journalists did. Polls were actually showing the Brexit camp ahead throughout the first two weeks of June. It was only once MP Jo Cox was tragically murdered on June 16 that polls favored the "Stay" vote for the final days of the campaign. Yet on the day of the vote, the "Stay" camp was ahead by only 4%. That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit, in other words, should have been a lot higher than the 30% estimated by the markets (Chart 23). Chart 23ASmart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Smart Money Got Brexit Wrong... Chart 23B...Despite Close Polling ...Despite Close Polling ...Despite Close Polling Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory. What the modelers missed was the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for Barack Obama and his policies, and general discontent, partly signaled by the non-negligible polling of third-party challengers. In addition, the modelers ignored that American polls have a track record of underestimating, or overestimating, performance by about 2-3% (Chart 24). And crucially, the 2016 election was different in that the number of undecided voters at the cusp of the vote was nearly triple the average of the previous three elections (Chart 25). Chart 24Election Polls Usually Miss By A Few Points The French Revolution The French Revolution Chart 25Undecided Voters Decided The Election Undecided Voters Decided The Election Undecided Voters Decided The Election The polls were much closer, in other words, than the dominant media narrative revealed. With four months until the election, Donald Trump actually took a slight lead against Hillary Clinton, following the July GOP convention. In aggregate polling, he never trailed Clinton by more than 7% from that point onwards (Chart 26). With four months until the second round of the French election in May, Marine Le Pen is trailing her two centrist opponents by 20-30% (Chart 27)! In other words, Trump at this point in the campaign was roughly three times more competitive than Le Pen! Chart 26Le Pen Is No Trump Le Pen Is No Trump Le Pen Is No Trump Chart 27Second Round Polls Are All That Matters The French Revolution The French Revolution We will therefore agree with the narrative that Le Pen could be the next Trump or Brexit when she starts performing in the polls as well as Trump and Brexit! Right now, she is nowhere close to that. Could Marine Le Pen close the gap in the next four months? It is unlikely. Le Pen is not a political "unknown" like Trump. She is not going to "surprise" voters into voting for her in 2017. She was her party's presidential candidate in the 2012 election. Her father, Jean-Marie Le Pen, contested elections in 1988, 1995, 2002, and 2007. The National Front has contested elections in France since the 1970s. Voters know what they are getting with Le Pen. The best-case scenario for Le Pen is that Fillon gets into the second round, and then during the two-week interval between the first and second rounds (April 23, May 7) more corruption is revealed by Fillon and his popularity tanks. This is the "Clinton model" and it is certainly plausible. But it would have to be egregious corruption given that Le Pen's popularity ceiling appears to be the same percentage of French population not in favor of the euro. We suspect that this ceiling is hard. Which is why we have Le Pen's probability of winning the election at only 15%. In addition, there is no vast pool of the undecided in France. French turnouts for the presidential election are consistently 80%. Therefore, translating polling data to actual turnout data will be relatively straightforward. The polls are real. Le Pen may be able to outperform her polls by several points. But not by the 20-30% by which she trails Fillon and Macron in polling for the crucial second round. In fact, Le Pen could even struggle to get into the second round given that the winner of the Socialist Party primary - Benoit Hamon - could bleed left-wing voters away from Le Pen, leaving Fillon and Macron to enter the second round instead. At that point, the election becomes a coin toss between two reformers, but we would give the less "worrisome" Macron a slight edge. Precedent History is important because there is a precedent for solid Euroskpetic performances in France. In fact, Euroskeptic candidates - broadly defined - have won around 32% of the vote in the first round of the presidential election since 1995 (Chart 28). As such, Le Pen's current polling in the first round - 26% level of support - and second round - 37% of support - is within the historical average. It is on the high end, but still within the norm. Her father, for example, got 17% in the first round of the 2002 election and 18% in the second. Chart 28French Euroskepticism ##br##Is Not A Novel Concept The French Revolution The French Revolution We also have a very good recent case study - a natural experiment if you will - of the anti-establishment's electoral performance: the December 2015 regional elections. The two-round regional elections occurred only 23 days following the November 2015 terrorist attack in Paris and at the height of that year's migration crisis. They should have favored the Front National (FN). They also should have favored the FN for these technical and political reasons: Rules: The second round in the regional elections has a participation threshold of 10%, unlike the presidential and parliamentary elections which eliminate all but the top two candidates. This means that FN faced off against multiple candidates, reducing the probability that "strategic voting" drove centrist voters to choose the one remaining establishment candidate over the anti-establishment candidate, as will be the case in the upcoming presidential election. Protest vote: The regions of France have no authority to negotiate international treaties. As such, voters could freely vote for the anti-establishment FN as a sign of protest, without fear that the FN councilors would then take the country out of the euro and the EU. Voters faced no clear downside risk of sending a harsh message to the establishment. Context: Both the ruling Socialists and the opposition Union for a Popular Movement (now renamed Les Républicains) were in disarray ahead of the regional elections for a number of reasons, including the aforementioned terrorist attacks, unpopularity of President Hollande, leadership struggle within UMP, and EU mismanagement of the migration crisis. The National Front ended the first round with a slight lead in total votes, but captured the lead in six out of the 13 regions. The financial press went wild, calling it an extraordinary win for the anti-establishment in France. Yet despite the near optimal circumstances and a strong showing in the first round, FN was obliterated in the second round, a mere one week later. The populists won none of the regions that they captured in the first round! Why? Participation increased in the second round from 49% to 59%, signaling that many French voters were motivated to vote in less-relevant regional elections purely to keep FN out of power. The National Front share of the total vote remained stable at 27%, despite the increase in the turnout. This means that almost none of the "new" voters cast their support for FN, an incredible development. Socialist Party candidates withdrew from the contest in several regions where FN candidates were high profile politicians (Nord Pas de Calais led by Marine Le Pen herself and Province Alpes Cote d'Azur led by Le Pen's niece Marion Marechal Le Pen). Most importantly, Socialist voters did not swing to the economically left-leaning FN in these contest, but rather either stayed home or swung to the center-right rival, the UMP. If French voters decided to cast a strategic vote against FN in an election where the downside risk to a protest vote was non-existent, why would they do any different in a vote that clearly and presently matters? Furthermore, the fact that the higher turnout hurt FN should concern Le Pen. As we mentioned above, presidential election turnouts in France are around 80%. The 2015 election also should teach us an important lesson about France: polls work. Based on IFOP polling conducted two weeks before the election, the average polling error in the December 2015 regional election was 2.5%. Bottom Line: Marine Le Pen's support is precisely the inverse of the French support for the euro. Her anti-European stance is apparently a "deal breaker" for many voters who would otherwise support her candidacy. If she asked us for advice, we would say to flip-flop on the euro. It would make her far more competitive in 2017. Le Pen is trailing her centrist opponents by a massive margin in the second round. Polls can be wrong when they suggest that the contest is within the margin of error. But that is definitely not the case in the upcoming French election. Finally, the 2015 election teaches us that strategic voting continues in France, even when the establishment parties are in disarray and the geopolitical and political context favors populists. Cyclical View The French economy is currently experiencing an economic upswing. This upswing is not much of a mystery. It is explained by three factors: Easing monetary conditions in Europe, pent-up demand, and reflationary policies in China. Let's start with monetary conditions. The easing began in July 2012, with ECB president Mario Draghi's now famous pronouncement that he would do "Whatever it takes" to ensure the survival of the euro. Thanks to these soothing words, risk premia in the region collapsed, with a massive narrowing of government bond spreads between the periphery and Germany. France too benefited from that phenomenon, with its own spreads moving from a max of 190 basis points in late 2011, to 21 basis points seven months ago. Thanks to this normalization, lending rates to the private sector collapsed from 4.6% to 2% (Chart 29) This meant that the fall in the repo rate engineered by the ECB was finally passed on to the private sector. Additionally, the ECB stress tests of 2014 played a major role. In anticipation of that exercise, euro area banks curtailed credit in order to clean up their balance sheets. This resulted in a large contraction of the European credit impulse. However, once the tests were passed, euro area banks, with somewhat healthier balance sheets, normalized credit conditions, letting credit growth move closer in line with trend GDP growth. The result was a surge in the credit impulse that lifted growth in Europe (Chart 30). Chart 29Whatever It Takes Equals##br## Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Whatever It Takes Equals Lower Private Sector Rates Chart 30Credit Impulse Dynamics##br## And Growth Credit Impulse Dynamics And Growth Credit Impulse Dynamics And Growth The euro also was an important factor. In mid-2014, investors started to speculate on a major easing by the ECB, maybe even QE. Through this discounting process, the euro collapsed from a high of 1.39 in May 2014 to a low of 1.05 in March 2015, when the ECB indeed began implementing asset purchases. This incredible 25% collapse in the currency boosted net exports, and helped GDP, while limiting existing deflationary pressures in Europe. The final reflationary impulse came from fiscal policy. In the wake of 2008, French fiscal deficits ballooned. As a result, from 2011 to 2013, the French fiscal thrust was negative and subtracted an average 1% from GDP growth. However, starting 2014, this drag vanished, arithmetically lifting growth in the country (Chart 31). Ultimately, with the accumulated pent-up demand resulting from the double-dip recession, France was able to capitalize on these developments. First, after having contracted by 14% between 2008 and 2009, and then by another 3% between 2011 and 2013, capex growth was able to resume in earnest in 2015 . This was necessary because, due to the subpar growth in capital stock, even the current tepid economic improvement was able to push capacity utilization above its 5-year moving average. When this happens, the economy ends up displaying the clearest sign of capacity constraint, i.e. higher prices, which we are seeing today. It also results in growing orders (Chart 32). Chart 31The Vanishing Of ##br##French Fiscal Drag The Vanishing Of French Fiscal Drag The Vanishing Of French Fiscal Drag Chart 32French Capacity Utilization Has Tightened ##br##And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving French Capacity Utilization Has Tightened And Orders Are Improving Second, we have witnessed a stabilization in employment and wages. The unemployment rate has fallen by 1% from 10.5% in 2015 to 9.5% today. Most importantly, our wage and employment models are pointing toward higher salaries and job growth in the coming quarters (Chart 33). This is crucial. The French economy remains fundamentally driven by domestic demand and household consumption in particular. In fact, these signs of coming higher household income suggest that the consumer can once again begin to support economic activity in France. First, we expect real retail sales to improve in the coming quarter. Second, because of the combined effect of rising labor income, consumer confidence, and housing prices, the recent upswing in housing activity should gather momentum (Chart 34), creating a further floor under economic activity. Chart 33Improving French Labor Market Conditions Improving French Labor Market Conditions Improving French Labor Market Conditions Chart 34Housing Will Contribute More To Growth Housing Will Contribute More To Growth Housing Will Contribute More To Growth Third, the improvement in credit growth corroborates these developments. In fact, being supported by easing credit standards, it even suggests that broad economic activity in France could accelerate further in the coming months. The key question mark at this point in time is China. France exports to China are only 3.7% of total exports, or 0.7% of GDP, below Belgium. However, the largest single export market for France is Germany, at 16.2% of total exports or 3.3% of GDP (Chart 35). Most interestingly, combined French exports to Germany and China are an important source of economic volatility for France. However, because French exports to Germany are a function of broader German income shocks and demand for German exports, the result is that French exports to Germany and China are a direct function of Chinese industrial activity, as illustrated with their tight correlation with the Keqiang index (Chart 36). As a result, French manufacturing conditions have displayed co-relationship with Chinese LEIs since 2002. Chart 35French Export ##br## Distribution The French Revolution The French Revolution Chart 36French Business Cycle And China: ##br##Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link French Business Cycle And China: Germany Is The Key Link So going forward, what to expect? The recent surge in the ZEW expectation index is likely to be validated and French GDP growth is likely to improve from 1% today to nearly 2% in mid-2017, well above the current expectation of 1.3%. We are more confident about the robustness of domestic demand than international demand. The support created by higher wages and rising credit will have a lagged effect for a few more quarters. In fact, the up-tick to 0.5% from -0.2% in underlying inflation suggests that French real borrowing costs for the private sector should remain well contained despite the recent improvement in capacity utilization. This means the support to housing activity remains solid, especially as France has some of the strongest demographics of the whole euro zone, and thus demand for housing is solid. Chart 37France Too Would Be Affected##br## By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration France Too Would Be Affected By A Chinese Deceleration Fillon's threat to cut public sector employment by 500,000 thousand could at face value derail the improvement in the labor market - if such measures were implemented today and in one shot, the unemployment rate would spike from 9.5% to 11.2%. However, Fillon's victory is not yet baked in the cake, and even if he wins, this risk is unlikely to materialize in 2017 as it will take time to get the required laws passed. Moreover, the progressive nature of the cut, along with the tax cuts and regulatory easing for the private sector, suggest that firms would likely create many jobs during the same time frame, mitigating the pain created by such drastic job cutting. Nonetheless, some downside to growth should be expected from Fillon's policies. China and EM represent a more palpable risk. The Chinese uptake of machinery has recently spiked and real estate activity and prices have surged (Chart 37). Beijing is currently uneasy with this development and the PBoC has already increased medium-term lending-facility rates in recent weeks despite low loan demand and disappointing fixed-asset investment numbers. Moreover, China has also massively curtailed the fiscal stimulus that has been a key component of its recent powerful rebound in industrial activity. Finally, the strength in the dollar along with rising real rates globally could put a lid on commodity price appreciation, which means that the rise in Chinese producer prices that has greatly contributed to lower Chinese real rates and thus easier Chinese monetary conditions could be waning. French exports to Germany and China might be seeing their heyday as we write. Bottom Line: The French economy is enjoying a healthy upswing powered by easier monetary conditions in Europe, slight fiscal thrust, pent-up demand and improving credit conditions. While these domestic factors will prove durable, the improvement in external demand faced by France in 2016 raises a slight question mark. Nonetheless, we expect French economic growth to move toward 2% in 2017, a sharp beat of currently depressed expectations. On the political front, robust growth should help centrist candidates and hurt the anti-establishment Le Pen. Investment Implications While reforms, tax cuts, strong domestic demand, and potentially falling political risk premia point to an outperformance of French small cap equities, the story is more complex. Indeed, French small caps are heavily weighted toward IT and biotech firms, and have been mimicking the performance of the Nasdaq, corrected for currency developments (Chart 38). Thus, they do not represent a play on the story above. Instead, we favor buying French industrial equities relative to Germany's. Both sectors are exposed to similar global risk factors as their sales are a function of commodity prices and EM developments. However, French unit labor costs should be contained relative to German ones going forward. French competitiveness has been hampered by decades of rigidities while German competitiveness benefited greatly following the implementation of the Hartz IV labor reforms. Not only should the potential for reform help France over Germany, but the fact that the French unemployment rate remains elevated while that of Germany is at generational lows points also toward rising German labor costs vis-à-vis France (Chart 39). Additionally, our secular theme of overweighting defense stocks plays in France's favor, given that France is the world's fourth largest global defense exporter.14 Finally, adding to the attractiveness of the trade, French industrial equities are trading near the low of their 12-year trading range against German ones (Chart 40). Chart 38French Small Cap Equals Nasdaq##br## (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) French Small Cap Equals Nasdaq (And The Euro, Of Course) Chart 39Reforms Could ##br##Close This Gap Reforms Could Close This Gap Reforms Could Close This Gap Chart 40Industrials: Buy France / ##br##Short Germany Industrials: Buy France / Short Germany Industrials: Buy France / Short Germany In a broader sense, the implementation of the Hartz IV reforms in Germany resulted in a general outperformance of German stocks over French stocks. Now that reforms have been fully implemented and priced in Germany, while investors remain highly skeptical of the outlook for French reforms (and indeed, fear an anti-establishment revolution), today may be the time to begin overweighting French equities at the expense of German ones in European portfolios on a structural basis. Finally, the spike in French yield differentials against German suggest that investors are imbedding a risk premium for the probability of a Le Pen win in the May election. A Le Pen victory would represent a death knell for the euro. As such, the euro countertrend bounce could find further support from a falling risk premium. Any selloff in the euro if Le Pen wins the first round of the election would represent a tactical buying opportunity in EUR/USD. Bottom Line: French industrials should be the key outperformers vis-a-vis Germany in the event of a Fillon or Macron electoral victory. However, French stocks in general should be able to outperform. Buy the euro on any election-related dip, particularly following the first round of the election on April 23. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see The Economist, "The sick man of the euro," dated June 3, 1999, available at economist.com. 2 The figures presented here are actually the reduced numbers from the 2013 Acte III de la decentralization. 3 Please see BCA Research Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 4 A generous pension system is part of the problem. The effective retirement age is around 61 years, well below the legal age of 65. According to the OECD, the French spend 25 years in retirement, the longest in the developed world. 5 To address this problem, President François Hollande's Responsibility and Solidarity Pact has begun to shift the burden of financing the public purse away from payroll taxes and onto consumption (via higher VAT taxes). But a greater effort is needed. 6 Oddly, France does not do that badly in the World Bank Ease of Doing Business ranking - it is 29th out of 190, ahead of Switzerland and Japan and only one place behind the Netherlands. 7 Please see Gary Banks, OECD, "Structural reform Australian-style: lessons for others?" presentations to the IMF and World Bank, May 26-27, 2005, and OECD, May 31, 2005, available at oecd.org. 8 Please see BCA Research Global Investment Strategy, "Après Paris," dated November 20, 2015, available at gis.bcaresearch.com. 9 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 10 IFOP poll from December 2016. 11 To be fair, French law does not require parties to publish their donations and spending. Please see Bloomberg, "Le Pen Struggling to Fund French Race as Russian Bank Fails," dated December 22, 2016, available at Bloomberg.com. 12 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 13 Please see BCA Research Geopolitical Strategy Special Report, "After BREXIT, N-Exit?" dated July 13, 2016, and The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at gps.bcaresearch.com. 14 Please see Global Alpha Sector Strategy and Geopolitical Strategy Special Report, "Brothers In Arms," dated January 11, 2017, available at gps.bcaresearch.com.

Highlights U.S. growth will remain firm over the next 12 months, but then will begin to slow from its above-trend pace as the economy runs out of spare capacity. Fiscal stimulus, by the time it is enacted, may simply end up pushing up wages, interest rates, and the dollar, rather than boosting corporate profits. While the U.S. is not at an imminent risk of a recession, the historic record suggests that recessions are more likely to occur when an economy has achieved full employment. Equity investors should favor Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are reasonably favorable. Feature The Rusty Lining The U.S. economy is approaching full employment. The headline unemployment rate has fallen to 4.7%, close to most estimates of NAIRU. Broader measures of labor market slack, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 1). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are near 2007 levels (Chart 2). Chart 1U.S. Labor Market: Not Much Slack Left The Downside To Full Employment The Downside To Full Employment Chart 2Most Labor Market Survey Measures ##br## Now Consistent With Full Employment Most Labor Market Survey Measures Now Consistent With Full Employment Most Labor Market Survey Measures Now Consistent With Full Employment It is obviously good news that most people in the U.S. who want to work are able to find jobs. However, at the risk of sounding like spoilsports, we see three risks associated with this development. First, and most obviously, the fact that the U.S. economy is close to full employment means that it will not be able to grow at an above-trend pace for much longer. Second, efforts by the Trump administration to lift aggregate demand with fiscal stimulus may prove to be counterproductive: Rather than boosting GDP growth, the stimulus may simply lead to higher wage inflation and a stronger dollar. This could hurt corporate profits. Third, there is compelling evidence that the risks of a recession rise as an economy approaches full employment and begins to overheat. We discuss all three issues in turn. Weak Supply Will Limit Growth One of the more striking aspects of the U.S. economic recovery is that the output gap - the difference between what an economy is capable of producing and what it actually is producing - has nearly disappeared even though GDP growth has been rather lackluster. This has occurred for one simple reason: Potential GDP growth has been extremely weak. Chart 3 shows that the slowdown in potential GDP growth has been a global phenomenon. In every major economy, the output gap would be larger today than in 2008 if potential GDP had grown at the rate that the IMF forecasted back then. Chart 3AWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Chart 3BWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Many commentators are hopeful that the combination of sizeable tax cuts and President Trump's pledge to reduce red tape will lead to a marked acceleration in potential U.S. GDP growth. There is some validity to this view. Statutory corporate tax rates in the U.S. are among the highest in the OECD, while the Code of Federal Regulations is 178,000 pages long, eight times the size that it was in 1960 (Chart 4). Still, we are skeptical that the economic benefits of slashing corporate taxes and cutting red tape would be as great as some pundits are touting. If one includes the various loopholes and deductions that companies can avail themselves of, effective corporate tax rates in the U.S. are not particularly high compared with those of other countries.1 Cutting corporate taxes may also do precious little to lift investment spending, given that U.S. companies are already flush with cash and have access to plenty of cheap financing. While the regulatory burden on U.S. businesses has increased somewhat over the past seven years, it is still quite low compared to other major economies according to the World Bank's Doing Business report (Chart 5). And many of the regulations that businesses routinely complain about serve a useful purpose, particularly in the areas of health, clean air and water, and financial stability. Consistent with the analysis above, there is little evidence that Reagan's tax cuts and deregulation initiatives had much effect on productivity growth in the 1980s (Chart 6). Meanwhile, Trump's efforts to crack down on illegal immigration will reduce labor force growth, curbing potential GDP growth in the process. Trade protectionism will also dent productivity in some sectors of the economy. The bottom line is that potential growth is unlikely to rise much above 2% for the foreseeable future. Chart 4There Are Prolific Writers In The U.S. Administration There Are Prolific Writers In The U.S. Administration There Are Prolific Writers In The U.S. Administration Chart 5Regulatory Burden In The U.S. Is Relatively Low The Downside To Full Employment The Downside To Full Employment Chart 6The Reagan Years Were No Boon For U.S. Productivity The Downside To Full Employment The Downside To Full Employment Flagging Fiscal Multipliers As we discussed last week, market participants may be overestimating the extent to which fiscal policy will be eased over the next two years.2 Suppose, however, that the optimists are right; suppose Donald Trump is able to fully deliver on his campaign pledge to raise infrastructure spending and slash taxes. Let us also suppose that, contrary to our expectations, lower personal and corporate tax rates do prompt households to significantly boost spending, while incentivizing firms to increase capital expenditures. What then? The answer is that this still may not translate into significantly faster economic growth. The reason is straightforward: When the output gap is small, an increase in aggregate demand will largely translate into higher inflation rather than increased output. An overheated economy, in turn, will drive up real interest rates, leading to less spending on rate-sensitive goods such as consumer durables, housing, and business equipment. In addition, higher interest rates will cause the dollar to strengthen, swelling imports and reducing exports. This "crowding out" effect will reduce the net effect of fiscal stimulus on growth. The empirical evidence bears this out. Table 1 shows the fiscal multipliers are much smaller when an economy is close to full employment. Table 1The Effect Of A $1 Increase In Fiscal Spending On Aggregate Demand The Downside To Full Employment The Downside To Full Employment The implication is that Trump's fiscal stimulus plan, by the time it is enacted, may simply end up lifting interest rates, the dollar, and wages, without delivering much acceleration in real business sales. Again, this is not just a theoretical possibility. Chart 7 shows that the ratio of corporate profits-to-GDP has tended to decline when the unemployment rate has fallen below its full employment level. This suggests that the re-acceleration in earnings growth that began last summer could run out of steam later this year. Chart 7The Effects Of Full Employment The Effects Of Full Employment The Effects Of Full Employment Recession Risks Are Slowly Rising Business cycle recoveries may not die of old age. However, as anyone who's been around long enough knows, old age isn't exactly conducive to good health either. Chart 8 shows that there is a positive correlation between the degree of labor market slack and the length of time until the next recession. This implies that recessions are more likely to occur when an economy approaches full employment. In fact, outside of the 1982 recession, which in many respects was just a continuation of the 1980 recession, there has never been a case in the post-war era where a recession began at a time when the unemployment rate was above its full employment level. Formal econometric analysis bears this out: According to our calculations, the U.S. has had nearly a 31% chance of falling into recession over the subsequent 12-month period when the economy was at or above full employment, compared with only an 8% chance at all other times.3 Part of the relationship between economic slack and recession risk can be explained by the fact that the unemployment rate is mean reverting. Thus, when the unemployment rate is very low, it is more likely to go up than down. And history suggests that even a slight rise in the unemployment rate is a powerful harbinger of recession. In fact, Chart 9 shows that there has never been a case where the unemployment rate has risen more than one third of a percentage point without the U.S. falling into a recession. Chart 8U.S.: A Tighter Labor Market Means We Are Getting Closer To The Next Recession The Downside To Full Employment The Downside To Full Employment Chart 9Even A Small Increase In The Unemployment Rate Warns Of A Recession Even A Small Increase In The Unemployment Rate Warns Of A Recession Even A Small Increase In The Unemployment Rate Warns Of A Recession When Animal Spirits Bite Back Mean reversion, however, is only part of the story. As Hyman Minsky famously noted, stability begets instability. By this, he meant that good economic times tend to encourage excessive risk taking, and this sows the seeds of a future crisis. The good news is that the U.S. does not currently suffer from any major economic imbalances. Perhaps it was the severity of the crisis; perhaps it was the lackluster recovery; but whatever the reason, animal spirits have been slow to return this time around. Sure, stocks have soared thanks to ultra-low interest rates, but both business and residential investment remain subdued (Chart 10). Nevertheless, signs of excess are starting to appear in places. Corporations may have been restrained in their capital spending plans, but that did not stop them from piling on new debt to finance share buybacks, and mergers and acquisitions (Chart 11). As a result, our Corporate Health Monitor has been in deteriorating territory since the second half of 2013 (Chart 12). Chart 10Business And Residential Investment Remain Subdued Business And Residential Investment Remain Subdued Business And Residential Investment Remain Subdued Chart 11Companies Have Been Piling On New Debt Companies Have Been Piling On New Debt Companies Have Been Piling On New Debt Chart 12U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating Policy risks have also increased. These include the possibility of a global trade war, rising support for anti-establishment parties in Europe, and a pronounced slowdown in China that precipitates mass capital flight and a sharp depreciation of the RMB. Complicating matters is the fact that policy rates remain quite low across all major economies, which limits the ability of central banks to respond to another economic downturn. Investment Conclusions Chart 13More Optimism About The ##br##Longevity Of The Business Cycle The Downside To Full Employment The Downside To Full Employment Fears of secular stagnation, which were all the rage just 12 months ago, have given way to unbridled confidence about the future. Investors now dismiss the exact same things they once feared from Donald Trump, even though Trump the President has proven to be little different from Trump the Candidate. Among participants in the New York Fed's Survey of Primary Dealers who assign a non-zero probability that rates will fall back to zero at some point over the next three years, the median respondent expects that it would take 27 months to reach this sorry state of affairs, up from 11 months in April 2016 (Chart 13).4 If one uses this as proxy for when investors believe the next recession will roll around, it implies that market participants now believe that the recovery will last more than twice as long as they thought last summer. We agree that U.S. growth is likely to remain firm over the next 12 months. As we argued last October in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the U.S. economy has a lot of momentum behind it.5 As such, we continue to expect Treasury yields to rise and the dollar to appreciate over the next 12 months. Nevertheless, we are cognizant that much can go wrong with this assessment. Chart 14 shows that most of the recent better-than-expected data has been confined to survey measures of economic activity - what economists call "soft data." The so-called "hard data" has been mediocre. This is not a major red flag, as the hard data often lags the survey results, but it does underscore the fragile nature of the recovery. Chart 14Survey Measures Have Improved More Than The Hard Data Survey Measures Have Improved More Than The Hard Data Survey Measures Have Improved More Than The Hard Data All this puts U.S. stocks in a difficult position. If growth does end up disappointing, equities will suffer. However, if growth remains strong, bond yields are likely to rise further, taking the dollar up with them. Meanwhile, a tight labor market will increasingly put upward pressure on real wages, hurting corporate profit margins in the process. With that in mind, investors should overweight equity markets in Europe and Japan, two places where central banks are in no hurry to raise rates, profit margins still have room to expand, and valuations are more favorable. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 According to a report by the Congressional Research Service, the U.S. statutory corporate tax rate was 39.2% while the GDP-weighted average rate in the OECD excluding the U.S. was 29.6% (based on 2010 data). Meanwhile, the U.S. effective tax stood at 27.1% versus the 27.7% average of its OECD peers (based on 2008 data). Studies conducted before the Great Recession also show that the U.S. effective rate is about the same as the GDP-weighted average rate of other major countries. For further details, please see Jane G. Gravelle, "International Corporate Tax Rate Comparisons and Policy Implications," Congressional Research Service (January 6, 2014). 2 Please see Global Investment Strategy Weekly Report, "Two Speed Bumps For The Global Reflation Trade," dated January 27, 2017, available at gis.bcaresearch.com. 3 The probability of a U.S. recession occurring within the next 12 months is calculated by employing a simple logistic model using data from 1960 to the present. The dependent variable (Y) is assigned the value "1" during months when a recession occurs over the subsequent 12-month period, or "0" otherwise. An independent variable (X) is assigned the value "1" when the economy is at full employment, or "0" otherwise. Assuming full employment is reached when the unemployment rate is at least 25 bps lower than the non-accelerating inflation rate of unemployment, the resulting probabilities for a recession within the next year are as follows: P(Y=1 given that X=1) = 31%; P(Y=1 given that X=0) = 8%; P(Y=1 given that X=1 or given that X=0) = 17%. In a nutshell, the probability of a recession occurring increases by 23 percentage points (from 8% to 31%) once full employment is reached. 4 In both the April 2016 and December 2016 surveys, all but one respondent indicated that there was a non-zero chance that rates will fall to zero over the relevant forecast horizon. 5 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades