Economic Growth

Highlights Overall Strategy: The global economy is entering a reflationary sweet spot that will last for the next two years. Investors should overweight equities, maintain slightly below benchmark exposure to government bonds, and underweight cash over a 12-month horizon. Fixed Income: Global bond yields will rise only modestly over the next two years, reflecting an abundance of spare capacity in many parts of the world. A major bond bear market will begin towards the end of the decade, as stagflationary forces gather steam. Equities: Investors should underweight the U.S. for the time being, while overweighting Europe and Japan in currency-hedged terms. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate another 6% from current levels. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is approaching a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks later this year. Feature I. Key Theme: A Reflationary Window The global economy is entering a reflationary sweet spot where deflationary forces are in retreat but fears of excess inflation have yet to surface. Activity data are surprising to the upside and leading economic indicators have turned higher (Chart 1). Falling unemployment in most major economies is boosting confidence, fueling a virtuous cycle of rising spending and even further declines in joblessness. Manufacturing activity is bouncing back after a protracted inventory destocking cycle (Chart 2). In addition, the stabilization in commodity prices has given some relief to emerging markets, while fueling a modest rebound in resource sector capital spending. Meanwhile, easier fiscal policy is providing a welcome tailwind to growth. The aggregate fiscal thrust for advanced economies turned positive in 2016 - the first time this has happened in six years. We expect this trend to persist for the foreseeable future. Reflecting these developments, market-based measures of inflation expectations have risen, offsetting the increase in nominal interest rates. In fact, real rates in the euro area and Japan have actually declined across most of the yield curve since the U.S. presidential election (Chart 3). This should translate into higher household and business spending in the months ahead. Chart 1Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating Chart 2Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 3Falling Real Rates In The Euro Area And Japan Falling Real Rates In The Euro Area And Japan Falling Real Rates In The Euro Area And Japan Supply Matters Yet, there has been a dark side to this reflationary trend, and one that could sow the seeds for stagflation as the decade wears on. Simply put, much of the reduction in spare capacity over the past eight years has occurred not because of much faster demand growth, but because of continued slow supply growth. Chart 4 shows that output gaps in the main developed economies would still be enormous today if potential GDP had grown at the rate the IMF forecasted back in 2008. Chart 4AWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Chart 4BWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Unfortunately, we do not expect this state of affairs to change much over the coming years. The decline in birth rates that began in the 1960s has caused working-age populations to grow more slowly in almost all developed and emerging economies (Chart 5). In some countries such as the U.S., the downward pressure on labor force growth has been exacerbated by a structural decline in participation rates, especially among the less educated (Chart 6). Chart 5Slowing Workforce Growth Slowing Workforce Growth Slowing Workforce Growth Chart 6U.S.: The Less Educated Are Shunning The Labor Force First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Productivity growth has also fallen (Chart 7). Part of this phenomenon is cyclical in nature, reflecting the impact of several years of weak corporate investment in new plant and equipment. However, much of it is structural. As Fed economist John Fernald has shown, the slowdown in productivity growth since 2004 has been concentrated in sectors that benefited the most from the adoption of new information technologies in the late 1990s (Chart 8).1 Recent technological innovations have focused more on consumers than on businesses. This has resulted in slower productivity growth. Chart 7Slowing Productivity Growth Around The World Slowing Productivity Growth Around The World Slowing Productivity Growth Around The World Chart 8The Productivity Slowdown Has Been ##br##Greatest In Sectors That Benefited The Most From The I.T. Revolution First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation To make matters worse, human capital accumulation has decelerated both in the U.S. and elsewhere, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the rate it did in the 1990s (Chart 9). Educational achievement, as measured by standardized test scores, has also peaked, and is now falling in many countries (Chart 10). Chart 9The Contribution To Growth ##br##From Rising Human Capital Is Falling First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 10Math Skills Around The World First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation From Deflation To Inflation To reiterate what we have discussed at length in the past, the slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on.2 Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 11). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period during which productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 12). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 12An Aging Population Eventually Pushes Up Interest Rates First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Is Debt Deflationary Or Inflationary? The answer is both. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Moreover, once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. Acting on that incentive also becomes easier as the output gap evaporates. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to maintain interest rates at ultra-low levels, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, an adverse economic shock, etc. In contrast, if the output gap is already close to zero, a promise to let the economy run hot is more likely to be taken seriously. The U.S. Economy: Still In A Reflationary Sweet Spot The stagflationary demons described above will eventually come back to haunt the U.S., but for now and probably for the next two years, the economy will remain in a reflationary sweet spot. After a weak start to 2016, growth has bounced back. Real GDP grew by 3.5% in Q3. The Atlanta Fed's GDPNow model points to still-healthy growth of 2.9% in Q4. We expect growth to stay robust in 2017, as improving confidence and a stabilization in energy-sector investment lift overall business capex, homebuilding picks up after contracting in both Q2 and Q3 of 2016, and rising wages push up real incomes and personal consumption. Above-trend growth will continue to erode spare capacity. The headline unemployment rate has fallen to 4.6%, close to most estimates of NAIRU. Broader measures of unemployment, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 13). 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 all at or above 2007 levels (Chart 14). In contrast to most measures of labor market slack, industrial utilization still remains quite low by historic standards (Chart 15). In fact, the Congressional Budget Office's "capacity utilization-based" estimate of the output gap stands at around 3% of GDP, whereas its "unemployment-based" estimate is close to zero. Chart 13U.S. Labor Market: Not Much Slack Left First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 14Most U.S. Labor Market Measures ##br## Are Back To Pre-Recession Levels Most U.S. Labor Market Measures Are Back To Pre-Recession Levels Most U.S. Labor Market Measures Are Back To Pre-Recession Levels Chart 15U.S.: Industrial Capacity Utilization Remains Low U.S.: Industrial Capacity Utilization Remains Low U.S.: Industrial Capacity Utilization Remains Low A strong dollar, as well as the ongoing decline of the U.S. manufacturing base, partly explain the low level of industrial utilization. However, another important reason bears noting: Years of depressed real wage growth has made labor scarce compared with capital. The free market solution to this problem is higher wages for workers. Good news for Main Street; but perhaps not so good news for Wall Street. Stagflation Is Coming, Just Not Yet While inflation will creep higher in 2017, a major spike is unlikely over the next two years. There are two main reasons for this. First, if the economy does run into severe capacity constraints, the Fed will have to step up the pace of rate hikes. Higher interest rates will push up the value of the dollar, curbing growth and inflation. Second, the historic evidence suggests that it takes a while for an overheated economy to generate meaningfully higher inflation. Consider how inflation evolved during the 1960s. U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 due to rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 16). The relationship between economic slack and inflation is depicted by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 17). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Chart 16It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 17The Phillips Curve Has Flattened First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation The adoption of inflation targeting, coupled with more transparent Fed communication, has helped anchor inflation expectations. This has flattened the Phillips curve. A flatter Phillips curve implies a lower "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. Going forward, the temptation to exploit the flatness of the Phillips curve may be too great to resist. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that she is at least willing to entertain the idea. Interest rates are still fairly low and a few more hikes are unlikely to cause much distress among corporate and household borrowers. As rates continue to climb, however, this may change, making it difficult for the Fed to further tighten monetary policy. This is especially the case if potential real GDP growth remains lackluster, as this would make it harder for borrowers to generate enough income to service their debts. Trump's budget-busting fiscal deficits may also put some pressure on the Fed to eschew raising rates too much in an effort to hold down interest costs. Even if such political pressures do not materialize, the challenges posed by the zero bound constraint on nominal interest rates could still justify efforts to raise the Fed's 2% inflation target. After all, if inflation were higher, this would give the Federal Reserve the ability to push down real rates further into negative territory in the event of an economic downturn. Admittedly, such a step is unlikely to be taken anytime soon. Nevertheless, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF; San Francisco Fed President John Williams; and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. The bottom line is that inflation is likely to move up slowly over the next two years, but could begin to accelerate more sharply towards the end of the decade. Japan: The End Of Deflation? Like the U.S., Japan has also entered a reflationary window. Retail sales surprised on the upside in November, rising 1.7%, against market expectations of 0.8%. Industrial production and exports continue to rebound, a trend that should persist thanks to the yen's recent depreciation (Chart 18). Stronger economic growth is causing the labor market to heat up. The Bank of Japan estimates that the "labor input gap" is now positive, meaning that the economy has run out of surplus workers (Chart 19). Reflecting this, the ratio of job openings-to-applicants has reached a 25-year high (Chart 20). Chart 18Japan: Some Positive Economic News Japan: Some Positive Economic News Japan: Some Positive Economic News Chart 19Japan: Labor Market Slack Has Evaporated, But Industrial Capacity Utilization Has Fallen First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 20Japan: Sign Of Tightening Labor Market Japan: Sign Of Tightening Labor Market Japan: Sign Of Tightening Labor Market Wage growth so far has been tepid, but that should change over the next two years. The labor force expanded by 0.9% year-over-year in November - the latest month for which data are available - largely due to the continued influx of women into the labor force. Chart 21 shows that the employment-to-population ratio for Japanese prime-age women now exceeds that of the U.S. by three percentage points. As Japanese female labor participation stabilizes, overall labor force growth will turn negative, pushing up wages in the process. Chart 21Japan: Female Labor Force ##br##Participation Now Exceeds The U.S. Japan: Female Labor Force Participation Now Exceeds The U.S. Japan: Female Labor Force Participation Now Exceeds The U.S. In contrast to the Fed, the BoJ is unlikely to tighten monetary policy in response to higher inflation. As a consequence, real yields will continue to fall as inflation expectations rise further. This will lead to higher net exports via a weaker yen, as well as increased spending on interest-rate sensitive goods such as consumer durables and business equipment. Indeed, a virtuous circle could develop where an overheated labor market pushes down real rates, causing aggregate demand and inflation to rise, leading to even lower real rates. If this occurs, growth could accelerate sharply, avoiding the need for more radical measures such as "helicopter money." In short, Japan may be on the verge of escaping its deflationary trap. This is something that could have happened shortly after Prime Minister Abe assumed office, but was short-circuited by the government's lamentable decision to tighten fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. Europe: Fine... For Now The European economy grew at an above-trend pace in 2016. Real GDP in the EU is estimated to have expanded by 1.9%, compared to 1.6% in the U.S. The euro area is estimated to have grown by 1.7% - the first time that growth in the common currency bloc exceeded the U.S. since the Great Recession. Euro area growth should remain reasonably strong in 2017, as telegraphed by a number of leading economic indicators (Chart 22). Fiscal austerity has been shelved in favor of modest stimulus. The European Commission is now even advising member countries to loosen fiscal policy more than they themselves are targeting (Chart 23). Chart 22Euro Area Growth Will Remain On Solid Footing In 2017 Euro Area Growth Will Remain On Solid Footing In 2017 Euro Area Growth Will Remain On Solid Footing In 2017 Chart 23The European Commission Recommends Greater Fiscal Expansion First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Ongoing efforts to strengthen the euro area's banking system will also help. As we noted in the "Italian Bank Job," the costs of cleaning up the Italian banking system are modest compared with the size of the Italian economy.3 The failure to have done it earlier represents a massive "own goal" by the Italian and EU authorities. As banking stresses recede, the gap in economic performance between northern and southern Europe should narrow. The overall stance of monetary policy will facilitate this trend. If the ECB keeps interest rates near zero for the foreseeable future, as it almost certainly will, Germany's economy will overheat. Chart 24 shows that the German unemployment rate has fallen to a 25-year low, while wage growth is now running at twice the rate as elsewhere in the euro area. Chart 24German Labor Market Going Strong German Labor Market Going Strong German Labor Market Going Strong An overheated German economy will help the periphery in two important ways: First, higher wage inflation in Germany will give a competitive advantage to Club Med producers seeking to sell their goods in the euro area's biggest economy. Second, faster wage growth and stronger domestic demand in Germany will erode the country's gargantuan current account surplus of nearly 9% of GDP. This will put downward pressure on the euro, giving the periphery a further competitive boost. Of course, all this rests on the assumption that Germany accepts an overheated economy. One could objectively argue that it is in Germany's political best interest to do so, as this may be the only means by which to hold the euro area together. One could also argue that rebalancing German growth towards domestic demand, and away from its historic reliance on exports, would be in the country's long-term best interest. One might also contend that German banks would accept a few more years of low rates if this helped lower nonperforming loans across the euro area, while also paving the way for the eventual abandonment of ZIRP and NIRP. Chart 25Italy Lags Peers On Euro Support Italy Lags Peers On Euro Support Italy Lags Peers On Euro Support Whatever the merits of these arguments, they clash with Germany's historical antipathy towards inflation. This means that political risk could escalate over the coming years. Against the backdrop of growing anti-establishment sentiment - fueled in no small measure by the EU's deer-in-the-headlights response to the migration crisis - Europe's populist parties will continue to make gains at the polls. Timing is important, however. With unemployment trending lower, our hunch is that any truly disruptive populist shock may have to wait until the next recession, which is likely still a few years away. BCA's Geopolitical Strategy team holds a strong conviction view that Marine Le Pen, the leader of the eurosceptic National Front, will be defeated in the second round of the presidential election in May. They also think that Angela Merkel will cling to power, partly because Germany still lacks an effective anti-establishment opposition party. Italy is more of a concern, given that support for the common currency among Italians has been falling and is now lower than virtually anywhere else in the euro area (Chart 25). Nevertheless, our geopolitical strategists assign very low odds to Italy following Britain's example and voting to leave the EU. Indeed, it is still not even clear that the U.K. will actually follow through and exit the EU. Brussels is likely to play hardball with the U.K. during the negotiations slated to begin in March. EU officials are keen to send a clear warning to other EU members who may be tempted to leave the club. It is still quite possible that another referendum will be held in one or two years concerning the terms of the negotiated agreement that would govern Britain's future relationship with the EU. Given how close the first referendum was, there is a reasonable chance that U.K. voters will choose EU membership over a bad deal. In that case, Brussels will back off from its threat that triggering Article 50 would irrevocably lead to the U.K.'s expulsion from the EU. China: Still In Need Of A Spender-Of-Last Resort Investor angst about China rose to a fever pitch early last year, but has since faded into the background. The main reason for this is that the deflationary forces which once threatened to precipitate a hard landing for the economy have abated. Growth has picked up and producer price inflation has risen from -5.3% in early 2016 to 3.3% in November (Chart 26). As our China strategists have argued, the end of PPI deflation is a major positive development for the Chinese corporate sector, as it improves its pricing power while reducing its real cost of funding (Chart 27). Real bank lending rates deflated by the PPI rose to near-record highs early last year, but have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This has bestowed dramatic relief on some highly-levered, asset-heavy industries. These industries were the biggest casualties of the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bode well for banks. Chart 26China: Improving Growth Momentum China: Improving Growth Momentum China: Improving Growth Momentum Chart 27China: Real Interest Rates Dropping ##br## Thanks To Easing Deflation China: Real Interest Rates Dropping Thanks To Easing Deflation China: Real Interest Rates Dropping Thanks To Easing Deflation Unfortunately, the reflationary forces in China are masking deep underlying problems. Structural reform has been patchy at best; credit continues to expand much faster than GDP; and speculation in the real estate sector is rampant (Chart 28). Meanwhile, capital continues to flow out of the country, taking the PBOC's foreign exchange reserves down from a high of $4 trillion in June 2014 to $3.1 trillion at present. There are no easy solutions to these problems. Tightening monetary policy could help fend off capital flight, but this would hurt growth and potentially plunge the economy back into deflation. This week's spike in interbank rates is evidence of just how sensitive the economy has become to any withdrawal of monetary accommodation (Chart 29). Chart 28China: Credit Continues Expanding And The##br## Real Estate Sector Is Getting Frothy China: Credit Continues Expanding And The Real Estate Sector Is Getting Frothy China: Credit Continues Expanding And The Real Estate Sector Is Getting Frothy Chart 29China: Yet Another Spike In Interbank Rates China: Yet Another Spike In Interbank Rates China: Yet Another Spike In Interbank Rates As we controversially argued in "China Needs More Debt," China's underlying problem is a chronic excess of savings.4 This has kept aggregate demand below the level commensurate with the economy's productive capacity. In the past, China was able to export some of those excess savings abroad via a large current account surplus, which peaked at 10% of GDP in 2007 (Chart 30). However, China is now too large to export its way out of its problems. It was one thing for China to run a current account surplus of 10% of GDP when its economy represented 6% of global GDP. It is quite another to do so when the economy represents 15% of global GDP, as it does now. This is especially the case when other economies are also keen to have cheap currencies. Faced with this reality, the government has been trying to buttress aggregate demand by funneling a huge amount of credit towards state-owned companies, which have then used these funds to finance all sorts of investment projects. The problem is that China no longer needs as much new capacity as it once did. As trend GDP growth has slowed, the level of investment necessary to maintain a constant capital-to-output ratio has fallen by about 10% of GDP over the past decade.5 China's aging population will eventually lead to a drop in savings. Government plans to strengthen the social safety net should also help this transition along by reducing household precautionary savings. However, these are long-term developments. Over the next couple of years, China will have little choice but to let credit grow at a rapid pace. The good news is that China has ample domestic savings to continue financing credit expansion. The ratio of bank loans-to-deposits remains near all-time lows (Chart 31). The government also has plenty of fiscal resources to safeguard the banks from losses on nonperforming loans extended to local governments and state-owned enterprises. Chart 30China Used To Rely On Large ##br##Current Account Surplus To Export Excess Savings China Used To Rely On Large Current Account Surplus To Export Excess Savings China Used To Rely On Large Current Account Surplus To Export Excess Savings Chart 31China: Banks Have Ample Deposit Coverage China: Banks Have Ample Deposit Coverage China: Banks Have Ample Deposit Coverage All that may not be enough, however. Given the risks to financial stability from excessive investment by state-owned enterprises, the government may have little choice but to cajole households into spending more by suppressing bank deposit rates while purposely engineering higher inflation. The resulting decline in real rates will reduce the incentive to save while helping to inflate away the mountain of debt that has already been accumulated. II. Financial Markets Equities Chart 32Investors Are Optimistic Investors Are Optimistic Investors Are Optimistic Deflation is bad for equities, as is stagflation. But between deflation and stagflation there is reflation - and that is good for stocks. This reflationary window should remain open for the next two years. As such, we expect global equities to be higher in 12 months than they are today. However, the risks for stocks are tilted to the downside over both a shorter-term horizon of less than two months and a longer-term horizon exceeding two years. The near-term outlook is complicated by the fact that global equities are overbought, and hence vulnerable to a selloff. Chart 32 shows that bullish sentiment is stretched to the upside. Expectations of long-term U.S. earnings growth have also jumped to over 12%, something that strikes us as rather fanciful. Renewed rumblings in China could also spook the markets for a while. We expect global equities to correct 5%-to-10% from current levels, setting the stage for a more durable recovery. Once that recovery begins, higher-beta developed markets such as Japan and Europe should outperform the U.S. As my colleague, Mark McClellan, has shown, Europe and Japan are considerably cheaper than the U.S., even after adjusting for sector skews and structural valuation differences.6 The relative stance of monetary policy also favors Europe and Japan. Neither the ECB nor the BoJ is likely to hike rates anytime soon. This means that rising inflation expectations in these two economies will push down real rates, weakening their currencies in the process. Emerging markets are a tougher call. The combination of a strengthening dollar, growing protectionist sentiment in the developed world, and high debt levels are all bad news for emerging markets. EM equity valuations are also not especially cheap by historic standards (Chart 33). Nevertheless, a reflationary environment has typically been positive for EM equities. The tight correlation between EM and global cyclical stocks has broken down over the past three months (Chart 34). We suspect the relationship will reassert itself again over the course of 2017, giving EM stocks a bit of a boost. Chart 33EM Stocks Are Not Particularly Cheap EM Stocks Are Not Particularly Cheap EM Stocks Are Not Particularly Cheap Chart 34EM Stocks Are Lagging EM Stocks Are Lagging EM Stocks Are Lagging On balance, EM equities are likely in a bottoming phase where returns over the next 12 months will be positive but not spectacular. BCA's favored markets are Korea, Taiwan, China, India, Thailand, and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil, and Peru. Turning to global equity sectors, a bias towards cyclical names is appropriate in an environment of rising global growth. Longer term, our equity sector specialists like health care and technology names. The outlook for financial stocks remains a key area of debate within BCA. Most of my colleagues would still avoid banks. I am more partial to the sector. As I argued in September in "Three Controversial Calls: Global Banks Finally Outperform," steeper yield curves will boost net interest margins over the next few years while rising demand for credit will support top-line growth (Chart 35). On a price-to-earnings basis, global banks are quite cheap, despite being much better capitalized than they were in the past (Chart 36). Chart 35AHigher Yields Will Benefit Banks Higher Yields Will Benefit Banks Higher Yields Will Benefit Banks Chart 35BHigher Yields Will Benefit Banks Higher Yields Will Benefit Banks Higher Yields Will Benefit Banks Lastly, in terms of size exposure, we prefer small caps over large caps. Small capitalization stocks tend to do better in reflationary environments (Chart 37). The ongoing retreat from globalization will also benefit smaller domestically-focused firms at the expense of those with large global footprints. In the U.S. specifically, small caps face a potential additional benefit. If the new Trump administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Chart 36Global Banks Are Cheap ##br##And Better Capitalized Since The Crisis Global Banks Are Cheap And Better Capitalized Since The Crisis Global Banks Are Cheap And Better Capitalized Since The Crisis Chart 37Reflationary Backdrop ##br##Favors Small Caps Outperformance Reflationary Backdrop Favors Small Caps Outperformance Reflationary Backdrop Favors Small Caps Outperformance Fixed Income And Credit Back in March 2015, we predicted that the 10-year Treasury yield would fall to 1.5% even if the U.S. economy avoided a recession.7 The call was notably out of consensus at the time, but proved to be correct: The 10-year yield reached a record closing low of 1.37% on July 5th. As luck would have it, on that very same day, we sent out a note entitled "The End Of The 35-Year Bond Bull Market," advising clients to position for higher bond yields. Global bonds have sold off sharply since then, with the selloff intensifying after the U.S. presidential election. As discussed above, inflation in the U.S. and elsewhere will be slow to rise over the next two years. Hence, global bond yields are unlikely to move significantly higher from current levels. Indeed, the near-term path for yields is to the downside if our expectation of a global equity correction proves true. However, once the stagflationary forces described in this report begin to gather steam towards the end of the decade, bond yields could spike higher, imposing significant pain on fixed-income and equity investors alike. Regionally, we favor Japanese and euro area bonds relative to their U.S. counterparts over a 12-month horizon. Inflation in both Japan and the euro area remains well below target, suggesting that neither the BoJ nor the ECB will tighten monetary policy anytime soon. In contrast, the Fed is likely to raise rates three times in 2017, one more hike than the market is currently pricing in. In addition, we would underweight U.K. gilts. While U.K. growth will decelerate next year as uncertainty over the Brexit negotiations takes its toll, a weaker pound and some fiscal loosening will keep the economy from flying off the rails. In this light, the market's expectations that U.K. rates will rise to only 0.66% at end-2019 seems too pessimistic. Elsewhere in the developed world, our global fixed-income strategists are neutral on Canada and New Zealand bonds, but are underweight Australia. A modest underweight to EM government bonds is also warranted. Turning to credit, a reflationary backdrop is positive for spread product insofar as it will keep defaults in check, while also propping up the appetite for riskier assets. That said, U.S. high-yield credit is now quite expensive based on our fundamental models (Chart 38). Private-sector leverage remains at elevated levels and our Corporate Health Monitor is still in deteriorating territory (Chart 39). Rising government yields could also prompt yield-hungry investors to move some of their money back into sovereign debt. On balance, U.S. corporate spreads are likely to narrow slightly this year, but corporate credit will still underperform equities. Regionally, we see more upside in European credit, given the ECB's continued bond-buying program and greater scope for corporate profit margins to rise across the region. Chart 38U.S. High-Yield Valuations U.S. High-Yield Valuations U.S. High-Yield Valuations Chart 39U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating Currencies And Commodities BCA's Global Investment Strategy service has been bullish on the dollar since October 2014, a view that has generated a gain of nearly 17% for our long DXY trade recommendation. We reiterated this position last October in a note entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"8 where we predicted that the dollar would rally a further 10%. Since that report was published, the real trade-weighted dollar has gained 4%, implying another 6% of upside from current levels. Chart 40Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Both economic and political forces have conspired to keep the dollar well bid. The resurgent U.S. economy has pushed up real rate expectations in the U.S. relative to its trading partners. Chart 40 shows the amazingly strong correlation between the trade-weighted dollar and real interest rate differentials. Rate differentials should widen further over the coming months as investors price in more Fed rate hikes, and rising inflation expectations abroad push down real rates in economies such as Japan and the euro area. As we predicted in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Wins And The Dollar Rallies," Donald Trump's triumph on November 8th has given the greenback an additional boost. Progress in implementing any of Trump's three signature policy proposals - fiscal stimulus, trade protectionism, and immigration restrictions - will cause the U.S. output gap to narrow more quickly than it otherwise would, forcing the Fed to pick up the pace of rate hikes. Chart 41The Pound Is A Bargain The Pound Is A Bargain The Pound Is A Bargain The adoption of a "destination-based tax system" would further strengthen the dollar. Under the existing corporate tax structure, taxes are assessed on corporate profits regardless of where they are derived. In contrast, under a destination-based system, taxes would be assessed only on the difference between domestic sales and domestic costs. In practice, this means that imports would be subject to taxes, while exports would receive a tax rebate. In the simplest economic models, the imposition of a destination-based tax has no effect on domestic economic activity, inflation, or the distribution of corporate profits across the various sectors of the economy. This is because the dollar is assumed to appreciate by precisely enough to keep net exports unchanged. For that to happen, however, the requisite change in the currency needs to be quite large. For example, if the Trump administration succeeds in bringing down effective corporate tax rates to 20%, the required appreciation would be 1/(1-tax rate)=25%. Under current law, the required appreciation would be over 30%! In reality, the dollar probably would not adjust that quickly, implying that the transition period to a destination-based tax system would disproportionately benefit exporters at the expense of importers. Partly for this reason, the proposal will probably be heavily watered down if it is ever passed. Nevertheless, overall U.S. policy will continue to be biased towards a stronger dollar. Looking at the various dollar crosses, we still see more downside for the yen. The BoJ's policy of pegging the 10-year nominal yield will result in ever-lower real yields as Japanese inflation expectations rise. The euro should also continue to drift lower, most likely reaching parity against the dollar later this year. The pound could dip further if an impasse is reached during Brexit negotiations, as is likely at some point this year. That said, sterling is now very cheap, which limits the downside for the currency (Chart 41). Chart 42The Dollar Has Weighed On Gold The Dollar Has Weighed On Gold The Dollar Has Weighed On Gold The Chinese yuan will continue to grind lower, in line with most other EM currencies. As we discussed in March 2015 in a report entitled "A Weaker RMB Ahead," China's excess savings problem necessitates a weaker currency. The real trade-weighted RMB has fallen by 7% since that report was written, but a bottom for the currency remains elusive.9 As noted above, the Chinese government may have no choice but to boost household spending by suppressing deposit rates while working to engineer higher inflation. Negative real borrowing rates will keep capital flowing out of the country, putting downward pressure on the yuan. The overall direction of the Canadian and Aussie dollars will be dictated by the path of commodity prices. A reflationary environment tends to be bullish for commodities. Nevertheless, an uncertain macro outlook in China muddies the waters. We prefer oil over metals, given that the former is more geared towards growth in developed economies while the latter is heavily dependent on Chinese demand. This also makes the Canadian dollar a more attractive currency than the Aussie dollar. Lastly, a few words on gold: The combination of political uncertainty, rising inflation expectations, and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar. The strengthening of the dollar clearly was a factor undermining gold prices in the second half of 2016 (Chart 42). On balance, we would maintain a modest position in gold for the time being, but would look to increase exposure later this year as the dollar peaks. Peter Berezin Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 John G. Fernald, "Productivity and Potential Output Before, During, and After the Great Recession," Federal Reserve Bank of San Francisco, Working Paper 2014-15, (June 2014), and John G. Fernald, "The Pre-Great Recession Slowdown in U.S. Productivity Growth," (November 16, 2015). 2 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. 5 Back in 2007, trend growth was around 10%. Consistent with the empirical literature, let us assume that an appropriate capital-to-GDP ratio is 250% and that the capital stock depreciates at 5% a year. With a trend growth of 10%, China needs 2.5*10%=25% of GDP in new investment before depreciation to keep its capital-to-GDP ratio constant, and an additional 2.5*5%=12.5% of GDP in investment to cover depreciation, for a grand total of 37.5% of GDP in required investment. With a trend GDP growth rate of 6%, however, the required investment-to-GDP ratio would only be 2.5*6%+2.5*5%=27.5%. 6 Please see The Bank Credit Analyst Monthly Reports Section 2, "Are Eurozone Stocks Really That Cheap?" dated June 30, 2016, and "Japanese Equities: Good Value Or Value Trap?" dated November 24, 2016, available at bca.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 8 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. 9 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 06, 2015, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Dear Client, This is our last report of the year. We will be back the first week of January with our 2017 Strategy Outlook. On behalf of BCA's Global Investment Strategy team, I would like to take this moment to wish you and your loved ones a Merry Christmas, Happy Holidays, and all the best for the coming year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The global economy has entered a reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. Emerging markets should also gain from a more reflationary environment. However, a rising dollar and elevated debt levels will take the bloom off the rose. Chronically low productivity and labor force growth will make it difficult for central banks to contain inflation once it does begin to accelerate. Global bond yields will rise only modestly next year, but could begin to surge as the decade wears on. Feature Stagflation Is Coming, But Not Yet Bill Gates once noted that "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." This observation applies just as well to the risk of stagflation as it does to technology. For the next few years, the likelihood of a disorderly rise in inflation is extremely low. Beyond then, however, the risk is that inflation surprises to the upside, perhaps significantly so. Three factors will prevent global inflation from rising too rapidly over the next two-to-three years: The global economy still suffers from a fair amount of spare capacity; While spare capacity is likely to decline further, it will do so only gradually; Even when all remaining spare capacity is exhausted, the knock-on effect to inflation will initially be quite small. Spare Capacity Lingers Chart 1 shows that the global output gap has declined from its high in 2009, but is still larger than it has been at any time since the early 1990s. This can be seen in low industrial capacity utilization rates in some countries (Chart 2), as well as in the high levels of joblessness and involuntary part-time employment (Charts 3 and 4). Chart 1Mind The (Output) Gap Mind The (Output) Gap Mind The (Output) Gap Chart 2Global Capacity Utilization Remains Low Global Capacity Utilization Remains Low Global Capacity Utilization Remains Low Chart 3AJoblessness Still Elevated In Europe bca.gis_wr_2016_12_23_c3a bca.gis_wr_2016_12_23_c3a Chart 3BJoblessness Still Elevated In Europe bca.gis_wr_2016_12_23_c3b bca.gis_wr_2016_12_23_c3b Chart 4AHigher Incidence Of Involuntary ##br##Part-Time Employment bca.gis_wr_2016_12_23_c4a bca.gis_wr_2016_12_23_c4a Chart 4BHigher Incidence Of Involuntary ##br##Part-Time Employment bca.gis_wr_2016_12_23_c4b bca.gis_wr_2016_12_23_c4b Granted, the U.S. is much closer to full employment than most other economies. However, high levels of spare capacity abroad will still exert downward pressure on U.S. inflation. The reason for this was first laid out by Robert Mundell and Marcus Fleming in the early 1970s. The Mundell-Fleming model, as it is now called, posits that a country's interest rate will rise in response to stronger growth, thereby pushing up the value of its currency. Indeed, Mundell and Fleming showed that easier fiscal policy would not benefit a small open economy at all in a world of perfect capital mobility and flexible exchange rates because any gains from the stimulus would be entirely offset by a deterioration in the trade balance. Chart 5Real Rate Differentials ##br##Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar While the Mundell-Fleming model is a gross oversimplification of how the global economy actually functions, it is still highly relevant for understanding today's macro environment. The real broad trade-weighted dollar has appreciated by 21% since mid-2014, largely due to the widening of interest rate differentials between the U.S. and its trading partners (Chart 5). We estimate that the stronger dollar has reduced the level of U.S. real GDP by 1% so far, and will reduce it by another 0.5% stemming from the lagged effects from the recent dollar rally. The buoyant greenback will keep a lid on U.S. inflation both directly, in the form of lower import prices and indirectly, in the form of slower employment growth. The analysis above leads to three important investment implications. First, it implies that the dollar will remain well bid as long as the Fed remains the only major central bank in hiking mode. We have been long the DXY since October 2014 - a trade that has gained 18.6%. We think there is another 5% of upside from current levels. Second, a stronger dollar will help redistribute growth to Europe and Japan, two economies that desperately need it. We are bullish on European and Japanese stocks and bearish on the euro and the yen. Third, Treasury yields will be hard-pressed to rise substantially from current levels until spare capacity outside the U.S. is extinguished. Only once other central banks start raising rates will the Fed be able to hike rates in a sustainable manner. Until then, any Fed tightening beyond what the market is currently expecting will put upward pressure on the dollar, reducing the need for further hikes. A Gradual Recovery Table 1Global Growth Will Improve Next Year The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation Global growth should pick up next year in line with the IMF's most recent projections (Table 1). Alongside stronger growth in Japan and continued above-trend growth in Europe, the U.S. economy will benefit from robust consumer spending on the back of rising real wages. In addition, residential investment should rise, as foreshadowed by the jump in homebuilder confidence in December. Tighter credit spreads, deregulation, and a modest recovery in energy sector investment should also boost business capex. Despite this welcome reflationary backdrop, a number of factors will hold back growth. Most prominently, debt levels are still high around the world (Chart 6). In fact, emerging market debt continues to rise more quickly than GDP. Even in the optimistic scenario where the ratio of EM debt-to-GDP merely stabilizes, this would still entail a negative credit impulse (Chart 7). Chart 6Global Debt Levels Are Still High Global Debt Levels Are Still High Global Debt Levels Are Still High Chart 7Negative EM Credit Impulse Looming Negative EM Credit Impulse Looming Negative EM Credit Impulse Looming Meanwhile, monetary policy continues to be constrained by the zero bound in a number of developed economies. Many EM central banks will also be reluctant to cut interest rates due to fears that this could precipitate a disorderly plunge in their currencies. And while fiscal policy around the world will no longer be restrictive, a major burst of government stimulus is not in the cards. Donald Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. As we have noted before, most of America's infrastructure needs consist of basic maintenance. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions. There is also a significant risk that Congressional Republicans will try to sneak through cuts to Social Security and Medicare, much to the annoyance of many of Trump's voters. As for Trump's proposed personal tax cuts, while they are hefty in size, their bang for the buck is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Indeed, it is possible that cutting the estate tax would actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that companies are already flush with cash and effective tax rates are well below statutory levels. The bottom line is that global growth is likely to rise in 2017, but not by enough to cause inflation to surge. A Flat Phillips Curve ... For Now Chart 8The Phillips Curve Has Flattened The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation It might take a few more years for most of the developed world to claw its way back to something approximating full employment, but with any luck, it will get there. What happens to inflation then? The answer is probably not much. The relationship between economic slack and inflation is encapsulated by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 8). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Economists have proposed a variety of reasons for why the Phillips curve may have flattened out over time. Globalization is often cited as one factor, but the empirical evidence for this view is rather shaky.1 True, free trade and capital mobility have helped keep inflation in check by diverting excess domestic demand into higher net imports via the Mundell-Fleming channel discussed above. However, this only implies that globalization may prevent economies from sliding too far along the Phillips curve. It says nothing about the slope of the curve itself. A fall in unionization rates and a decline in the use of inflation-indexed wage contracts are also often cited as reasons for why the correlation between inflation and economic slack has diminished. Here again, the evidence is rather mixed. While the U.S. has experienced a pronounced decline in unionization rates, Canada has not (Chart 9). Nevertheless, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-index contracts in the 1970s appears mainly to have been a response to rising inflation, rather than a cause of it (Chart 10). The one point on which most economists agree is that long-term inflation expectations are much more stable now than they used to be, which has reduced the volatility of actual inflation. Central banks deserve some of the credit for this. The adoption of inflation targeting, coupled with more transparent communication policies, has helped anchor inflation expectations. A more sober assessment of economic conditions has also been a plus. Back in the 1970s, the Fed continuously overstated the degree of economic slack (Chart 11). This led it to keep interest rates too low for too long, thereby sowing the seeds for much higher inflation later on. Chart 9Inflation Fell In Canada, ##br##Despite A High Unionization Rate bca.gis_wr_2016_12_23_c9 bca.gis_wr_2016_12_23_c9 Chart 10When High Inflation ##br##Entailed Inflation-Indexed Contracts When High Inflation Entailed Inflation-Indexed Contracts When High Inflation Entailed Inflation-Indexed Contracts Chart 11The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack The Fed Continuously Overstated The Magnitude Of Economic Slack The Fed Continuously Overstated The Magnitude Of Economic Slack Shifting Sands For Inflation The Fed has vowed not to make the same mistake again, but the temptation to exploit the flatness of the Phillips curve may be too great to resist. A flattish Phillips curve implies a low "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that it is at least willing to entertain the idea. The 25-year period of falling inflation that began in the early 1980s had a dark side. As Hyman Minsky first noted, economic stability can beget instability: The so-called "Great Moderation" that policymakers were patting themselves on the back for before the financial crisis created a fertile milieu for rising debt levels. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. The challenges posed by the zero-bound constraint could also justify efforts to raise inflation targets. After all, if inflation were higher, this would give central banks the ability to push down real rates further into negative territory in the event of an economic downturn. Such a step is unlikely to be taken anytime soon. That said, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF, San Francisco Fed President John Williams, and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. In any event, as we discussed in great detail last week, underlying economic trends - ranging from the retreat from globalization to the slowdown in potential GDP growth - are all pushing the global economy in a more inflationary direction.2 This suggests that inflation could move appreciably higher towards the end of this decade. Investment Conclusions Chart 12Near-Term Inflation Risk Is Low Near-Term Inflation Risk Is Low Near-Term Inflation Risk Is Low Inflation is unlikely to rise significantly over the next few years. Indeed, the sharp appreciation in the dollar since the election will put downward pressure on U.S. inflation in the coming months. This view is supported by the Federal Reserve Bank of St. Louis Price Pressure gauge, which shows that there is less than an 8% chance that inflation will rise above 2.5% over the next 12 months (Chart 12). And even when the economy has reached full employment and the effects of a stronger dollar have washed through the system, inflation will be slow to increase. Consider how inflation evolved during the 1960s. As my colleague Mathieu Savary has pointed out, U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 on the back of rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 13).3 The lesson is that it often takes a number of years for an overheated economy to generate meaningful inflation. This suggests that the global economy is entering a "goldilocks" reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. This is obviously good news for global risk assets, and underpins our cyclically constructive view on global equities. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. In fact, both economies have seen a decline in real yields since the U.S. elections, as rising inflation expectations have outpaced the increase in nominal yields (Chart 14). Emerging markets should also gain from a more reflationary environment, but a rising dollar and elevated debt levels will take the bloom off the rose. Chart 13It Can Take A While For Inflation ##br##To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 14Europe And Japan: Rising Inflation ##br##Expectations Suppressing Real Yields Europe And Japan: Rising Inflation Expectations Suppressing Real Yields Europe And Japan: Rising Inflation Expectations Suppressing Real Yields While we have a positive cyclical (3-to-24 month) view on risk assets, we have significant concerns about both the near-term and longer-term outlooks. From a short-term tactical perspective, developed market equities - especially U.S. equities - are highly vulnerable to a correction. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 15). It can also be seen in the weak historic performance of global stocks following sharp spikes in bond yields (Table 2). Chart 15U.S. Equity Sentiment Is Stretched U.S. Equity Sentiment Is Stretched U.S. Equity Sentiment Is Stretched Table 2Stocks Tend To Suffer When Bond Yields Spike The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation Over a longer-term horizon, the risks to global equities are also to the downside. Once inflation is on a firm upward trajectory, central banks may find it more difficult to arrest the trend. Against the backdrop of weak productivity and labor force growth, memories of stagflation may reappear. As Chart 16 shows, stagflation in the 1970s was devastating for equities, and this time may not be any different. The bottom line is that investors should lease the bull market in stocks, rather than own it. Chart 16Stagflation Was Devastating For Stocks Stagflation Was Devastating For Stocks Stagflation Was Devastating For Stocks From The Vault: Two "Big Picture" Holiday Reports Lastly, for those who would like to take their minds off the nitty-gritty of the financial world for the next two weeks and focus more on transcendent issues, let me recommend two special reports. The first, entitled A Smarter World is based on a speech I delivered at the 2014 BCA New York Investment Conference. I argue that genetic changes in the human population sowed the seeds for the Industrial Revolution. This development then unleashed a virtuous cycle where rising living standards led to better health and educational outcomes, generating even further gains in living standards. Many countries now appear to be at the end of this cycle, but new technologies could one day generate huge gains in IQs, sending humanity down a path towards immortality. Of course, before we get there, we have to contend with all sorts of existential pitfalls. With that in mind, the second report, Doomsday Risk, examines what is literally a life-and-death issue: the likelihood of human extinction. Drawing on insights from biology, history, cosmology, and probability theory, our analysis yields a number of surprising investment implications. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Eddie Gerba and Corrado Macchiarelli, "Is Globalization Reducing The Ability Of Central Banks To Control Inflation?" European Parliament, Policy Department A: Economic and Scientific Policy, Brussels, Belgium (2015); Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, "Some Simple Tests Of The Globalization And Inflation Hypothesis," International Finance Vol. 13, no. 3 (2010): pp. 343-375; and Laurence M. Ball, "Has Globalization Changed Inflation?" NBER Working Paper No. 12687 (2006). 2 Please see Global Investment Strategy Weekly Report, "Main Street Bonds, Wall Street Stocks," dated December 16, 2016, available at gis.bcaresearch.com. 3 Please see Foreign Exchange Strategy, "Outlook: 2017's Greatest Hits," dated December 16, 2016, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Mr. X is a long-time BCA client who visits our offices towards the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: What a year it has been. The Brexit vote in the U.K. and the U.S. election result took me completely by surprise and have added to an already uncertain economic environment. A year ago, you adopted the theme of "Stuck In A Rut" to describe the economic and financial market environment and that turned out to be quite appropriate. Consistent with that rut, many issues concerning me for some time have yet to be resolved. Global economic growth has stayed mediocre, debt levels remain elevated almost everywhere, the outlook for China continues to be shrouded in fog, and stimulative monetary policies are still distorting markets. And now we face political shifts that will have major economic and financial effects. Some big changes are underway and I fear that we are more likely to head in a negative rather than positive direction. Therefore, I am very interested to learn how you see things developing. You have recommended a cautious investment stance during the past year and I was happy to go along with that given all my concerns about the economic and policy environment. While stocks have done rather better than I expected, it has all been based on flimsy foundations in my opinion. I have never been comfortable buying an asset just because prices are being supported by excessively easy money policies. The question now is whether looming changes in the policy and economic environment and in global politics will fuel further gains in risk assets or whether a significant setback is in prospect. I hope our discussion will give some clarity on this but, before talking about the future, let's quickly review what you predicted a year ago. BCA: It has indeed been a momentous year and we do seem to be at important turning points in many areas. For example, changing attitudes toward free trade and fiscal policy do have important implications for economic growth and interest rates. And this is being reinforced by cyclical economic trends as labor markets tighten in the U.S. However, it is too soon to know the extent to which political and policy uncertainties will diminish in the U.S. and Europe. You seek clarity on the investment outlook, but that will remain as challenging an objective as ever. You asked to start with a review of last year's predictions and this is always a moment of some trepidation. A year ago, our key conclusions were as follows: The current global economic malaise of slow growth and deflationary pressures reflects more than just a temporary hangover from the 2007-09 balance sheet recession. Powerful structural forces are at work, the effects of which will linger for a long time. These include an ongoing overhang of debt, the peak in globalization, adverse demographics in most major economies, monetary policy exhaustion, and low financial asset returns. Investor expectations have yet to adjust to the fact that sub-par growth and low inflation are likely to persist for many years. The Debt Supercycle is over, but weak nominal GDP growth has made it virtually impossible to reduce debt burdens. Nonetheless, a debt crisis in the advanced economies is not in prospect any time soon because low interest rates are keeping a lid on debt servicing costs. Perhaps high inflation and debt monetization will be the end-point, but that is many years away and would be preceded by a deflationary downturn. Despite ongoing exciting technological advances, the IT boom has lost its edge in terms of boosting economic growth. Even if productivity is understated, the corollary is that inflation is overstated, suggesting that central bankers will continue to face a policy dilemma. The Fed will raise interest rates by less than implied by their current projections. And the European Central Bank and Bank of Japan may expand their QE programs. Yet, monetary policy has become ineffective in boosting growth. Fiscal policy needs to play a bigger role, but it will require another recession to force a shift in political attitudes toward more stimulus. The U.S. economy will remain stuck in sub-2.5% growth in 2016, with risks to the downside. The euro zone's performance has improved recently, but 2016 growth will fall short of the IMF's 1.9% forecast. Japan's growth will continue to disappoint as it will in most other developed economies. China will continue to avoid a hard landing but growth will likely average below 6% in 2016 and beyond. Other emerging economies face a difficult environment of weak commodity prices, declining global trade. Those with excessive foreign-currency debt face additional pressures with weak exchange rates preventing an easing in monetary policy. Bonds offer poor long-term returns from current yields, but sovereign bonds in the major developed countries offer a hedge against downside macro risks and we recommend benchmark weightings. The fundamental backdrop to corporate and EM bonds remain bearish and spreads have not yet reached a level that discounts all of the risks. A buying opportunity in high-yield securities could emerge in the coming year but, for the moment, stay underweight spread product. We have turned more cautious on equities given a deterioration in the earnings outlook and in some technical indicators. No more than benchmark weighting is warranted and we would not argue against a modest underweight. The typical warning signs of a bear market are not in place but risks have risen. The U.S. equity market is expected to underperform that of Europe and Japan. Continue to stay away from emerging equities and commodity-oriented bourses. We continue to favor a defensive sector stance, favoring consumer staples and health care over cyclical sectors such as materials, energy and industrials. The bear market in commodities is not over. The sharp drop in oil prices will eventually restore balance to that market by undermining non-OPEC production and supporting demand, but this could take until the third quarter of 2016. The oil price is expected to average around $50 a barrel for the 2016-2018 period. The strong dollar and deflationary environment create a headwind for gold, offsetting the benefits of negative real interest rates. But modest positions are a hedge against a spike in risk aversion. The dollar is likely to gain further against emerging and commodity-oriented currencies. But the upside against the euro and the yen will be limited given the potential for disappointments about the U.S. economy. As was the case a year ago, geopolitical risks are concentrated in the emerging world. Meanwhile, the new world order of multipolarity and an increased incidence of military conflicts is not yet priced into markets. We do not expect the U.S. elections to have any major adverse impact on financial markets. On the economic front, we suggested that economic risks would stay tilted to the downside and this turned out to be correct with global growth, once again, falling short of expectations. A year ago, the IMF forecast global growth of 3.6% in 2016 and this has since been downgraded to 3.1%, the weakest number since the recovery began (Table 1). The U.S. economy fell particularly short of expectations (1.6% versus 2.8%). The downgrading of growth forecasts continued a pattern that has been in place since the end of the 2007-09 downturn (Chart 1). We cannot recall any other time when economic forecasts have been so wrong for such an extended period. The two big disappointments regarding growth have been the lackluster performance of global trade and the ongoing reluctance of businesses to expand capital spending. Not surprisingly, inflation remained low, as we expected. Table 1IMF Economic Forecasts January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 1Persistent Growth Downgrades Persistent Growth Downgrades Persistent Growth Downgrades Given the disappointing economic performance, we were correct in predicting that the Federal Reserve would not raise interest rates by as much as their earlier forecasts implied. When we met last year, the Fed had just raised the funds rate from 0.25% to 0.5% and the median expectation of FOMC members was that it would reach 1.4% by end-2016 and 2.4% by end-2017. As we now know, the Fed is now targeting a funds rate of 0.5% to 0.75% and median FOMC projections are for 1.4% by end-2017 (Chart 2). Meanwhile, as we expected, both the ECB and Bank of Japan expanded their quantitative easing programs in an attempt to stimulate growth. Chart 2Changes In the Fed's Expectations Changes in the Fed's Expectations Changes in the Fed's Expectations Our concerns about the poor prospects for emerging economies were validated. The median 2016 growth rate for 152 emerging economies tracked by the IMF was only 3.1%, a notch below the 2015 pace and, barring 2009, the weakest number since the late 1990s Asia crisis. The official Chinese data overstate growth, but there was no hard landing, as many commentators continued to predict. Turning to the markets, there was considerable volatility during the year (Table 2). For example, U.S. bond yields fell sharply during the first half then rebounded strongly towards the end of the year, leaving them modestly higher over the 12 months. Yields in Europe and Japan followed a similar pattern - falling in the first half and then rebounding, but the level continued to be held down by central bank purchases. Japanese bonds outperformed in common currency terms and we had not expected that to occur, although there was a huge difference between the first and second halves of the year, with the yen unwinding its earlier strength in the closing months of the year. Table 2Market Performance January 2017 - Shifting Regimes January 2017 - Shifting Regimes Our caution toward spread product - corporate and EM bonds - turned out to have been unjustified. Despite worsening fundamentals, most notably rising leverage, the search for yield remained a powerful force keeping spreads down and delivering solid returns for these securities. Spreads are back to very low levels, warning that further gains will be hard to achieve. Equity markets made moderate net gains over the course of the year, but it was a roller coaster journey. A nasty early-year downturn was followed by a rebound, an extended trading range and a late-year rally. While the all-country index delivered a total return of around 8% for the year in common currency terms, almost one-third of that was accounted for by the dividend yield. The price index rose by less than 6% in common currency and 7% in local currency. However, our recommendation to overweight Europe and Japan did not pan out. Once again, the U.S. was an outperformer with the financially-heavy European index weighed down by ongoing concerns about banks, and Japan held back by its lackluster economic performance. Oil prices moved much as we expected, with Brent averaging around $45 over the year. At this time in 2015, prices were below $40, but we argued that a gradual rebalancing would bring prices back into a $45-$60 range in the second half of 2016. We did not expect much of a rise in the gold price and it increased less than 7% over the year. However, we did not try to dissuade you from owning some gold given your long-standing attraction to the asset, subject to keeping the allocation to 5% or less of your portfolio. Industrial commodity prices have been much stronger than we predicted, benefiting from a weak dollar in the first half of the year and continued buoyant demand from China. Finally, the dollar moved up as we had predicted, with the gains concentrated in the second half of the year. The yen's first-half strength was a surprise, but this was largely unwound in the second half as U.S. bond yields climbed. Mr. X: Notably absent has been any mention of the two political shocks of 2016. BCA: We did tell you that the U.K. referendum on Brexit was the key risk facing Europe in 2016 and that the polls were too close to have a strong view. Yet, we did not anticipate that the vote to leave the EU would pass. And when you pushed us a year ago to pick a winner for the U.S. election we wrongly went with Clinton. Our Global Strategist, Peter Berezin, was on record predicting a Trump victory as long ago as September 2015. But it seemed such an outrageous idea that our consensus view stuck to the safer option of Clinton. Interestingly, during our discussion at the end of 2014, we did note that a retreat from globalization was one of the risks in the outlook and we re-emphasized that point last year, pointing to rising populist pressures. However, we underestimated the ability of Brexit campaigners and Donald Trump to capitalize on the anger of disaffected voters. Trade and immigration policies are not the only areas where policy appears to be at a turning point. For example, fiscal conservatism is giving way to stimulus in the U.S. and several other countries, inflation and interest rates are headed higher, at least temporarily, and 2017-2018 should finally arrest the multi-year spectacle of downgrades to global growth projections. Yet, markets have a tendency to overreact and that currently seems to be the case when it comes to discounting prospective changes in the economic environment for the coming year. Turning Points And Regime Shifts: How Much Will Really Change? Mr. X: The U.S. election result and Brexit vote obviously were seismic events with potentially major policy implications. But there seem to be more questions than answers in terms of how policies actually will evolve over the next few years and the extent to which they will be good or bad for growth. The markets are assuming that economic growth will get a big boost from changes in fiscal policy. Do you agree with that view? Chart 3Fiscal Austerity Ended In 2015 Fiscal Austerity Ended in 2015 Fiscal Austerity Ended in 2015 BCA: We need to begin by putting things into perspective. Fiscal austerity came to an end pretty much everywhere a couple of years ago. Data from the IMF show that the peak years for fiscal austerity in the advanced economies were 2011-2013, and the budget cutbacks in those years did not even fully offset the massive stimulus that occurred during the downturn in 2008-10. Since 2013, the fiscal drag on GDP has gradually diminished and policy shifts are estimated to have added to GDP in the U.S., euro area and Japan in 2016 (Chart 3). Nonetheless, with economic growth falling short of expectations and easy money losing its effectiveness, there have been widespread calls for fiscal policy to do more. President-elect Trump has made major tax cuts and increased spending an important part of his policy platform, so the issue is the extent to which he follows through on his plans. Inevitably, there are some challenges: The plan to boost U.S. infrastructure spending is welcome, but the intention seems to be to emphasize private/public partnerships rather than federally-funded projects. Setting up such agreements could take time. Meanwhile, although there is great scope to improve the infrastructure, it is far less clear that a number of "shovel-ready" projects are simply waiting for finance. The bottom line is that increased infrastructure spending is more a story for 2018 and beyond, rather than 2017. And the same also is true for defense, where it may take time to put new programs in place. Turning to the proposed tax cuts, history shows there can be a huge difference between election promises and what eventually is legislated. According to the Tax Policy Center, Trump's plans would add more than $6 trillion to outstanding federal debt over the next decade and more than $20 trillion over 20 years. And that excludes the impact of higher interest costs on the debt. Even if one were to take an optimistic view of a revenue boost from faster economic growth, there would still be a large increase in federal deficits and thus debt levels and this could be problematic for many Republicans. It seems inevitable that the tax plans will be watered down. An additional issue is the distributional impact of the proposed tax cuts. Eliminating the estate tax and proposed changes to marginal rates would disproportionally help the rich. Estimates show the lowest and second lowest quintile earners would receive a tax cut of less than 1% of income, compared to 6.5% for the top 1%. Given that the marginal propensity to consume is much higher for those with low incomes, this would dilute the economic impact. Moreover, there is again the issue of timing - the usual bargaining process means that tax changes will impact growth more in 2018 than 2017. Mr. X: You did not mention the plan to cut the corporate tax rate from 35% to 15%. Surely that will be very good for growth? BCA: According to the OECD, the U.S. has a marginal corporate tax rate of 38.9% (including state and local corporate taxes), making it by far the highest in the industrialized world. The median rate for 34 other OECD economies is 24.6%. However, the actual rate that U.S. companies pay after all the various deductions is not so high. According to national accounts data, the effective tax rate for domestic non-financial companies averaged 25% in the four quarters ended 2016 Q2. Data from the IRS show an average rate of around 21% for all corporations. And for those companies with significant overseas operations, the rate is lower. There certainly is a good case for lowering the marginal rate and simplifying the system by removing deductions and closing loopholes. But special interests always make such reforms a tough battle. Even so, there is widespread support to reduce corporate taxes so some moves are inevitable and this should be good for profits and, hopefully, capital spending. The bottom line is that you should not expect a major direct boost to growth in 2017 from changes in U.S. fiscal policy. The impact will be greater in 2018, perhaps adding between 0.5% and 1% to growth. However, don't forget that there could be an offset from any moves to erect trade barriers. Mr. X: What about fiscal developments in other countries? Chart 4Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare BCA: The Japanese government has boosted government spending again, but the IMF estimates that fiscal changes added only 0.3% to GDP in 2016, with an even smaller impact expected for 2017. And a renewed tightening is assumed to occur in 2018 as postponed efforts to reign in the deficit take hold. Of course, a sales tax hike could be delayed yet again if the economy continues to disappoint. But, with an overall budget deficit of 5% of GDP and gross government debt of more than 250% of GDP, Japan's room for additional stimulus is limited (Chart 4). Although the Bank of Japan owns around 40% of outstanding government debt, the authorities cannot openly admit that this will be written off. While more fiscal moves are possible in Japan, it is doubtful they would significantly alter the growth picture. The euro area peripheral countries have moved past the drastic fiscal austerity that was imposed on them a few years ago. Nevertheless, there is not much room for maneuver with regard to adopting an overtly reflationary stance. It is one thing to turn a blind eye to the fiscal constraints of the EU's Growth and Stability Pact and quite another to move aggressively in the opposite direction. Most of the region's economies have government debt-to-GDP ratios far above the 60% required under the Maastricht Treaty. In sum, a move to fiscal stimulus is not in the cards for the euro area. The U.K. is set to adopt more reflationary policies following the Brexit vote, but this would at most offset private sector retrenchment. In conclusion, looming shifts in fiscal policy will be positive for global growth in the next couple of years, but are unlikely to be game changers. Of course, fiscal policy is not the only thing that might change - especially in the U.S. There also are hopes that an easing in regulatory burdens will be very positive for growth. Mr. X: I am glad you raised that point. I have many business contacts in the U.S. who complain bitterly about regulatory overload and they are desperate for some relief. BCA: There certainly is a need for action on this front as regulatory burdens have increased dramatically in the U.S. in recent years. The monthly survey of small businesses carried out by the National Federation of Independent Business shows that rising health care costs, excessive regulation and income taxes are regarded as the top three problems. According to the Heritage Foundation, new regulations from the Obama administration have added more than $100 billion annually to costs for businesses and individuals since 2009. While the U.S. has a good score in the World Bank's Ease of Doing Business Index (8th best out of 190 countries), it is ranked 51st in the component that measures how easy it is to start a business, which puts it behind countries such as Jamaica, Mongolia and Albania. So we can hope that the new administration will act to improve that situation. We can be confident that there will be major reductions in regulations relating to energy and the environment. Other areas may be more challenging. It did not take long for Trump to back away from his pledge to repeal the Affordable Care Act (ACA) in its entirety. Returning to the previous status quo will not be politically acceptable and devising an alternative plan is no small task. The end result still will be a major modification of the ACA and this should ease health care costs for small businesses. With regard to the financial sector, it is no surprise that the pendulum swung massively toward increased regulation given the pre-crisis credit excesses. The economic and financial downturn of 2008-09 left a legacy of strong populist resentment of Wall Street and the banks, so a return to the previous laissez-faire model is not in the cards. At one stage, Trump indicated that he was in favor of replacing Dodd-Frank with a Glass-Steagall system, requiring commercial banks to divest themselves of their securities' businesses. The large banks would employ legions of lobbyists to prevent a new Glass-Steagall Act. The end result will be some watering down of the Dodd-Frank regulatory requirements, but again, a return to the pre-crisis status quo is not in the cards. The Retreat From Globalization Mr. X: You have challenged the consensus view that fiscal stimulus will deliver a meaningful boost to the global economy over the coming year. Having downplayed the main reason to be more positive about near-term growth, let's turn to global trade, the issue that causes most nervousness about the outlook. The Brexit vote in the U.K. was at least partly a vote against globalization and we are all familiar with Trump's threat to dramatically raise tariffs on imports from China and Mexico. What are the odds of an all-out trade war? BCA: At the risk of sounding complacent, we would give low odds to this. Again, there will be a large difference between campaign promises and actual outcomes. Let's start with China where the U.S. trade deficit ran at a $370 billion annual rate in the first nine months of 2016, up from around $230 billion a decade before (Chart 5). China now accounts for half of the total U.S. trade deficit compared to a 25% share a decade ago. On the face of it, the U.S. looks to have a good bargaining position, but the relationship is not one-sided. China has been a major financer of U.S. deficits and is the third largest importer of U.S. goods, after Canada and Mexico. Meanwhile, U.S. consumers have benefited enormously from the relative cheapness of imported Chinese goods. As for the threat to label China as a currency manipulator, it is interesting to note that its real effective exchange rate has increased by almost 20% since the mid-2000s, and since then, the country's current account surplus as a share of GDP has fallen from almost 10% to around 2.5% (Chart 6). The renminbi has fallen by around 10% against the dollar since mid-2015, but that has been due to the latter currency's broad-based rally, not Chinese manipulation. The fact that China's foreign-exchange reserves have declined in the past couple of years indicates that the country has intervened to hold its currency up, not push it down. Chart 5China-U.S. Trade: ##br##A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? Chart 6China Has Not Manipulated ##br##Its Currency Downward China Has Not Manipulated Its Currency Downward China Has Not Manipulated Its Currency Downward Of course, facts may not be the guiding factor when it comes to U.S. trade policy, and we can expect some tough talk from the U.S. This could well involve the imposition of some tariffs and perhaps some concessions from China in the form of increased imports from the U.S. Overall, we are hopeful that rational behavior will prevail and that an all-out trade war will not occur. Mr. X: I also would like to believe that, but nothing in the U.S. election process made me think that rationality is guaranteed. BCA: Of course it is not guaranteed, and we will have to monitor the situation carefully. We should also talk about Mexico - the other main target of Trump's attacks. The U.S. trade deficit with Mexico accounts for less than 10% of the total U.S. deficit and has changed little in the past decade. More than 80% of the U.S. trade deficit with Mexico is related to vehicles and Trump clearly will put pressure on U.S. companies to move production back over the border. Within a week of the election, Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. And Trump subsequently browbeat Carrier Corporation into cancelling some job transfers across the border. If other companies follow suit, it could forestall major changes to NAFTA. Ironically, the Mexican peso has plunged by 10% against the dollar since the election, boosting the competitiveness of Mexico and offsetting some of the impact of any tariff increase. Not all the news on global trade is bad. After seven years of negotiation, the EU and Canada agreed a free trade deal. This has bolstered the U.K.'s hopes that it can arrange new trade deals after it leaves the EU. However, this will not be easy given the sheer number of bi-country deals that will be required. The time it took to negotiate the EU-Canada deal should be a salutary warning given that there was no particular animosity toward Canada within the EU. That will not be the case when it comes to negotiations with the U.K. Mr. X: Let's try and pull all this together. You have downplayed the risk of an all-out trade war and I hope that you are right. But do you expect trade developments to be a drag on economic activity, perhaps offsetting any positive impact from fiscal stimulus? Chart 7Only Modest Growth In World Trade Only Modest Growth In World Trade Only Modest Growth In World Trade BCA: You might think that trade is a zero-sum game for the global economy because one country's exports simply are another's imports. But expanding trade does confer net benefits to growth in terms of allowing a more efficient use of resources and boosting related activities such as transportation and wholesaling. Thus, the rapid expansion in trade after the fall of the Berlin Wall was very good for the global economy. Trade ceased to be a net contributor to world growth several years ago, highlighted by the fact that global export volumes have been growing at a slower pace than GDP (Chart 7). This has not been due to trade barriers but is more a reflection of China's shift away from less import-intensive growth. A return to import-intensive growth in China is not likely, and technological innovations such as 3-D printing could further undermine trade. If we also add the chances of some increase in protectionist barriers then it is reasonable to assume that trends in global trade are more likely to hinder growth than boost it over the coming couple of years. It really is too soon to make hard and fast predictions about this topic as we need to see exactly what actions the new U.S. administration will take. Nevertheless, we lean toward the optimistic side, and assume the economic impact of fiscal reflation will exceed any drag from trade restrictions. Again, this is a more of a story for 2018 than 2017. What we can say with some confidence is that the previous laissez-faire approach to globalization is no longer politically acceptable. Policymakers are being forced to respond to voter perceptions that the costs of free trade outweigh the benefits and that points to a more interventionist approach. This can take the form of overt protectionism or attempts to influence corporate behavior along the lines of president-elect Trump's exhortations to U.S. companies. Mr. X: What about the issue of immigration? Both the Brexit vote and the U.S. election result partly reflected voter rebellion against unrestrained immigration. And we know that nationalist sentiments also are rising in a number of other European countries. How big a problem is this? Chart 8Immigration's Rising Contribution ##br##To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth BCA: In normal circumstances, immigration represents a win-win situation for all parties. The vast majority of immigrants are prepared to work hard to improve their economic position and in many cases take jobs that residents are not willing to accept. This all works well in a fast-growing economy, but difficulties arise when growth is weak: competition for jobs increases, especially among the unskilled, and the result is downward pressure on wages. The irony is that the U.S. and U.K. labor markets have tightened to the point where wage growth is accelerating. However, this all happened too late to affect the opinions of those who voted for tighter controls over immigration. There is an even more important issue from a big-picture perspective. As you know, an economy's potential growth rate comes from two sources: the growth in the labor force and productivity. According to the Census Bureau, U.S. population growth will average 0.8% a year over the next decade, slowing to 0.6% a year over the subsequent ten years. But more than half of this growth is assumed to come from net migration. Excluding net migration, population growth is predicted to slow to a mere 0.1% a year by the end of the 2030s (Chart 8). Thus, major curbs on immigration would directly lower potential GDP by a significant amount. In Europe, the demographic situation is even more precarious because birth rates are far below replacement levels. Europe desperately needs immigration to achieve even modest population increases. However, the migrant crisis is causing a backlash against cross-border population flows, again with negative implications for long-run economic growth. Even ignoring humanitarian considerations, major curbs on immigration would not be a good idea. Labor shortages would quickly become apparent in a number of industries. Some may welcome the resulting rise in wages, but the resulting pressure on inflation also would have adverse effects. So this is another area of policy that we will have to keep a close eye on. Inflation And Interest Rates Chart 9A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture Mr. X: I am glad that you mentioned inflation. There are good reasons to think that an important inflection point in inflation has been reached. And bond investors seem to agree, judging by the recent spike in yields. If true, this would indeed represent a significant regime shift because falling inflation and bond yields have been such a dominant trend for several decades. Do you agree that the era of disinflation is over, along with the secular bull market in bonds? BCA: Inflation and bond yields in the U.S. have passed a cyclical turning point, but this does not mean that a sustained major uptrend is imminent. Let's start with inflation. A good portion of the rise in the underlying U.S. inflation rate has been due to a rise in housing rental costs, and, more recently, a spike in medical care costs. Neither of these trends should last: changes to the ACA should arrest the rising cost of medical care while increased housing construction will cap the rise in rent inflation. The rental vacancy rate looks to be stabilizing while rent inflation is rolling over. Meanwhile, the inflation rate for core goods has held at a low level and likely will be pushed lower as a result of the dollar's ascent (Chart 9). Of course, this all assumes that we do not end up with sharply higher import tariffs and a trade war. The main reason to expect a further near-term rise in underlying U.S. inflation is the tightening labor market and resulting firming in wage growth. With the economy likely to grow above a 2% pace in 2017, the labor market should continue to tighten, pushing wage inflation higher. So the core PCE inflation rate has a good chance of hitting the Federal Reserve's 2% target before the year is out. And bond investors have responded accordingly, with one-year inflation expectations moving to their highest level since mid-2014, when oil prices were above $110 a barrel (Chart 10). Long-run inflation expectations also have spiked since the U.S. election, perhaps reflecting the risk of higher import tariffs and the risks of political interference with the Fed. When it comes to other developed economies, with the exception of the U.K., there is less reason to expect underlying inflation to accelerate much over the next year. Sluggish growth in the euro area and Japan will continue to keep a lid on corporate pricing power and the markets seem to agree, judging by the still-modest level of one-year and long-run inflation expectations (Chart 11). The U.K. will see some pickup in inflation in response to the sharp drop in sterling and this shows up in a marked rise in market expectations. Chart 10U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked Chart 11Inflation Expectations In Europe And Japan Inflation Expectations In Europe and Japan Inflation Expectations In Europe and Japan Turning back to the U.S., a key question regarding the longer-term inflation outlook is whether the supply side of the economy improves. If the new administration succeeds in boosting demand but there is no corresponding expansion in the supply capacity of the economy, then the result will be higher inflation. That will lead to continued monetary tightening and, as in past cycles, an eventual recession. But, if businesses respond to a demand boost with a marked increase in capital spending then the result hopefully would be faster productivity growth and a much more muted inflation response. Thus, it will be critical to monitor trends in business confidence and capital spending for signs that animal spirits are returning. Mr. X: So you don't think the Fed will be tempted to run a "hot" economy with inflation above the 2% target? BCA: That might have been a possibility if there was no prospect of fiscal stimulus, leaving all the economic risks on the downside. With easier fiscal policy on the horizon, the Fed can stick to a more orthodox policy approach. In other words, if the economy strengthens to the point where inflation appears to be headed sustainably above 2%, then the Fed will respond by raising rates. Unlike the situation a year ago, we do not have a strong disagreement with the Fed's rate hike expectations for the next couple of years. Nothing would please the Fed more than to return to a familiar world where the economy is behaving in a normal cyclical fashion, allowing a move away from unusually low interest rates. At the same time, the Fed believes, as we do, that the equilibrium real interest rate is far below historical levels and may be close to zero. Thus, interest rates may not need to rise that much to cool down the economy and ease inflationary pressures. This is especially true if the dollar continued to rise along with Fed tightening. Another potentially important issue is that the composition of the Federal Reserve Board could change dramatically in the next few years. There currently are two unfilled seats on the Board and it is very likely that both Janet Yellen and Stanley Fischer will leave in 2018 when their respective terms as Chair and Vice-Chair end (February 3 for Yellen and June 12 for Fischer). That means the incoming administration will be able to appoint four new Board members, and possibly more if other incumbents step down. Judging by the views of Trump's current economic advisers, he seems likely to choose people with a conservative approach to monetary policy. In sum, we do not rule out a rise in U.S. inflation to as much as 3%, but it would be a very short-lived blip. Steady Fed tightening would cap the rise, even at the cost of a renewed recession. Indeed, a recession would be quite likely because central banks typically overshoot on the side of restraint when trying to counter a late-cycle rise in inflation. Mr. X: I am more bearish than you on the inflation outlook. Central banks have been running what I regard as irresponsible policies for the past few years and we now also face some irresponsible fiscal policies in the U.S. That looks like a horrendously inflationary mix to me although I suppose inflation pressures would ease in the next recession. We can return to that possibility later when we discuss the economy in more detail. Where do you see U.S. short rates peaking in the current cycle and what does this mean for your view on long-term interest rates? To repeat my earlier question: is the secular bond bull market over? BCA: During the past 30 years, the fed funds rate tended to peak close to the level of nominal GDP growth (Chart 12). That would imply a fed funds rate of over 5% in the current cycle, assuming peak real GDP growth of around 3% and 2-3% inflation. However, that ignores the fact that debt burdens are higher than in the past and structural headwinds to growth are greater. Thus, the peak funds rate is likely to be well below 5%, perhaps not much above 3%. Chart 12The Fed Funds Rate And The Economic Cycle The Fed Funds Rate and the Economic Cycle The Fed Funds Rate and the Economic Cycle With regard to your question about the secular bull market in bonds, we believe it has ended, but the bottoming process likely will be protracted. We obviously are in the midst of a cyclical uptrend in U.S. yields that could last a couple of years. The combination of a modestly stronger economy, easier fiscal stance and monetary tightening are all consistent with rising bond yields. Although yields moved a lot in the second half of 2016, the level is still not especially high, so there is further upside. It would not be a surprise to see the 10-year Treasury yield reach 3% by this time next year. However, there could be a last-gasp renewed decline in yields at some point in the next few years. If the U.S. economy heads back into recession with the fed funds rate peaking at say 3.5%, then it is quite possible that long-term bond yields would revisit their 2016 lows - around 1.4% on the 10-year Treasury. There are no signs of recession at the moment, but a lot can change in the next three years. In any event, you should not be overly concerned with the secular outlook at this point. The cyclical outlook for yields is bearish and there should be plenty of advance notice if it is appropriate to switch direction. Update On The Debt Supercycle Mr. X: I would like to return to the issue of the Debt Supercycle - one of my favorite topics. You know that I have long regarded excessive debt levels as the biggest threat to economic and financial stability and nothing has occurred to ease my concerns. In the past, you noted that financial repression - keeping interest rates at very low levels - would be the policy response if faster economic growth could not achieve a reduction in debt burdens. But the recent rise in bond yields warns that governments cannot always control interest rate moves. Few people seem to worry anymore about high debt levels and I find that to be another reason for concern. BCA: You are correct that there has been very little progress in reducing debt burdens around the world. As we have noted in the past, it is extremely difficult for governments and the private sector to lower debt when economic activity and thus incomes are growing slowly. Debt-to-GDP ratios are at or close to all-time highs in virtually every region, even though debt growth itself has slowed (Chart 13A, Chart 13B). Chart 13ADebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High Chart 13BDebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High As a reminder, our End-of-Debt Supercycle thesis never meant that debt-to-GDP ratios would quickly decline. It reflected our belief that lenders and private sector borrowers had ended their love affair with debt and that we could no longer assume that strong credit growth would be a force boosting economic activity. And our view has not altered, even though government borrowing may show some acceleration. Chart 14The Credit Channel Is Impaired The Credit Channel Is Impaired The Credit Channel Is Impaired The failure of exceptionally low interest rates to trigger a vigorous rebound in private sector credit demand is consistent with our view. In the post-Debt Supercycle world, monetary policy has lost effectiveness because the credit channel - the key pillar of the monetary transmission process - is blocked. The drop in money multipliers and in the velocity of circulation is a stark reminder of the weakened money-credit-growth linkage (Chart 14). You always want to know what the end-point of higher debt levels will be, and we always give you a hedged answer. Nothing has changed on that front! A period of higher inflation may help bring down debt ratios for a while, but not to levels that would ease your concerns. This means that financial repression will be the fallback plan should markets rebel against debt levels. For the moment, there is still no problem because interest rates are still low and this is keeping debt-servicing costs at very low levels. If interest rates are rising simply because economic activity is strengthening, then that is not a serious concern. The danger time would be if rates were to rise while growth and inflation were weak. At that point, central banks would move aggressively to reduce market pressures with massive asset purchases. The ultimate end-point for dealing with excessive debt probably will be significantly higher inflation. But that is some time away. Central banks would not likely embrace a major sustained rise in inflation before we first suffered another serious deflationary downturn. At that point, attitudes toward inflation could change dramatically and a new generation of central bankers would probably be in charge with a very different view of the relative economic risks of inflation and deflation. However, it is premature to worry about a major sustained inflation rise if we must first go through a deflationary downturn. Mr. X: Perhaps you are right, but I won't stop worrying about debt. The buildup in debt was decades in the making and I am convinced that the consequences will extend beyond a few years of subdued economic growth. And central bank efforts to dampen the economic symptoms with unusually low interest rates have just created another set of problems in the form of distorted asset prices and an associated misallocation of capital. BCA: We agree that there may be a very unhappy ending to the debt excesses, but timing is everything. It has been wrong to bet against central banks during the past seven years and that will continue to be the case for a while longer. We will do our best to give you plenty of warning when we see signs that things are changing for the worse. Mr. X: I will hold you to that. Meanwhile, you talked earlier about the possibility of another recession in the U.S. Let's use that as a starting point to talk about the economic outlook in more detail. It seems strange to talk about the possibility of a recession in the U.S. when interest rates are still so low and we are about to get more fiscal stimulus. The Economic Outlook BCA: We do not expect a recession in the next year or two, absent some new major negative shock. But by the time we get to 2019, the recovery will be ten years old and normal late-cycle pressures should be increasingly apparent. The labor market already is quite tight, with wages growing at their fastest pace in eight years, according to the Atlanta Fed's wage tracker (Chart 15). Historically, most recessions were triggered by tight monetary policy with a flat or inverted yield curve being a reliable indicator (Chart 16). Obviously, that is extremely hard to achieve when short-term rates are at extremely low levels. However, if the Fed raises the funds rate to around 3% by the end of 2019, as it currently predicts, then it will be quite possible to again have a flat or inverted curve during that year. Chart 15U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend Chart 16No Sign Of A U.S. Recession No Sign Of A U.S. Recession No Sign Of A U.S. Recession The recent environment of modest growth has kept inflation low and forced the Fed to maintain a highly accommodative stance. As spare capacity is absorbed, the Fed will be forced to tighten, raising the odds of a policy overshoot. And this is all without taking account of the potential threat of a trade war. Mr. X: I have never believed that the business cycle has been abolished so it would not surprise me at all to have a U.S. recession in the next few years, but the timing is critical to getting the markets right. What will determine the timing of the next economic downturn? BCA: As we mentioned earlier, the key to stretching out the cycle will be improving the supply side of the economy, thereby suppressing the cyclical pressures on inflation. That means getting productivity growth up which, in turn will depend on a combination of increased capital spending, global competition and technological innovations. Chart 17Companies Still ##br##Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Thus far, there is no indication that U.S. companies are increasing their investment plans: the trend in capital goods orders remains very lackluster (Chart 17). Nonetheless, we have yet to see post-election data. The optimistic view is that the prospect of lower corporate taxes, reduced regulation and a repatriation of overseas earnings will all combine to revive the corporate sector's animal spirits and thus their willingness to invest. Only time will tell. The key point is that it is too soon for you to worry about a recession in the U.S. and for the next year or two, there is a good chance that near-term economic forecasts will be revised up rather than down. That will mark an important reversal of the experience of the past seven years when the economy persistently fell short of expectations. Mr. X: It would be indeed be a welcome change to have some positive rather than negative surprises on the economic front, but I remain somewhat skeptical. I suppose I can see some reasons to be more optimistic about the U.S., but the picture in most other countries seems as bleak as ever. The outlook for the U.K. has worsened following the Brexit vote, the euro area and Japan cannot seem to break out of a low-growth trap and China continues to skirt the edge of a precipice. BCA: The global economy still has lots of problems, and we are a long way from boom-like conditions. The IMF predicts that 2017 growth in the euro area and China will be below the 2016 level, and forecasts for the U.K. have been revised down sharply since the Brexit vote. On a more positive note, the firming in commodity prices should help some previously hard-hit emerging economies. Overall global growth may not pick up much over the coming year, but it would be a significant change for the better if we finally stop the cycle of endless forecast downgrades. Mr. X: Let's talk a bit more about the U.K. I know that it is too early to make strong predictions about the implications of Brexit, but where do you stand in terms of how damaging it will be? I am not convinced it will be that bad because I sympathize with the view that EU bureaucracy is a big drag on growth, and exiting the EU may force the U.K. government to pursue supply-side policies that ultimately will be very good for growth. BCA: The Brexit vote does not spell disaster for the U.K., but adds to downside risks at a time when the global economy is far from buoyant. The EU is not likely to cut a sweet deal for the U.K. To prevent copycat departures, the EU will demonstrate that exit comes with a clear cost. Perhaps, the U.K. can renegotiate new trade deals that do not leave it significantly worse off. But this will take time and, in the interlude, many businesses will put their plans on hold until new arrangements are made. Meanwhile, the financial sector - a big engine of growth in the past - could be adversely affected by a move of business away from London. Chart 18The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem Of course, the government will not simply stand on the sidelines, and it has already announced increased infrastructure spending that will fill some of the hole created by weaker business capital spending. And the post-vote drop in sterling has provided a boost to U.K. competitiveness. Nevertheless, it seems inevitable that there will be a hit to growth over the next couple of years. The optimistic view is that the U.K. will use the opportunity of its EU departure to launch a raft of supply-side reforms and tax cuts with the aim of creating a much more dynamic economy that will be very attractive to overseas investors. Some have made the comparison with Singapore. This seems a bit of a stretch. In contrast to the pre-vote rhetoric, EU membership did not turn the U.K. into a highly-regulated economy. For example, the U.K. already is in 7th place out of 190 countries in the World Bank's Ease Doing Business Index and one of the least regulated developed economies according to the OECD. Thus, the scope to boost growth by sweeping away regulations probably is limited. At the same time, the U.K.'s ability to engage in major fiscal stimulus via tax cuts or increased spending is limited by the country's large balance-of-payments deficit and the poor state of its government finances (Chart 18). Overall, the U.K. should be able to avoid a major downturn in the next couple of years, but we don't disagree with the OECD's latest forecasts that growth will slow to round 1% in 2017 and 2018 after 2% in 2016. And that implies the risks of one or two quarters of negative growth within that period. Mr. X: I am not a fan of the EU so am inclined to think that the U.K. will do better than the consensus believes. But, I am less confident about the rest of Europe. Euro area banks are in a mess, weighed down by inadequate capital, a poor return on assets, an overhang of bad loans in Italy and elsewhere, and little prospect of much revival in credit demand. At the same time, the political situation looks fragile with voters just as disenchanted with the establishment status quo as were the ones in the U.K. and U.S. Against this background, I can't see why any companies would want to increase their capital spending in the region. Chart 19Euro Area Optimism Improves Euro Area Optimism Improves Euro Area Optimism Improves BCA: We agree that euro area growth is unlikely to accelerate much from here. The structural problems of poor demographics, a weak banking system and constrained fiscal policy represent major headwinds for growth. And the political uncertainties related to elections in a number of countries in the coming year give consumers and companies good reason to stay cautious. Yet, we should note that the latest data show a modest improvement in the business climate index, breaking slightly above the past year's trading range (Chart 19). There are some positive developments to consider. The nomination of François Fillon as the conservative candidate in France's Presidential election to be held on April 2017 is very significant. We expect him to beat Marine Le Pen and this means France will have a leader who believes in free markets and deregulation - a marked change from previous statist policies. This truly could represent a major regime shift for that country. Meanwhile, the ECB has confirmed that it will continue its QE program through 2017, albeit at a slightly reduced pace. This has costs in terms of market distortions, but will help put a floor under growth. Mr. X: You noted the fragile state of the region's banks. How do you see that playing out? BCA: Euro area banks have more than €1 trillion of non-performing loans (NPLs) and have provisioned for only about half of that amount. Nevertheless, most countries' banking sectors have enough equity capital to adequately absorb losses from these un-provisioned NPLs. On the other hand, the high level of NPLs is a protracted drag on profitability and thereby increases the banks' cost of capital. The shortage of capital constrains new lending. The biggest concern is Italy, which we estimate needs to recapitalize its banks by close to €100 billion. Complicating matters is that the EU rules on state aid for banks changed at the start of 2016. Now, a government bailout can happen only after a first-loss 'bail-in' of the bank's equity and bond holders. So if an undercapitalized bank cannot raise the necessary funds privately in the markets, there is a danger that its investors could suffer heavy losses before the government is allowed to step in. But once investors have been bailed-in, the authorities will do "whatever it takes" to prevent banking problems turning into a systemic crisis that threaten to push the economy into another recession. Mr. X: I would now like to shift our attention to Asia, most notably Japan and China. Starting with Japan, that economy seems to perfectly describe the world of secular stagnation. Despite two decades of short-term interest rates near zero and major fiscal stimulus, real growth has struggled to get above 1% and deflation rather than inflation has been the norm. Prime Minister Shinzo Abe has made a big deal about his "three arrow" approach to getting the economy going again, but I don't see much evidence that it is working. Is there any prospect of breaking out of secular stagnation? BCA: Probably not. A big part of Japan's problem is demographics - an unfortunate combination of a declining labor force and a rapidly aging population. While this means that per capita GDP growth looks a lot better than the headline figures, it is not a growth-friendly situation. Twenty years ago there were 4.6 people of working age for everyone above 64. This has since dropped to 2.2 and within another 20 years it will be down to 1.6. That falling ratio of taxpayers to pensioners and major consumers of health care is horrendous for government finances. And an aging population typically is not a dynamic one which shows up in Japan's poor productivity performance relative to that of the U.S. (Chart 20). Of course, Japan can "solve" its public finances problem by having the Bank of Japan cancel its large holdings of JGBs. Yet that does nothing to deal with the underlying demographics issue and ongoing large budget deficits. Japan desperately needs a combination of increased immigration and major supply-side reforms, but we do not hold out much prospect of either changing by enough to dramatically alter the long-run growth picture. Mr. X: I will not disagree with you as I have not been positive about Japan for a long time. We should now turn to China. It is very suspicious that the economy continues to hum along at a 6% to 7% pace, despite all the excesses and imbalances that have developed. I really don't trust the data. We talked about China at our mid-2016 meeting and, if I remember correctly, you described China as like a tightrope walker, wobbling from time to time, but never quite falling off. Yet it would only take a gust of wind for that to change. I liked that description so my question is: are wind gusts likely to strengthen over the coming year? BCA: You are right to be suspicious of the official Chinese data, but it seems that the economy is expanding by at least a 5% pace. However, it continues to be propped up by unhealthy and unsustainable growth in credit. The increase in China's debt-to-GDP ratio over the past few years dwarves that during the ultimately disastrous credit booms of Japan in the 1980s and the U.S. in the 2000s (Chart 21). The debt increase has been matched by an even larger rise in assets, but the problem is that asset values can drop, while the value of the debt does not. Chart 20Japan's Structural Headwinds Japan's Structural Headwinds Japan's Structural Headwinds Chart 21China's Remarkable Credit Boom January 2017 - Shifting Regimes January 2017 - Shifting Regimes The government would like to rein in credit growth, but it fears the potential for a major economic slowdown, so it is trapped. The fact that the banking system is largely under state control does provide some comfort because it will be easy for the government to recapitalize the banks should problems occur. This means that a U.S.-style credit freeze is unlikely to develop. Of course, the dark side of that is that credit excesses never really get unwound. You asked whether wind gusts will increase, threating to blow the economy off its tightrope. One potential gust that we already talked about is the potential for trade fights with the new U.S. administration. As we mentioned earlier, we are hopeful that nothing serious will occur, but all we can do is carefully monitor the situation. Trends in China's real estate sector represent a good bellwether for the overall economic situation. The massive reflation of 2008-09 unleashed a powerful real estate boom, accompanied by major speculative excesses. The authorities eventually leaned against this with a tightening in lending standards and the sector cooled off. Policy then eased again in 2015/16 as worries about an excessive economic slowdown developed, unleashing yet another real estate revival. The stop-go environment has continued with policy now throttling back to try and cool things off again. It is not a sensible way to run an economy and we need to keep a close watch on the real estate sector as a leading indicator of any renewed policy shifts. Over time, the Chinese economy should gradually become less dependent on construction and other credit-intensive activities. However, in the near-term, there is no escaping the fact that the economy will remain unbalanced, creating challenges for policymakers and a fragile environment for the country's currency and asset markets. Fortunately, the authorities have enough room to maneuver that a hard landing remains unlikely over the next year or two. There are fewer grounds for optimism about the long-run unless the government can move away from its stop-go policy and pursue more supply-side reforms. Mr. X: What about other emerging economies? Are there any developments particularly worth noting? BCA: Emerging economies in general will not return to the rapid growth conditions of the first half of the 2000s. Slower growth in China has dampened export opportunities for other EM countries and global capital will no longer pour into these economies in its previous, indiscriminate way. Nevertheless, the growth outlook is stabilizing and 2017 should be a modestly better year than 2016 for most countries. Chart 22India Has A Long Way To Go India Has A Long Way To Go India Has A Long Way To Go The rebound in oil and other commodity prices has clearly been positive for Russia, Brazil and other resource-dependent countries. Commodity prices will struggle to rise further from current elevated levels but average 2017 prices should exceed those of 2016. On the negative side, a firm dollar and trade uncertainty will represent a headwind for capital flows to the EM universe. The bottom line is that the growth deceleration in emerging economies has run its course but a major new boom is not in prospect. The Indian economy grew by around 7½% in 2016, making it, by far, the star EM performer. Growth will take a hit from the government's recent decision to withdraw high-denomination bank notes from circulation - a move designed to combat corruption. Fortunately, the impact should be relatively short-lived and growth should return to the 7% area during the coming year. Still, India has a long way to go to catch up with China. In 1990, India's economy was almost 90% as big as China's in PPP terms, but 20 years later, it was only 40% as large. Even though India is expected to keep growing faster than China, its relative size will only climb to 45% within the next five years, according to the IMF (Chart 22). Mr. X: Let me try and summarize your economic views before we move on to talk about the markets. The growth benefit from fiscal stimulus in the U.S. is more a story for 2018 than 2017. Nevertheless, a modest improvement in global growth is likely over the coming year, following several years of economic disappointments. The key risks relate to increased trade protectionism and increased inflation in the U.S. if the rise in demand is not matched by an increase in the economy's supply-side capacity. In that event, tighter monetary policy could trigger a recession in 2019. You do not expect any major changes in the underlying economic picture for Europe, Japan or China, although political shifts in Europe represent another downside risk. BCA: That captures our views quite well. Going back to our broad theme of regime shifts, it is important to re-emphasize that shifting attitudes toward fiscal policy and trade in the U.S. raise a red flag over the longer-term inflation outlook. And this of course feeds into the outlook for interest rates. Bond Market Prospects Mr. X: That is the perfect segue for us to shift the discussion to the investment outlook, starting with bonds. You already noted that you believe the secular bull market in bonds has ended, albeit with a drawn-out bottoming process. Given my concerns about the long-run inflation outlook, I am happy to agree with that view. Yet, yields have risen a lot recently and I am wondering if this represents a short-term buying opportunity. BCA: The late-2016 sell-off in bonds was violent and yields rose too far, too fast. So we recently shifted our tactical bond recommendation from underweight (short duration) to neutral. But obviously that is not the same as telling you to buy. The underlying story for bonds - especially in the U.S. - is bearish. The prospect of fiscal stimulus, rising short rates and a pickup in inflation suggests that U.S. yields will be higher over the next 12 months. Although yields may decline somewhat in the very near-term, we doubt the move will be significant enough or last long enough to warrant an overweight position. The outlook is not quite so bad in the euro zone given the ECB's ongoing bond purchases and a continued benign inflation outlook. But, even there, the market will remain highly correlated with trends in U.S. Treasurys so yields are more likely to rise than fall over the coming year. The story is different in Japan given the central bank's new policy of pegging the 10-year yield at zero. That will be a static market for some time. Although global yields may have bottomed from a secular perspective, the upturn will be gradual in the years ahead. A post-Debt Supercycle environment implies that private sector credit growth will remain subdued, and during 2018, the market may start to attach growing odds of a U.S. recession within a year or two. A more powerful bear trend in bonds awaits the more significant upturn in inflation that likely will follow the next economic downturn. Chart 23Treasurys Are High Yielders Treasurys Are High Yielders Treasurys Are High Yielders Mr. X: I am somewhat surprised at how much the spread between U.S. and euro area bonds has widened - it is now at the highest level since the late 1980s. Obviously, a positive spread makes sense given the relative stance of monetary policy and economic outlook. Yet, it is quite amazing how investors have benefited from both higher yields in the U.S. and a stronger dollar. If the dollar stays firm in 2017, will the spread remain at current high levels? BCA: Most of the increased spread during the past year can be attributed to a widening gap in inflation expectations, although the spread in real yields also spiked after the U.S. election, reflecting the prospects for fiscal stimulus (Chart 23). While the spread is indeed at historical highs, the backdrop of a massive divergence in relative monetary and fiscal policies is not going to change any time soon. We are not expecting the spread to narrow over the next year. You might think that Japanese bonds would be a good place to hide from a global bond bear market given BoJ's policy to cap the 10-year yield at zero percent. Indeed, JGBs with a maturity of 10-years or less are likely to outperform Treasurys and bunds in local currency terms over the coming year. However, this means locking in a negative yield unless you are willing to move to the ultra-long end of the curve, where there is no BoJ support. Moreover, there is more upside for bond prices in the U.S. and Eurozone in the event of a counter-trend global bond rally, simply because there is not much room for JGB yields to decline. Mr. X: O.K., I get the message loud and clear - government bonds will remain an unattractive investment. As I need to own some bonds, should I focus on spread product? I know that value looks poor, but that was the case at the beginning of 2016 and, as you showed earlier, returns ended up being surprisingly good. Will corporate bonds remain a good investment in 2017, despite the value problem? BCA: This a tricky question to answer. On the one hand, you are right that value is not great. Corporate spreads are low in the U.S. at a time when balance sheet fundamentals have deteriorated, according to our Corporate Health Monitor (Chart 24). After adjusting the U.S. high-yield index for expected defaults, option-adjusted spreads are about 165 basis points. In the past, excess returns (i.e. returns relative to Treasurys) typically were barely positive when spreads were at this level. Valuation is also less than compelling for U.S. investment-grade bonds. One risk is that a significant amount of corporate bonds are held by "weak hands," such as retail investors who are not accustomed to seeing losses in their fixed-income portfolios. At some point, this could trigger some panic selling into illiquid markets, resulting in a sharp yield spike. On a more positive note, the search for yield that propped up the market in 2016 could remain a powerful force in 2017. The pressure to stretch for yield was intense in part because the supply of government bonds in the major markets available to the private sector shrank by around $547 billion in 2016 because so much was purchased by central banks and foreign official institutions (Chart 25). The stock will likely contract by another $754 billion in 2017, forcing investors to continue shifting into riskier assets such as corporate bonds. Chart 24U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated Chart 25Government Bonds In Short Supply Government Bonds In Short Supply Government Bonds In Short Supply Weighing the poor valuation and deteriorating credit quality trend against the ongoing pressure to search for yield, we recommend no more than a benchmark weighting in U.S. corporate investment-grade bonds and a modestly underweight position in high-yield. There are better relative opportunities in euro area corporates, where credit quality is improving and the ECB's asset purchase program is providing a nice tailwind. We are slightly overweight in both investment-grade and high-yield euro area corporates. Finally, we should mention emerging market bonds, although we do not have much good to say. The prospect of further declines in EM currencies versus the dollar is a major problem for these securities. There is a big risk that global dollar funding will dry up as the dollar moves higher along with U.S. bond yields, creating problems for EM economies running current account and fiscal deficits. You should stay clear of EM bonds. Mr. X: None of this is helping me much with my bond investments. Can you point to anything that will give me positive returns? Chart 26Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low BCA: Not in the fixed-income market. Your concerns about inflation might lead you to think that inflation-indexed bonds are a good place to be, but prices in that market have already adjusted. Moreover, the case for expecting higher inflation rests a lot on the assumption that economic growth is going to strengthen and that should imply a rise in real yields, which obviously is bad for inflation-indexed bonds. Real yields currently are still very low by historical standards (Chart 26). A world of stagflation - weak real growth and rising inflation - would be a good environment for these securities, but such conditions are not likely in the next couple of years. Mr. X: After what you have told me, I suppose I will concentrate my fixed-income holdings in short-term Treasurys. But I do worry more than you about stagflation so will hold on to my inflation-indexed bonds. At the same time, I do understand that bonds will represent a hedge against downside risks rather than providing positive returns. So let's talk about the stock market as a more attractive place to invest. Equity Market Outlook Mr. X: I like to invest in equities when the market offers good value, there is too much pessimism about earnings and investor sentiment is gloomy. That is not the picture at the moment in the case of the U.S. market. I must confess that the recent rally has taken me by surprise, but it looks to me like a major overshoot. As we discussed earlier, the new U.S. administration's fiscal platform should be good for 2018 economic growth but the U.S. equity market is not cheap and it seems to me that there is more euphoria than caution about the outlook. So I fear that the big surprise will be that the market does much worse than generally expected. BCA: Obviously, the current market environment is nothing like the situation that exists after a big sell-off. You are correct that valuations are not very appealing and there is too much optimism about the outlook for earnings and thus future returns. Analysts' expectations of long-run earnings growth for the S&P 500 universe have risen to 12%, which is at the high end of its range over the past decade (Chart 27). And, as you suggested, surveys show an elevated level of optimism on the part of investors and traders. The outlook for earnings is the most critical issue when it comes to the long-run outlook for stocks. Low interest rates provide an important base of support, but as we noted earlier, rates are more likely to rise than fall over the next couple of years, possibly reaching a level that precipitates a recession in 2019. Investors are excited about the prospect that U.S. earnings will benefit from both faster economic growth and a drop in corporate tax rates. We don't disagree that those trends would be positive, but there is another important issue to consider. One of the defining characteristics of the past several years has been the extraordinary performance of profit margins which have averaged record levels, despite the weak economic recovery (Chart 28). The roots of this rise lay in the fact that businesses rather than employees were able to capture most of the benefits of rising productivity. This showed up in the growing gap between real employee compensation and productivity. As a result, the owners of capital benefited, while the labor share of income - previously a very mean-reverting series - dropped to extremely low levels. The causes of this divergence are complex but include the impact of globalization, technology and a more competitive labor market. Chart 27Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Chart 28Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? With the U.S. unemployment back close to full-employment levels, the tide is now turning in favor of labor. The labor share of income is rising and this trend likely will continue as the economy strengthens. And any moves by the incoming administration to erect barriers to trade and/or immigration would underpin the trend. The implication is that profit margins are more likely to compress than expand in the coming years, suggesting that analysts are far too optimistic about earnings. Long-term growth will be closer to 5% than 12%. The turnaround in the corporate income shares going to labor versus capital represents another important element of our theme of regime changes. None of this means that the stock market faces an imminent plunge. Poor value and over-optimism about earnings raises a red flag over long-term return prospects, but says little about near-term moves. As we all know, market overshoots can move to much greater extremes and last for much longer than one can rationally predict. And the fact remains that the conditions for an overshoot could well persist for another 12 months or even longer. Optimism about the economic benefits of the new administration's policies should last for a while as proposals for tax cuts and increased fiscal spending get debated. Meanwhile, although the Fed plans to raise rates again over the next year, the level of interest rates will remain low by historical standards, sustaining the incentive to put money into stocks rather than interest-bearing assets. Mr. X: So are you telling me to buy U.S. stocks right now? BCA: No we are not. The stock market is vulnerable to a near-term setback following recent strong gains, so this is not a great time to increase exposure. However, we do expect prices to be higher in a year's time, so you could use setbacks as a buying opportunity. Of course, this is with the caveat that long-run returns are likely to be poor from current levels and we have the worry about a bear market some time in 2018 if recession risks are building. Playing market overshoots can be very profitable, but it is critical to remember that the fundamental foundations are weak and you need to be highly sensitive to signs that conditions are deteriorating. Mr. X: I am very well aware of the opportunities and risks of playing market overshoots. I completely underestimated the extent of the tech-driven overshoot in the second half of the 1990s and remained on the sidelines while the NASDAQ soared by 130% between end-1998 and March 2000. But my caution was validated when the market subsequently collapsed and it was not until 2006 that the market finally broke above its end-1998 level. I accept that the U.S. market is not in a crazy 1990s-style bubble, but I am inclined to focus on markets where the fundamentals are more supportive. BCA: The U.S. market is only modestly overvalued, based on an average of different measures. It is expensive based on both trailing and forward earnings and relative to book value, but cheap compared to interest rates and bond yields. A composite valuation index based on five components suggests that the S&P 500 currently is only modestly above its 60-year average (Chart 29). Valuation is not an impediment to further significant gains in U.S. equities over the coming year although it is more attractive in other markets. Chart 29The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive If we use the cyclically-adjusted price-earnings ratio for non-financial stocks as our metric, then Japan and a number of European markets are trading at valuations below their historical averages (Chart 30). The picture for Japan is muddied by the fact that the historical average is biased upwards by the extreme valuations that existed during the bubble years and in the aftermath when earnings were exceptionally weak. Nonetheless, even on a price-to-book basis, Japan is trading far below non-bubble historical averages (Chart 31). Chart 30Valuation Ranking Of Developed Equity Markets January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 31Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market With regard to Europe, the good value is found in the euro area periphery, rather than in the core countries of Germany, France and the Netherlands. In fact, these core countries are trading more expensively than the U.S., relative to their own history. As you know, valuation is not the only consideration when it comes to investing. Nonetheless, the direction of monetary policy also would support a better outlook for Japan and the euro area given that the Fed is raising rates while the ECB and BoJ are still implementing QE policies. Exchange rate moves complicate things a bit because further gains in the dollar would neutralize some of the relative outperformance when expressed in common currency. Even so, we would expect the euro area and Japan to outperform the U.S. over the next 12 months. The one important qualification is that we assume no new major political shocks come from Europe. A resurgence of political uncertainty in the euro area would poses the greatest threat to the peripheral countries, which partly explains why they are trading at more attractive valuations than the core. Mr. X: There seem to be political risks everywhere these days. It is a very long time since I could buy stocks when they offered great value and I felt very confident about the economic and political outlook. I agree that value looks better outside the U.S., but I do worry about political instability in the euro area and Brexit in the U.K. I know Japan looks cheap, but that has been a difficult and disappointing market for a long time and, as we already discussed, the structural outlook for the economy is very troubling. Turning to the emerging markets, you have not backed away from your bearish stance. The long-run underperformance of emerging markets relative to the U.S. and other developed bourses has been quite staggering and I am glad that I have followed your advice. Are you expecting to shift your negative stance any time soon? BCA: The global underperformance of EM has lasted for six years and may be close to ending. But the experience of the previous cycle of underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound (Chart 32). Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors - materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors (Chart 33). Chart 32A Long Period Of EM Underperformance A Long Period Of EM Underperformance A Long Period Of EM Underperformance Chart 33EM Fundamentals Still Poor EM Fundamentals Still Poor EM Fundamentals Still Poor More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year's rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces. In sum, we expect EM equities to underperform DM markets for a while longer. If you want to have some EM exposure then our favored markets are Korea, Taiwan, China, India, Thailand and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil and Peru. Mr. X: None of this makes very keen to invest in any equity market. However, even in poor markets, there usually are some areas that perform well. Do you have any strong sector views? Chart 34Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot BCA: Our near-term sector views reflect the expectation of a pullback in the broad equity market. The abrupt jump in the price of global cyclicals (industrials, materials & energy) versus defensives (health care, consumer staples & telecom services) has been driven solely by external forces - i.e. the sell-off in the bond market, rather than a shift in underlying profit drivers. For instance, emerging markets and the global cyclicals/defensives price ratio have tended to move hand-in-hand. The former is pro-cyclical, and outperforms when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the cyclical/defensive price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debts. Meanwhile, the growth impetus required to support profit outperformance for deep cyclicals may be elusive. As a result, we expect re-convergence to occur via a rebound in defensive relative to cyclical sectors (Chart 34). On a longer-term basis, one likely long-lasting effect of the retreat from globalization is that "small is beautiful." Companies with large global footprints will suffer relative to domestically focused firms. One way to position for this change is to emphasize small caps at the expense of large caps, a strategy applicable in almost every region. Small caps are traditionally domestically geared irrespective of their domicile. In the U.S. specifically, small caps face a potential additional benefit. If the new administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Moreover, small companies would benefit most from any cuts in regulations. When it comes to specifics, our overweight sectors in the U.S. are consumer discretionary, telecoms, consumer staples and health care. We would underweight industrials, technology and materials. For Europe, we also like health care and would overweight German real estate. We would stay away from European banks even though they are trading at historically cheap levels. Commodities And Currencies Mr. X: A year ago, you predicted that oil prices would average $50/bbl over the 2016-18 period. As that is where prices have now settled, do you still stick with that prediction? Chart 35Oil Market Trends Oil Market Trends Oil Market Trends BCA: We have moved our forecast up to an average of $55/bbl following the recent 1.8 million b/d production cuts agreed between OPEC, led by Saudi Arabia, and non-OPEC, led by Russia. The economic pain from the drop in prices finally forced Saudi Arabia to blink and abandon its previous strategy of maintaining output despite falling prices. Of course, OPEC has a very spotty record of sticking with its plans and we expect that we will end up with a more modest 1.1 to 1.2 million b/d in actual output reductions. Yet, given global demand growth of around 1.3 million b/d and weakness in other non-OPEC output, these cuts will be enough to require a drawdown in inventories from current record levels. Even with the lower level of cuts that we expect, OECD oil inventories could drop by around 300 million barrels by late 2017, enough to bring down stocks roughly to their five-year average level (Chart 35). That is the stated goal of Saudi Arabia and the odds are good that the level of compliance to the cuts will be better than the market expects. Mr. X: How does shale production factor into your analysis? What are the odds that a resurgence of U.S. shale production will undermine your price forecast? BCA: We expect U.S. shale-oil production to bottom in the first quarter of 2017, followed by a production increase of around 200,000 b/d in the second half. However, that will not be enough to drive prices back down. The bigger risk to oil prices over the next year or two is for a rise, not a decline given the industry's massive cutbacks in capital spending. More than $1 trillion of planned capex has been cut for the next several years, which translates into more than seven million b/d of oil-equivalent (oil and natural gas) production that will not be developed. And increased shale production cannot fully offset that. In addition to meeting demand growth, new production also must offset natural decline rates, which amount to 8% to 10% of production annually. Replacing these losses becomes more difficult as shale-oil output increases, given its very high decline rates. Shale technology appears to be gaining traction in Russia, which could end up significantly boosting production but capex cuts will constrain the global supply outlook until after 2018. Mr. X: Non-oil commodity prices have shown surprising strength recently, with copper surging almost 30% in the space of a few weeks. Is that just Chinese speculation, or is something more fundamental at work? You have had a cautious long-term view of commodities on the grounds that changing technology and reduced Chinese demand would keep a lid on prices. Do you see any reason to change that view? BCA: Developments in China remain critical for non-oil commodity prices. China's reflationary policies significantly boosted real estate and infrastructure spending and that was the main driver of the rally in metals prices in 2016. As we discussed earlier, China has eased back on reflation and that will take the edge off the commodity price boom. Indeed, given the speed and magnitude of the price increases in copper and other metals, it would not be surprising to see some near-term retrenchment. For the year as a whole, we expect a trading range for non-oil commodities. Longer-run, we would not bet against the long-term downtrend in real commodity prices and it really is a story about technology (Chart 36). Real estate booms notwithstanding, economies are shifting away from commodity-sensitive activities. Human capital is becoming more important relative to physical capital and price rises for resources encourages both conservation and the development of cheaper alternatives. In the post-WWII period, the pattern seems to have been for 10-year bull markets (1972 to 1982 and 2002 to 2012) and 20-year bear markets (1952 to 1972 and 1982 to 2002). The current bear phase is only six years old so it would be early to call an end to the downtrend from a long-term perspective. Chart 36The Long-Term Trend In Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down Mr. X: You know that I can't leave without asking you about gold. I continue to believe that bullion provides a good hedge at a time of extreme monetary policies, political uncertainty and, now, the prospect of fiscal reflation. Can you see bullion at least matching its past year's performance over the coming 12 months? Chart 37A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion BCA: It is still a gold-friendly environment. The combination of political uncertainty, rising inflation expectations and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar: the strengthening of the dollar clearly was a factor undermining the gold price in the second half of 2016 (Chart 37). Nevertheless, a modest position in gold - no more than 5% of your portfolio - will give you some protection in what is likely to remain a very unsettled geopolitical environment. Mr. X: You mentioned the dollar so let me now delve into your currency views in more detail. The dollar has been appreciating for a few years and it seems quite a consensus view to be bullish on the currency. I know the U.S. economy is growing faster than most other developed economies but it surprises me that markets are ignoring the negatives: an ongoing large trade deficit, a looming rise in the fiscal deficit and uncertainty about the policies of the incoming administration. BCA: It is true that if you just looked at the U.S. economic and financial situation in isolation, you would not be very bullish on the currency. As you noted, the current account remains in large deficit, an increased federal deficit seems inevitable given the new administration's policy platform, and the level of short-rates is very low, despite the Fed's recent move. However, currencies are all about relative positions, and, despite its problems, the U.S. looks in better shape than other countries. The optimism toward the dollar is a near-term concern and suggests that the currency is ripe for a pullback. However, it will not require a major sell-off to unwind current overbought conditions. The main reasons to stay positive on the dollar on a cyclical basis are the relative stance of monetary policy and the potential for positive U.S. economic surprises relative to other countries. Ironically, if the administration follows up on its threat to impose trade barriers, that also would be positive for the currency, at least for a while. Longer-run it would be dollar bearish, because the U.S. probably would lose competiveness via higher inflation. The dollar is enjoying its third major upcycle since the era of floating rates began in the early 1970s (Chart 38). There are similarities in all three cases. Policy divergences and thus real interest-rate differentials were in the dollar's favor and there was general optimism about the U.S. economy relative to its competitors. In the first half of the 1980s, the optimism reflected President Reagan's pro-growth supply-side platform, in the second half of the 1990s it was the tech bubble, and this time it is the poor state of other economies that makes the U.S. look relatively attractive. Chart 38The Dollar Bull Market In Perspective January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bull market in the first half of the 1980s was the strongest of the three but was cut short by the 1985 Plaza Accord when the leading industrial economies agreed to coordinated intervention to push the dollar back down in order to forestall a U.S. protectionist response to its soaring trade deficit. The second upturn ended when the tech bubble burst. There is no prospect of intervention to end the current cycle and policy divergences will widen not narrow over the next year. Thus, the dollar should continue to appreciate over the next 12 months, perhaps by around 5% on a trade-weighted basis. The fiscal policies being promoted by the Trump team promise to widen the U.S. trade deficit but that will not stand in the way of a dollar ascent. The problems will occur if, as we discussed earlier, an overheating economy in 2018 and a resulting Fed response trigger a recession in 2019. At that point, the dollar probably would plunge. But it is far too soon to worry about that possibility. Mr. X: I was very surprised with the yen's strength in the first half of 2016 given Japan's hyper-easy policy stance. What was driving that? Also, I would be interested in your views on sterling and commodity and emerging currencies. BCA: The yen often acts as a safe-haven at times of great economic and political uncertainty and that worked in the yen's favor for much of the year. However, it lost ground when U.S. bond yields headed higher. Also, the U.S. election result did not help because Japan would be a big loser if the U.S. imposed trade restrictions. The policy settings in Japan are indeed negative for the yen and while the currency is oversold in the very short run, we expect the structural bear market to persist in 2017 (Chart 39). Sterling's trade-weighted index fell to an all-time low after the Brexit vote so it does offer good value by historical standards. However, with so much uncertainty about how Brexit negotiations will proceed, we remain cautious on the currency. The economy has performed quite well since the vote, but it is far too soon to judge the long-term consequences of EU departure. And the prospect of increased government spending when the country already has a large trade deficit and high public debt poses an additional risk. Turning to the commodity currencies, the rebound in oil and metals prices has stabilized the Canadian and Australian dollars (Chart 40). With resource prices not expected to make much further headway over the next year, these currencies likely will be range bound, albeit with risks to the downside, especially versus the U.S. dollar. Chart 39More Downside In The Yen More Downside In The Yen More Downside In The Yen Chart 40Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Finally, we remain bearish on emerging currencies given relatively poor economic fundamentals. And this is particularly true for those countries with chronically high inflation and/or large current account deficits, largely outside of Asia. Mr. X: What about the Chinese currency? The renminbi has dropped by 13% against the dollar over the past three years and president-elect Trump has threatened to label China as a currency manipulator. You already noted that the Chinese authorities have intervened to prop the currency up, but this does not seem to be working. Chart 41Renminbi Weakness Renminbi Weakness Renminbi Weakness BCA: The trend in the USD/RMB rate exaggerates the weakness of the Chinese currency. On a trade-weighted basis, the currency has depreciated more modestly over the past year, and the recent trend has been up, in both real and nominal terms (Chart 41). In other words, a good part of the currency's move has reflected across-the-board strength in the dollar. The Chinese authorities are sensitive to U.S. pressures and have taken some measures to contain private capital outflows. The next step would be to raise interest rates but this would be a last resort. With the dollar expected to rise further in 2017, the RMB will drift lower, but policy interventions should limit the decline and we doubt the U.S. will follow through with its threat to label China as a manipulator. Geopolitics Mr. X: Last, but certainly not least, we must talk about geopolitics. In addition to the new political order in the U.S. we have a very unstable political situation in Europe, most notably in Italy. We cannot rule out an anti-euro party taking power in Italy which would presumably trigger massive volatility in the markets. With elections also due in France, Germany and the Netherlands, 2017 will be a crucial year for determining the future of the single currency and the EU. What is your take on the outlook? Chart 42Europeans Still Support The EU Europeans Still Support The EU Europeans Still Support The EU BCA: Europe's electoral calendar is indeed ominously packed with four of the euro area's five largest economies likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As BCA's Geopolitical Strategy has argued since 2011, global multipolarity increases the logic for European integration. Crises such as Russian assertiveness, Islamic terrorism, and the migration wave are easier to deal with when countries act together rather than individually. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro or the EU (Chart 42). Despite all of its problems, the single currency should hold together, at least over the next five years. Take the recent Spanish and Austrian elections. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the more-establishment candidate for president, Alexander Van der Bellen, won the election despite fears to the contrary. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. We expect more of the same in the three crucial elections in the Netherlands, France, and Germany. Mr. X: What about Italy? BCA: The country certainly has its problems: it has lagged badly in implementing structural reforms and support for the euro is low compared to the euro area average. Yet, if elections were held today, polls show that the ruling Democratic Party would gain a narrow victory. There are three key points to consider regarding Italy: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum. The market will punish Italy the moment it sniffs out even a whiff of a potential "Itexit" referendum. This will bring forward the future pain of redenomination, influencing voters' choices. Benefits of EU membership for Italy are considerable, especially as it allows the country to integrate its unproductive, poor, and expensive southern regions. Outside the EU, the Mezzogiorno is Rome's problem, and it is a big one. The larger question is whether other euro area countries will be content for Italy to remain mired in its fragile and troubling status quo. We think the answer is yes, given that Italy is the definition of "too-big-to-fail." Mr. X: During the past few years you have emphasized the importance of the shift from a unipolar to multipolar world, reflecting the growing power of China, renewed Russian activism and a decline in U.S. influence. How does the policy platform of the incoming Trump administration affect your view of the outlook? It seems as if the U.S. may end up antagonizing China at the same time as it tries to improve relations with Russia. How would that play out? Chart 43Asia Sells, America Rules Asia Sells, America Rules Asia Sells, America Rules BCA: The media is overemphasizing the role of president-elect Trump in Sino-American relations. Tensions have been building between the two countries for several years. The two countries have fundamental, structural, problems and Trump has just catalyzed what, in our mind, has been an inevitable conflict. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were instrumental: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 43). For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its umbrella. Japan's economic model and large trade surpluses led it into a confrontation with the U.S. in the 1980s. President Ronald Reagan's economic team forced Japan to reform, but the result ultimately was a financial crisis as the artificial supports of its economic model fell away. Many investors have long suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it hinders U.S. access to its vast consumer market. There is a critical difference between the "Japan bashing" of the 1980s and the increasingly potent "China bashing" of today. In the 1980s, the U.S. had already achieved strategic supremacy over Japan as a result of WWII, but that is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the U.S. to preserve its security. Far from it - China has no greater security threat than the U.S. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. That means that when the Trump administration tries to "get tough" on long-standing American demands, these demands will not be taken as well-intentioned or trustworthy. Sino-American rivalry will be the chief geopolitical risk to investors in 2017. Mr. X: Are there any other geopolitical issues that might affect financial markets during the coming year? BCA: Investors are underestimating the risks that the defeat of the Islamic State Caliphate in the Middle East will pose. While the obvious consequence is a spread of terrorism as militants return home, the bigger question is what happens to the regional disequilibrium. In particular, we fear that Turkey will become embroiled in a conflict in both Syria and Iraq, potentially in a proxy war with Iran and Russia. The defeat of Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. The Turkish foray into the Middle East poses the chief risk of a shooting war that could impact global markets in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. Conclusions Mr. X: I think we should end our discussions here before you make me more depressed. A year ago, I was very troubled about the economic and financial outlook, and you did not say very much at that time to ease my concerns. And I feel in a similar situation again this year. I do not believe we are at the edge of a major economic or financial crisis, so that is not the issue. The problem for me is that policymakers continue to distort things with excessively easy monetary policies. And now we face fiscal expansion in the U.S., even though the economy is approaching full employment and wages are picking up. Meanwhile, nobody seems worried about debt anymore despite debt-to-GDP ratios that are at all-time highs throughout the world. And if that was not enough, we face the most uncertain political environment that I can remember, both in the U.S. and Europe. It would not be so bad if markets were cheap to compensate for the various risks and uncertainties that we face. But, as we discussed, that is not the case. So I am left with the same dilemma as last year: where to invest when most assets are fully valued. I am sure that you are right when you say that stock prices are well placed to overshoot over the coming year, but that is not a game I like to play. So I am inclined to stay with a cautious investment stance for a while longer, hoping for a better entry point into equities and other risk assets. BCA: We understand your caution, but you risk missing out on some decent gains in equities over the coming year if you remain on the sidelines. The equity market is due for a near-term pullback, but we would use that as a buying opportunity. Markets are not expensive everywhere and the policy backdrop will remain supportive of risk assets. And although we talked about an overshoot, there is plenty of upside before we need to be concerned that valuations have become a major constraint. We are certainly not trying to persuade you to throw caution to the wind. We have not changed our view that long-term returns from financial assets will be a pale shadow of their historical performance. The past 33 years have delivered compound returns of 10.3% a year from a balanced portfolio and we cannot find any comparable period in history that comes even close (Table 3). As we discussed at length in the past, these excellent returns reflected a powerful combination of several largely interrelated forces: falling inflation and interest rates, rising profit margins, a starting point of cheap valuations and strong credit growth. None of these conditions exist now: inflation and interest rates are headed up, profit margins are likely to compress, valuations are not cheap, and in a post-Debt Supercycle world, the days of rapid credit growth are over. Thus, that same balanced portfolio is likely to deliver compound returns of only 4% over the coming decade. Table 3The Past Is Not A Guide To The Future January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bottom line is that the economic and policy regime that delivered exceptional markets is shifting. The end of the Debt Supercycle a few years ago represented one element of regime shift and now we face several other elements such as the end of the era of falling inflation and interest rates, a rebalancing of the income shares going to labor and capital, and politically, in attitudes and thus policies regarding globalization. A world of modest returns is one where it is very important to get the right country and sector allocation, and ideally, catch shorter-term market swings. Of course, that is much more challenging than simply enjoying a rising tide that lifts all boats. As the year progresses, we will update you with our latest thinking on market trends and investment ideas. Mr. X: I am sure we are about to have a very interesting year and I will rely on your research to highlight investment opportunities and to keep me out of trouble. Once again, many thanks for spending the time to take me through your views and let's end with a summary of your main views. BCA: That will be our pleasure. The key points are as follows: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end-point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time-lags in implementing policy mean that the fiscal plans of president-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. They key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely to avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given president-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors December 20, 2016

Mr. X is a long-time BCA client who visits our offices towards the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: What a year it has been. The Brexit vote in the U.K. and the U.S. election result took me completely by surprise and have added to an already uncertain economic environment. A year ago, you adopted the theme of "Stuck In A Rut" to describe the economic and financial market environment and that turned out to be quite appropriate. Consistent with that rut, many issues concerning me for some time have yet to be resolved. Global economic growth has stayed mediocre, debt levels remain elevated almost everywhere, the outlook for China continues to be shrouded in fog, and stimulative monetary policies are still distorting markets. And now we face political shifts that will have major economic and financial effects. Some big changes are underway and I fear that we are more likely to head in a negative rather than positive direction. Therefore, I am very interested to learn how you see things developing. You have recommended a cautious investment stance during the past year and I was happy to go along with that given all my concerns about the economic and policy environment. While stocks have done rather better than I expected, it has all been based on flimsy foundations in my opinion. I have never been comfortable buying an asset just because prices are being supported by excessively easy money policies. The question now is whether looming changes in the policy and economic environment and in global politics will fuel further gains in risk assets or whether a significant setback is in prospect. I hope our discussion will give some clarity on this but, before talking about the future, let's quickly review what you predicted a year ago. BCA: It has indeed been a momentous year and we do seem to be at important turning points in many areas. For example, changing attitudes toward free trade and fiscal policy do have important implications for economic growth and interest rates. And this is being reinforced by cyclical economic trends as labor markets tighten in the U.S. However, it is too soon to know the extent to which political and policy uncertainties will diminish in the U.S. and Europe. You seek clarity on the investment outlook, but that will remain as challenging an objective as ever. You asked to start with a review of last year's predictions and this is always a moment of some trepidation. A year ago, our key conclusions were as follows: The current global economic malaise of slow growth and deflationary pressures reflects more than just a temporary hangover from the 2007-09 balance sheet recession. Powerful structural forces are at work, the effects of which will linger for a long time. These include an ongoing overhang of debt, the peak in globalization, adverse demographics in most major economies, monetary policy exhaustion, and low financial asset returns. Investor expectations have yet to adjust to the fact that sub-par growth and low inflation are likely to persist for many years. The Debt Supercycle is over, but weak nominal GDP growth has made it virtually impossible to reduce debt burdens. Nonetheless, a debt crisis in the advanced economies is not in prospect any time soon because low interest rates are keeping a lid on debt servicing costs. Perhaps high inflation and debt monetization will be the end-point, but that is many years away and would be preceded by a deflationary downturn. Despite ongoing exciting technological advances, the IT boom has lost its edge in terms of boosting economic growth. Even if productivity is understated, the corollary is that inflation is overstated, suggesting that central bankers will continue to face a policy dilemma. The Fed will raise interest rates by less than implied by their current projections. And the European Central Bank and Bank of Japan may expand their QE programs. Yet, monetary policy has become ineffective in boosting growth. Fiscal policy needs to play a bigger role, but it will require another recession to force a shift in political attitudes toward more stimulus. The U.S. economy will remain stuck in sub-2.5% growth in 2016, with risks to the downside. The euro zone's performance has improved recently, but 2016 growth will fall short of the IMF's 1.9% forecast. Japan's growth will continue to disappoint as it will in most other developed economies. China will continue to avoid a hard landing but growth will likely average below 6% in 2016 and beyond. Other emerging economies face a difficult environment of weak commodity prices, declining global trade. Those with excessive foreign-currency debt face additional pressures with weak exchange rates preventing an easing in monetary policy. Bonds offer poor long-term returns from current yields, but sovereign bonds in the major developed countries offer a hedge against downside macro risks and we recommend benchmark weightings. The fundamental backdrop to corporate and EM bonds remain bearish and spreads have not yet reached a level that discounts all of the risks. A buying opportunity in high-yield securities could emerge in the coming year but, for the moment, stay underweight spread product. We have turned more cautious on equities given a deterioration in the earnings outlook and in some technical indicators. No more than benchmark weighting is warranted and we would not argue against a modest underweight. The typical warning signs of a bear market are not in place but risks have risen. The U.S. equity market is expected to underperform that of Europe and Japan. Continue to stay away from emerging equities and commodity-oriented bourses. We continue to favor a defensive sector stance, favoring consumer staples and health care over cyclical sectors such as materials, energy and industrials. The bear market in commodities is not over. The sharp drop in oil prices will eventually restore balance to that market by undermining non-OPEC production and supporting demand, but this could take until the third quarter of 2016. The oil price is expected to average around $50 a barrel for the 2016-2018 period. The strong dollar and deflationary environment create a headwind for gold, offsetting the benefits of negative real interest rates. But modest positions are a hedge against a spike in risk aversion. The dollar is likely to gain further against emerging and commodity-oriented currencies. But the upside against the euro and the yen will be limited given the potential for disappointments about the U.S. economy. As was the case a year ago, geopolitical risks are concentrated in the emerging world. Meanwhile, the new world order of multipolarity and an increased incidence of military conflicts is not yet priced into markets. We do not expect the U.S. elections to have any major adverse impact on financial markets. On the economic front, we suggested that economic risks would stay tilted to the downside and this turned out to be correct with global growth, once again, falling short of expectations. A year ago, the IMF forecast global growth of 3.6% in 2016 and this has since been downgraded to 3.1%, the weakest number since the recovery began (Table 1). The U.S. economy fell particularly short of expectations (1.6% versus 2.8%). The downgrading of growth forecasts continued a pattern that has been in place since the end of the 2007-09 downturn (Chart 1). We cannot recall any other time when economic forecasts have been so wrong for such an extended period. The two big disappointments regarding growth have been the lackluster performance of global trade and the ongoing reluctance of businesses to expand capital spending. Not surprisingly, inflation remained low, as we expected. Table 1IMF Economic Forecasts January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 1Persistent Growth Downgrades Persistent Growth Downgrades Persistent Growth Downgrades Given the disappointing economic performance, we were correct in predicting that the Federal Reserve would not raise interest rates by as much as their earlier forecasts implied. When we met last year, the Fed had just raised the funds rate from 0.25% to 0.5% and the median expectation of FOMC members was that it would reach 1.4% by end-2016 and 2.4% by end-2017. As we now know, the Fed is now targeting a funds rate of 0.5% to 0.75% and median FOMC projections are for 1.4% by end-2017 (Chart 2). Meanwhile, as we expected, both the ECB and Bank of Japan expanded their quantitative easing programs in an attempt to stimulate growth. Chart 2Changes In the Fed's Expectations Changes in the Fed's Expectations Changes in the Fed's Expectations Our concerns about the poor prospects for emerging economies were validated. The median 2016 growth rate for 152 emerging economies tracked by the IMF was only 3.1%, a notch below the 2015 pace and, barring 2009, the weakest number since the late 1990s Asia crisis. The official Chinese data overstate growth, but there was no hard landing, as many commentators continued to predict. Turning to the markets, there was considerable volatility during the year (Table 2). For example, U.S. bond yields fell sharply during the first half then rebounded strongly towards the end of the year, leaving them modestly higher over the 12 months. Yields in Europe and Japan followed a similar pattern - falling in the first half and then rebounding, but the level continued to be held down by central bank purchases. Japanese bonds outperformed in common currency terms and we had not expected that to occur, although there was a huge difference between the first and second halves of the year, with the yen unwinding its earlier strength in the closing months of the year. Table 2Market Performance January 2017 - Shifting Regimes January 2017 - Shifting Regimes Our caution toward spread product - corporate and EM bonds - turned out to have been unjustified. Despite worsening fundamentals, most notably rising leverage, the search for yield remained a powerful force keeping spreads down and delivering solid returns for these securities. Spreads are back to very low levels, warning that further gains will be hard to achieve. Equity markets made moderate net gains over the course of the year, but it was a roller coaster journey. A nasty early-year downturn was followed by a rebound, an extended trading range and a late-year rally. While the all-country index delivered a total return of around 8% for the year in common currency terms, almost one-third of that was accounted for by the dividend yield. The price index rose by less than 6% in common currency and 7% in local currency. However, our recommendation to overweight Europe and Japan did not pan out. Once again, the U.S. was an outperformer with the financially-heavy European index weighed down by ongoing concerns about banks, and Japan held back by its lackluster economic performance. Oil prices moved much as we expected, with Brent averaging around $45 over the year. At this time in 2015, prices were below $40, but we argued that a gradual rebalancing would bring prices back into a $45-$60 range in the second half of 2016. We did not expect much of a rise in the gold price and it increased less than 7% over the year. However, we did not try to dissuade you from owning some gold given your long-standing attraction to the asset, subject to keeping the allocation to 5% or less of your portfolio. Industrial commodity prices have been much stronger than we predicted, benefiting from a weak dollar in the first half of the year and continued buoyant demand from China. Finally, the dollar moved up as we had predicted, with the gains concentrated in the second half of the year. The yen's first-half strength was a surprise, but this was largely unwound in the second half as U.S. bond yields climbed. Mr. X: Notably absent has been any mention of the two political shocks of 2016. BCA: We did tell you that the U.K. referendum on Brexit was the key risk facing Europe in 2016 and that the polls were too close to have a strong view. Yet, we did not anticipate that the vote to leave the EU would pass. And when you pushed us a year ago to pick a winner for the U.S. election we wrongly went with Clinton. Our Global Strategist, Peter Berezin, was on record predicting a Trump victory as long ago as September 2015. But it seemed such an outrageous idea that our consensus view stuck to the safer option of Clinton. Interestingly, during our discussion at the end of 2014, we did note that a retreat from globalization was one of the risks in the outlook and we re-emphasized that point last year, pointing to rising populist pressures. However, we underestimated the ability of Brexit campaigners and Donald Trump to capitalize on the anger of disaffected voters. Trade and immigration policies are not the only areas where policy appears to be at a turning point. For example, fiscal conservatism is giving way to stimulus in the U.S. and several other countries, inflation and interest rates are headed higher, at least temporarily, and 2017-2018 should finally arrest the multi-year spectacle of downgrades to global growth projections. Yet, markets have a tendency to overreact and that currently seems to be the case when it comes to discounting prospective changes in the economic environment for the coming year. Turning Points And Regime Shifts: How Much Will Really Change? Mr. X: The U.S. election result and Brexit vote obviously were seismic events with potentially major policy implications. But there seem to be more questions than answers in terms of how policies actually will evolve over the next few years and the extent to which they will be good or bad for growth. The markets are assuming that economic growth will get a big boost from changes in fiscal policy. Do you agree with that view? Chart 3Fiscal Austerity Ended In 2015 Fiscal Austerity Ended in 2015 Fiscal Austerity Ended in 2015 BCA: We need to begin by putting things into perspective. Fiscal austerity came to an end pretty much everywhere a couple of years ago. Data from the IMF show that the peak years for fiscal austerity in the advanced economies were 2011-2013, and the budget cutbacks in those years did not even fully offset the massive stimulus that occurred during the downturn in 2008-10. Since 2013, the fiscal drag on GDP has gradually diminished and policy shifts are estimated to have added to GDP in the U.S., euro area and Japan in 2016 (Chart 3). Nonetheless, with economic growth falling short of expectations and easy money losing its effectiveness, there have been widespread calls for fiscal policy to do more. President-elect Trump has made major tax cuts and increased spending an important part of his policy platform, so the issue is the extent to which he follows through on his plans. Inevitably, there are some challenges: The plan to boost U.S. infrastructure spending is welcome, but the intention seems to be to emphasize private/public partnerships rather than federally-funded projects. Setting up such agreements could take time. Meanwhile, although there is great scope to improve the infrastructure, it is far less clear that a number of "shovel-ready" projects are simply waiting for finance. The bottom line is that increased infrastructure spending is more a story for 2018 and beyond, rather than 2017. And the same also is true for defense, where it may take time to put new programs in place. Turning to the proposed tax cuts, history shows there can be a huge difference between election promises and what eventually is legislated. According to the Tax Policy Center, Trump's plans would add more than $6 trillion to outstanding federal debt over the next decade and more than $20 trillion over 20 years. And that excludes the impact of higher interest costs on the debt. Even if one were to take an optimistic view of a revenue boost from faster economic growth, there would still be a large increase in federal deficits and thus debt levels and this could be problematic for many Republicans. It seems inevitable that the tax plans will be watered down. An additional issue is the distributional impact of the proposed tax cuts. Eliminating the estate tax and proposed changes to marginal rates would disproportionally help the rich. Estimates show the lowest and second lowest quintile earners would receive a tax cut of less than 1% of income, compared to 6.5% for the top 1%. Given that the marginal propensity to consume is much higher for those with low incomes, this would dilute the economic impact. Moreover, there is again the issue of timing - the usual bargaining process means that tax changes will impact growth more in 2018 than 2017. Mr. X: You did not mention the plan to cut the corporate tax rate from 35% to 15%. Surely that will be very good for growth? BCA: According to the OECD, the U.S. has a marginal corporate tax rate of 38.9% (including state and local corporate taxes), making it by far the highest in the industrialized world. The median rate for 34 other OECD economies is 24.6%. However, the actual rate that U.S. companies pay after all the various deductions is not so high. According to national accounts data, the effective tax rate for domestic non-financial companies averaged 25% in the four quarters ended 2016 Q2. Data from the IRS show an average rate of around 21% for all corporations. And for those companies with significant overseas operations, the rate is lower. There certainly is a good case for lowering the marginal rate and simplifying the system by removing deductions and closing loopholes. But special interests always make such reforms a tough battle. Even so, there is widespread support to reduce corporate taxes so some moves are inevitable and this should be good for profits and, hopefully, capital spending. The bottom line is that you should not expect a major direct boost to growth in 2017 from changes in U.S. fiscal policy. The impact will be greater in 2018, perhaps adding between 0.5% and 1% to growth. However, don't forget that there could be an offset from any moves to erect trade barriers. Mr. X: What about fiscal developments in other countries? Chart 4Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare BCA: The Japanese government has boosted government spending again, but the IMF estimates that fiscal changes added only 0.3% to GDP in 2016, with an even smaller impact expected for 2017. And a renewed tightening is assumed to occur in 2018 as postponed efforts to reign in the deficit take hold. Of course, a sales tax hike could be delayed yet again if the economy continues to disappoint. But, with an overall budget deficit of 5% of GDP and gross government debt of more than 250% of GDP, Japan's room for additional stimulus is limited (Chart 4). Although the Bank of Japan owns around 40% of outstanding government debt, the authorities cannot openly admit that this will be written off. While more fiscal moves are possible in Japan, it is doubtful they would significantly alter the growth picture. The euro area peripheral countries have moved past the drastic fiscal austerity that was imposed on them a few years ago. Nevertheless, there is not much room for maneuver with regard to adopting an overtly reflationary stance. It is one thing to turn a blind eye to the fiscal constraints of the EU's Growth and Stability Pact and quite another to move aggressively in the opposite direction. Most of the region's economies have government debt-to-GDP ratios far above the 60% required under the Maastricht Treaty. In sum, a move to fiscal stimulus is not in the cards for the euro area. The U.K. is set to adopt more reflationary policies following the Brexit vote, but this would at most offset private sector retrenchment. In conclusion, looming shifts in fiscal policy will be positive for global growth in the next couple of years, but are unlikely to be game changers. Of course, fiscal policy is not the only thing that might change - especially in the U.S. There also are hopes that an easing in regulatory burdens will be very positive for growth. Mr. X: I am glad you raised that point. I have many business contacts in the U.S. who complain bitterly about regulatory overload and they are desperate for some relief. BCA: There certainly is a need for action on this front as regulatory burdens have increased dramatically in the U.S. in recent years. The monthly survey of small businesses carried out by the National Federation of Independent Business shows that rising health care costs, excessive regulation and income taxes are regarded as the top three problems. According to the Heritage Foundation, new regulations from the Obama administration have added more than $100 billion annually to costs for businesses and individuals since 2009. While the U.S. has a good score in the World Bank's Ease of Doing Business Index (8th best out of 190 countries), it is ranked 51st in the component that measures how easy it is to start a business, which puts it behind countries such as Jamaica, Mongolia and Albania. So we can hope that the new administration will act to improve that situation. We can be confident that there will be major reductions in regulations relating to energy and the environment. Other areas may be more challenging. It did not take long for Trump to back away from his pledge to repeal the Affordable Care Act (ACA) in its entirety. Returning to the previous status quo will not be politically acceptable and devising an alternative plan is no small task. The end result still will be a major modification of the ACA and this should ease health care costs for small businesses. With regard to the financial sector, it is no surprise that the pendulum swung massively toward increased regulation given the pre-crisis credit excesses. The economic and financial downturn of 2008-09 left a legacy of strong populist resentment of Wall Street and the banks, so a return to the previous laissez-faire model is not in the cards. At one stage, Trump indicated that he was in favor of replacing Dodd-Frank with a Glass-Steagall system, requiring commercial banks to divest themselves of their securities' businesses. The large banks would employ legions of lobbyists to prevent a new Glass-Steagall Act. The end result will be some watering down of the Dodd-Frank regulatory requirements, but again, a return to the pre-crisis status quo is not in the cards. The Retreat From Globalization Mr. X: You have challenged the consensus view that fiscal stimulus will deliver a meaningful boost to the global economy over the coming year. Having downplayed the main reason to be more positive about near-term growth, let's turn to global trade, the issue that causes most nervousness about the outlook. The Brexit vote in the U.K. was at least partly a vote against globalization and we are all familiar with Trump's threat to dramatically raise tariffs on imports from China and Mexico. What are the odds of an all-out trade war? BCA: At the risk of sounding complacent, we would give low odds to this. Again, there will be a large difference between campaign promises and actual outcomes. Let's start with China where the U.S. trade deficit ran at a $370 billion annual rate in the first nine months of 2016, up from around $230 billion a decade before (Chart 5). China now accounts for half of the total U.S. trade deficit compared to a 25% share a decade ago. On the face of it, the U.S. looks to have a good bargaining position, but the relationship is not one-sided. China has been a major financer of U.S. deficits and is the third largest importer of U.S. goods, after Canada and Mexico. Meanwhile, U.S. consumers have benefited enormously from the relative cheapness of imported Chinese goods. As for the threat to label China as a currency manipulator, it is interesting to note that its real effective exchange rate has increased by almost 20% since the mid-2000s, and since then, the country's current account surplus as a share of GDP has fallen from almost 10% to around 2.5% (Chart 6). The renminbi has fallen by around 10% against the dollar since mid-2015, but that has been due to the latter currency's broad-based rally, not Chinese manipulation. The fact that China's foreign-exchange reserves have declined in the past couple of years indicates that the country has intervened to hold its currency up, not push it down. Chart 5China-U.S. Trade: ##br##A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? Chart 6China Has Not Manipulated ##br##Its Currency Downward China Has Not Manipulated Its Currency Downward China Has Not Manipulated Its Currency Downward Of course, facts may not be the guiding factor when it comes to U.S. trade policy, and we can expect some tough talk from the U.S. This could well involve the imposition of some tariffs and perhaps some concessions from China in the form of increased imports from the U.S. Overall, we are hopeful that rational behavior will prevail and that an all-out trade war will not occur. Mr. X: I also would like to believe that, but nothing in the U.S. election process made me think that rationality is guaranteed. BCA: Of course it is not guaranteed, and we will have to monitor the situation carefully. We should also talk about Mexico - the other main target of Trump's attacks. The U.S. trade deficit with Mexico accounts for less than 10% of the total U.S. deficit and has changed little in the past decade. More than 80% of the U.S. trade deficit with Mexico is related to vehicles and Trump clearly will put pressure on U.S. companies to move production back over the border. Within a week of the election, Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. And Trump subsequently browbeat Carrier Corporation into cancelling some job transfers across the border. If other companies follow suit, it could forestall major changes to NAFTA. Ironically, the Mexican peso has plunged by 10% against the dollar since the election, boosting the competitiveness of Mexico and offsetting some of the impact of any tariff increase. Not all the news on global trade is bad. After seven years of negotiation, the EU and Canada agreed a free trade deal. This has bolstered the U.K.'s hopes that it can arrange new trade deals after it leaves the EU. However, this will not be easy given the sheer number of bi-country deals that will be required. The time it took to negotiate the EU-Canada deal should be a salutary warning given that there was no particular animosity toward Canada within the EU. That will not be the case when it comes to negotiations with the U.K. Mr. X: Let's try and pull all this together. You have downplayed the risk of an all-out trade war and I hope that you are right. But do you expect trade developments to be a drag on economic activity, perhaps offsetting any positive impact from fiscal stimulus? Chart 7Only Modest Growth In World Trade Only Modest Growth In World Trade Only Modest Growth In World Trade BCA: You might think that trade is a zero-sum game for the global economy because one country's exports simply are another's imports. But expanding trade does confer net benefits to growth in terms of allowing a more efficient use of resources and boosting related activities such as transportation and wholesaling. Thus, the rapid expansion in trade after the fall of the Berlin Wall was very good for the global economy. Trade ceased to be a net contributor to world growth several years ago, highlighted by the fact that global export volumes have been growing at a slower pace than GDP (Chart 7). This has not been due to trade barriers but is more a reflection of China's shift away from less import-intensive growth. A return to import-intensive growth in China is not likely, and technological innovations such as 3-D printing could further undermine trade. If we also add the chances of some increase in protectionist barriers then it is reasonable to assume that trends in global trade are more likely to hinder growth than boost it over the coming couple of years. It really is too soon to make hard and fast predictions about this topic as we need to see exactly what actions the new U.S. administration will take. Nevertheless, we lean toward the optimistic side, and assume the economic impact of fiscal reflation will exceed any drag from trade restrictions. Again, this is a more of a story for 2018 than 2017. What we can say with some confidence is that the previous laissez-faire approach to globalization is no longer politically acceptable. Policymakers are being forced to respond to voter perceptions that the costs of free trade outweigh the benefits and that points to a more interventionist approach. This can take the form of overt protectionism or attempts to influence corporate behavior along the lines of president-elect Trump's exhortations to U.S. companies. Mr. X: What about the issue of immigration? Both the Brexit vote and the U.S. election result partly reflected voter rebellion against unrestrained immigration. And we know that nationalist sentiments also are rising in a number of other European countries. How big a problem is this? Chart 8Immigration's Rising Contribution ##br##To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth BCA: In normal circumstances, immigration represents a win-win situation for all parties. The vast majority of immigrants are prepared to work hard to improve their economic position and in many cases take jobs that residents are not willing to accept. This all works well in a fast-growing economy, but difficulties arise when growth is weak: competition for jobs increases, especially among the unskilled, and the result is downward pressure on wages. The irony is that the U.S. and U.K. labor markets have tightened to the point where wage growth is accelerating. However, this all happened too late to affect the opinions of those who voted for tighter controls over immigration. There is an even more important issue from a big-picture perspective. As you know, an economy's potential growth rate comes from two sources: the growth in the labor force and productivity. According to the Census Bureau, U.S. population growth will average 0.8% a year over the next decade, slowing to 0.6% a year over the subsequent ten years. But more than half of this growth is assumed to come from net migration. Excluding net migration, population growth is predicted to slow to a mere 0.1% a year by the end of the 2030s (Chart 8). Thus, major curbs on immigration would directly lower potential GDP by a significant amount. In Europe, the demographic situation is even more precarious because birth rates are far below replacement levels. Europe desperately needs immigration to achieve even modest population increases. However, the migrant crisis is causing a backlash against cross-border population flows, again with negative implications for long-run economic growth. Even ignoring humanitarian considerations, major curbs on immigration would not be a good idea. Labor shortages would quickly become apparent in a number of industries. Some may welcome the resulting rise in wages, but the resulting pressure on inflation also would have adverse effects. So this is another area of policy that we will have to keep a close eye on. Chart 9A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture Inflation And Interest Rates Mr. X: I am glad that you mentioned inflation. There are good reasons to think that an important inflection point in inflation has been reached. And bond investors seem to agree, judging by the recent spike in yields. If true, this would indeed represent a significant regime shift because falling inflation and bond yields have been such a dominant trend for several decades. Do you agree that the era of disinflation is over, along with the secular bull market in bonds? BCA: Inflation and bond yields in the U.S. have passed a cyclical turning point, but this does not mean that a sustained major uptrend is imminent. Let's start with inflation. A good portion of the rise in the underlying U.S. inflation rate has been due to a rise in housing rental costs, and, more recently, a spike in medical care costs. Neither of these trends should last: changes to the ACA should arrest the rising cost of medical care while increased housing construction will cap the rise in rent inflation. The rental vacancy rate looks to be stabilizing while rent inflation is rolling over. Meanwhile, the inflation rate for core goods has held at a low level and likely will be pushed lower as a result of the dollar's ascent (Chart 9). Of course, this all assumes that we do not end up with sharply higher import tariffs and a trade war. The main reason to expect a further near-term rise in underlying U.S. inflation is the tightening labor market and resulting firming in wage growth. With the economy likely to grow above a 2% pace in 2017, the labor market should continue to tighten, pushing wage inflation higher. So the core PCE inflation rate has a good chance of hitting the Federal Reserve's 2% target before the year is out. And bond investors have responded accordingly, with one-year inflation expectations moving to their highest level since mid-2014, when oil prices were above $110 a barrel (Chart 10). Long-run inflation expectations also have spiked since the U.S. election, perhaps reflecting the risk of higher import tariffs and the risks of political interference with the Fed. When it comes to other developed economies, with the exception of the U.K., there is less reason to expect underlying inflation to accelerate much over the next year. Sluggish growth in the euro area and Japan will continue to keep a lid on corporate pricing power and the markets seem to agree, judging by the still-modest level of one-year and long-run inflation expectations (Chart 11). The U.K. will see some pickup in inflation in response to the sharp drop in sterling and this shows up in a marked rise in market expectations. Chart 10U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked Chart 11Inflation Expectations In Europe And Japan Inflation Expectations In Europe and Japan Inflation Expectations In Europe and Japan Turning back to the U.S., a key question regarding the longer-term inflation outlook is whether the supply side of the economy improves. If the new administration succeeds in boosting demand but there is no corresponding expansion in the supply capacity of the economy, then the result will be higher inflation. That will lead to continued monetary tightening and, as in past cycles, an eventual recession. But, if businesses respond to a demand boost with a marked increase in capital spending then the result hopefully would be faster productivity growth and a much more muted inflation response. Thus, it will be critical to monitor trends in business confidence and capital spending for signs that animal spirits are returning. Mr. X: So you don't think the Fed will be tempted to run a "hot" economy with inflation above the 2% target? BCA: That might have been a possibility if there was no prospect of fiscal stimulus, leaving all the economic risks on the downside. With easier fiscal policy on the horizon, the Fed can stick to a more orthodox policy approach. In other words, if the economy strengthens to the point where inflation appears to be headed sustainably above 2%, then the Fed will respond by raising rates. Unlike the situation a year ago, we do not have a strong disagreement with the Fed's rate hike expectations for the next couple of years. Nothing would please the Fed more than to return to a familiar world where the economy is behaving in a normal cyclical fashion, allowing a move away from unusually low interest rates. At the same time, the Fed believes, as we do, that the equilibrium real interest rate is far below historical levels and may be close to zero. Thus, interest rates may not need to rise that much to cool down the economy and ease inflationary pressures. This is especially true if the dollar continued to rise along with Fed tightening. Another potentially important issue is that the composition of the Federal Reserve Board could change dramatically in the next few years. There currently are two unfilled seats on the Board and it is very likely that both Janet Yellen and Stanley Fischer will leave in 2018 when their respective terms as Chair and Vice-Chair end (February 3 for Yellen and June 12 for Fischer). That means the incoming administration will be able to appoint four new Board members, and possibly more if other incumbents step down. Judging by the views of Trump's current economic advisers, he seems likely to choose people with a conservative approach to monetary policy. In sum, we do not rule out a rise in U.S. inflation to as much as 3%, but it would be a very short-lived blip. Steady Fed tightening would cap the rise, even at the cost of a renewed recession. Indeed, a recession would be quite likely because central banks typically overshoot on the side of restraint when trying to counter a late-cycle rise in inflation. Mr. X: I am more bearish than you on the inflation outlook. Central banks have been running what I regard as irresponsible policies for the past few years and we now also face some irresponsible fiscal policies in the U.S. That looks like a horrendously inflationary mix to me although I suppose inflation pressures would ease in the next recession. We can return to that possibility later when we discuss the economy in more detail. Where do you see U.S. short rates peaking in the current cycle and what does this mean for your view on long-term interest rates? To repeat my earlier question: is the secular bond bull market over? BCA: During the past 30 years, the fed funds rate tended to peak close to the level of nominal GDP growth (Chart 12). That would imply a fed funds rate of over 5% in the current cycle, assuming peak real GDP growth of around 3% and 2-3% inflation. However, that ignores the fact that debt burdens are higher than in the past and structural headwinds to growth are greater. Thus, the peak funds rate is likely to be well below 5%, perhaps not much above 3%. Chart 12The Fed Funds Rate And The Economic Cycle The Fed Funds Rate and the Economic Cycle The Fed Funds Rate and the Economic Cycle With regard to your question about the secular bull market in bonds, we believe it has ended, but the bottoming process likely will be protracted. We obviously are in the midst of a cyclical uptrend in U.S. yields that could last a couple of years. The combination of a modestly stronger economy, easier fiscal stance and monetary tightening are all consistent with rising bond yields. Although yields moved a lot in the second half of 2016, the level is still not especially high, so there is further upside. It would not be a surprise to see the 10-year Treasury yield reach 3% by this time next year. However, there could be a last-gasp renewed decline in yields at some point in the next few years. If the U.S. economy heads back into recession with the fed funds rate peaking at say 3.5%, then it is quite possible that long-term bond yields would revisit their 2016 lows - around 1.4% on the 10-year Treasury. There are no signs of recession at the moment, but a lot can change in the next three years. In any event, you should not be overly concerned with the secular outlook at this point. The cyclical outlook for yields is bearish and there should be plenty of advance notice if it is appropriate to switch direction. Update On The Debt Supercycle Mr. X: I would like to return to the issue of the Debt Supercycle - one of my favorite topics. You know that I have long regarded excessive debt levels as the biggest threat to economic and financial stability and nothing has occurred to ease my concerns. In the past, you noted that financial repression - keeping interest rates at very low levels - would be the policy response if faster economic growth could not achieve a reduction in debt burdens. But the recent rise in bond yields warns that governments cannot always control interest rate moves. Few people seem to worry anymore about high debt levels and I find that to be another reason for concern. BCA: You are correct that there has been very little progress in reducing debt burdens around the world. As we have noted in the past, it is extremely difficult for governments and the private sector to lower debt when economic activity and thus incomes are growing slowly. Debt-to-GDP ratios are at or close to all-time highs in virtually every region, even though debt growth itself has slowed (Chart 13A, Chart 13B). Chart 13ADebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High Chart 13BDebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High As a reminder, our End-of-Debt Supercycle thesis never meant that debt-to-GDP ratios would quickly decline. It reflected our belief that lenders and private sector borrowers had ended their love affair with debt and that we could no longer assume that strong credit growth would be a force boosting economic activity. And our view has not altered, even though government borrowing may show some acceleration. Chart 14The Credit Channel Is Impaired The Credit Channel Is Impaired The Credit Channel Is Impaired The failure of exceptionally low interest rates to trigger a vigorous rebound in private sector credit demand is consistent with our view. In the post-Debt Supercycle world, monetary policy has lost effectiveness because the credit channel - the key pillar of the monetary transmission process - is blocked. The drop in money multipliers and in the velocity of circulation is a stark reminder of the weakened money-credit-growth linkage (Chart 14). You always want to know what the end-point of higher debt levels will be, and we always give you a hedged answer. Nothing has changed on that front! A period of higher inflation may help bring down debt ratios for a while, but not to levels that would ease your concerns. This means that financial repression will be the fallback plan should markets rebel against debt levels. For the moment, there is still no problem because interest rates are still low and this is keeping debt-servicing costs at very low levels. If interest rates are rising simply because economic activity is strengthening, then that is not a serious concern. The danger time would be if rates were to rise while growth and inflation were weak. At that point, central banks would move aggressively to reduce market pressures with massive asset purchases. The ultimate end-point for dealing with excessive debt probably will be significantly higher inflation. But that is some time away. Central banks would not likely embrace a major sustained rise in inflation before we first suffered another serious deflationary downturn. At that point, attitudes toward inflation could change dramatically and a new generation of central bankers would probably be in charge with a very different view of the relative economic risks of inflation and deflation. However, it is premature to worry about a major sustained inflation rise if we must first go through a deflationary downturn. Mr. X: Perhaps you are right, but I won't stop worrying about debt. The buildup in debt was decades in the making and I am convinced that the consequences will extend beyond a few years of subdued economic growth. And central bank efforts to dampen the economic symptoms with unusually low interest rates have just created another set of problems in the form of distorted asset prices and an associated misallocation of capital. BCA: We agree that there may be a very unhappy ending to the debt excesses, but timing is everything. It has been wrong to bet against central banks during the past seven years and that will continue to be the case for a while longer. We will do our best to give you plenty of warning when we see signs that things are changing for the worse. Mr. X: I will hold you to that. Meanwhile, you talked earlier about the possibility of another recession in the U.S. Let's use that as a starting point to talk about the economic outlook in more detail. It seems strange to talk about the possibility of a recession in the U.S. when interest rates are still so low and we are about to get more fiscal stimulus. The Economic Outlook BCA: We do not expect a recession in the next year or two, absent some new major negative shock. But by the time we get to 2019, the recovery will be ten years old and normal late-cycle pressures should be increasingly apparent. The labor market already is quite tight, with wages growing at their fastest pace in eight years, according to the Atlanta Fed's wage tracker (Chart 15). Historically, most recessions were triggered by tight monetary policy with a flat or inverted yield curve being a reliable indicator (Chart 16). Obviously, that is extremely hard to achieve when short-term rates are at extremely low levels. However, if the Fed raises the funds rate to around 3% by the end of 2019, as it currently predicts, then it will be quite possible to again have a flat or inverted curve during that year. Chart 15U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend Chart 16No Sign Of A U.S. Recession No Sign Of A U.S. Recession No Sign Of A U.S. Recession The recent environment of modest growth has kept inflation low and forced the Fed to maintain a highly accommodative stance. As spare capacity is absorbed, the Fed will be forced to tighten, raising the odds of a policy overshoot. And this is all without taking account of the potential threat of a trade war. Mr. X: I have never believed that the business cycle has been abolished so it would not surprise me at all to have a U.S. recession in the next few years, but the timing is critical to getting the markets right. What will determine the timing of the next economic downturn? BCA: As we mentioned earlier, the key to stretching out the cycle will be improving the supply side of the economy, thereby suppressing the cyclical pressures on inflation. That means getting productivity growth up which, in turn will depend on a combination of increased capital spending, global competition and technological innovations. Chart 17Companies Still ##br##Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Thus far, there is no indication that U.S. companies are increasing their investment plans: the trend in capital goods orders remains very lackluster (Chart 17). Nonetheless, we have yet to see post-election data. The optimistic view is that the prospect of lower corporate taxes, reduced regulation and a repatriation of overseas earnings will all combine to revive the corporate sector's animal spirits and thus their willingness to invest. Only time will tell. The key point is that it is too soon for you to worry about a recession in the U.S. and for the next year or two, there is a good chance that near-term economic forecasts will be revised up rather than down. That will mark an important reversal of the experience of the past seven years when the economy persistently fell short of expectations. Mr. X: It would be indeed be a welcome change to have some positive rather than negative surprises on the economic front, but I remain somewhat skeptical. I suppose I can see some reasons to be more optimistic about the U.S., but the picture in most other countries seems as bleak as ever. The outlook for the U.K. has worsened following the Brexit vote, the euro area and Japan cannot seem to break out of a low-growth trap and China continues to skirt the edge of a precipice. BCA: The global economy still has lots of problems, and we are a long way from boom-like conditions. The IMF predicts that 2017 growth in the euro area and China will be below the 2016 level, and forecasts for the U.K. have been revised down sharply since the Brexit vote. On a more positive note, the firming in commodity prices should help some previously hard-hit emerging economies. Overall global growth may not pick up much over the coming year, but it would be a significant change for the better if we finally stop the cycle of endless forecast downgrades. Mr. X: Let's talk a bit more about the U.K. I know that it is too early to make strong predictions about the implications of Brexit, but where do you stand in terms of how damaging it will be? I am not convinced it will be that bad because I sympathize with the view that EU bureaucracy is a big drag on growth, and exiting the EU may force the U.K. government to pursue supply-side policies that ultimately will be very good for growth. BCA: The Brexit vote does not spell disaster for the U.K., but adds to downside risks at a time when the global economy is far from buoyant. The EU is not likely to cut a sweet deal for the U.K. To prevent copycat departures, the EU will demonstrate that exit comes with a clear cost. Perhaps, the U.K. can renegotiate new trade deals that do not leave it significantly worse off. But this will take time and, in the interlude, many businesses will put their plans on hold until new arrangements are made. Meanwhile, the financial sector - a big engine of growth in the past - could be adversely affected by a move of business away from London. Chart 18The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem Of course, the government will not simply stand on the sidelines, and it has already announced increased infrastructure spending that will fill some of the hole created by weaker business capital spending. And the post-vote drop in sterling has provided a boost to U.K. competitiveness. Nevertheless, it seems inevitable that there will be a hit to growth over the next couple of years. The optimistic view is that the U.K. will use the opportunity of its EU departure to launch a raft of supply-side reforms and tax cuts with the aim of creating a much more dynamic economy that will be very attractive to overseas investors. Some have made the comparison with Singapore. This seems a bit of a stretch. In contrast to the pre-vote rhetoric, EU membership did not turn the U.K. into a highly-regulated economy. For example, the U.K. already is in 7th place out of 190 countries in the World Bank's Ease Doing Business Index and one of the least regulated developed economies according to the OECD. Thus, the scope to boost growth by sweeping away regulations probably is limited. At the same time, the U.K.'s ability to engage in major fiscal stimulus via tax cuts or increased spending is limited by the country's large balance-of-payments deficit and the poor state of its government finances (Chart 18). Overall, the U.K. should be able to avoid a major downturn in the next couple of years, but we don't disagree with the OECD's latest forecasts that growth will slow to round 1% in 2017 and 2018 after 2% in 2016. And that implies the risks of one or two quarters of negative growth within that period. Mr. X: I am not a fan of the EU so am inclined to think that the U.K. will do better than the consensus believes. But, I am less confident about the rest of Europe. Euro area banks are in a mess, weighed down by inadequate capital, a poor return on assets, an overhang of bad loans in Italy and elsewhere, and little prospect of much revival in credit demand. At the same time, the political situation looks fragile with voters just as disenchanted with the establishment status quo as were the ones in the U.K. and U.S. Against this background, I can't see why any companies would want to increase their capital spending in the region. Chart 19Euro Area Optimism Improves Euro Area Optimism Improves Euro Area Optimism Improves BCA: We agree that euro area growth is unlikely to accelerate much from here. The structural problems of poor demographics, a weak banking system and constrained fiscal policy represent major headwinds for growth. And the political uncertainties related to elections in a number of countries in the coming year give consumers and companies good reason to stay cautious. Yet, we should note that the latest data show a modest improvement in the business climate index, breaking slightly above the past year's trading range (Chart 19). There are some positive developments to consider. The nomination of François Fillon as the conservative candidate in France's Presidential election to be held on April 2017 is very significant. We expect him to beat Marine Le Pen and this means France will have a leader who believes in free markets and deregulation - a marked change from previous statist policies. This truly could represent a major regime shift for that country. Meanwhile, the ECB has confirmed that it will continue its QE program through 2017, albeit at a slightly reduced pace. This has costs in terms of market distortions, but will help put a floor under growth. Mr. X: You noted the fragile state of the region's banks. How do you see that playing out? BCA: Euro area banks have more than €1 trillion of non-performing loans (NPLs) and have provisioned for only about half of that amount. Nevertheless, most countries' banking sectors have enough equity capital to adequately absorb losses from these un-provisioned NPLs. On the other hand, the high level of NPLs is a protracted drag on profitability and thereby increases the banks' cost of capital. The shortage of capital constrains new lending. The biggest concern is Italy, which we estimate needs to recapitalize its banks by close to €100 billion. Complicating matters is that the EU rules on state aid for banks changed at the start of 2016. Now, a government bailout can happen only after a first-loss 'bail-in' of the bank's equity and bond holders. So if an undercapitalized bank cannot raise the necessary funds privately in the markets, there is a danger that its investors could suffer heavy losses before the government is allowed to step in. But once investors have been bailed-in, the authorities will do "whatever it takes" to prevent banking problems turning into a systemic crisis that threaten to push the economy into another recession. Mr. X: I would now like to shift our attention to Asia, most notably Japan and China. Starting with Japan, that economy seems to perfectly describe the world of secular stagnation. Despite two decades of short-term interest rates near zero and major fiscal stimulus, real growth has struggled to get above 1% and deflation rather than inflation has been the norm. Prime Minister Shinzo Abe has made a big deal about his "three arrow" approach to getting the economy going again, but I don't see much evidence that it is working. Is there any prospect of breaking out of secular stagnation? BCA: Probably not. A big part of Japan's problem is demographics - an unfortunate combination of a declining labor force and a rapidly aging population. While this means that per capita GDP growth looks a lot better than the headline figures, it is not a growth-friendly situation. Twenty years ago there were 4.6 people of working age for everyone above 64. This has since dropped to 2.2 and within another 20 years it will be down to 1.6. That falling ratio of taxpayers to pensioners and major consumers of health care is horrendous for government finances. And an aging population typically is not a dynamic one which shows up in Japan's poor productivity performance relative to that of the U.S. (Chart 20). Of course, Japan can "solve" its public finances problem by having the Bank of Japan cancel its large holdings of JGBs. Yet that does nothing to deal with the underlying demographics issue and ongoing large budget deficits. Japan desperately needs a combination of increased immigration and major supply-side reforms, but we do not hold out much prospect of either changing by enough to dramatically alter the long-run growth picture. Mr. X: I will not disagree with you as I have not been positive about Japan for a long time. We should now turn to China. It is very suspicious that the economy continues to hum along at a 6% to 7% pace, despite all the excesses and imbalances that have developed. I really don't trust the data. We talked about China at our mid-2016 meeting and, if I remember correctly, you described China as like a tightrope walker, wobbling from time to time, but never quite falling off. Yet it would only take a gust of wind for that to change. I liked that description so my question is: are wind gusts likely to strengthen over the coming year? BCA: You are right to be suspicious of the official Chinese data, but it seems that the economy is expanding by at least a 5% pace. However, it continues to be propped up by unhealthy and unsustainable growth in credit. The increase in China's debt-to-GDP ratio over the past few years dwarves that during the ultimately disastrous credit booms of Japan in the 1980s and the U.S. in the 2000s (Chart 21). The debt increase has been matched by an even larger rise in assets, but the problem is that asset values can drop, while the value of the debt does not. Chart 20Japan's Structural Headwinds Japan's Structural Headwinds Japan's Structural Headwinds Chart 21China's Remarkable Credit Boom January 2017 - Shifting Regimes January 2017 - Shifting Regimes The government would like to rein in credit growth, but it fears the potential for a major economic slowdown, so it is trapped. The fact that the banking system is largely under state control does provide some comfort because it will be easy for the government to recapitalize the banks should problems occur. This means that a U.S.-style credit freeze is unlikely to develop. Of course, the dark side of that is that credit excesses never really get unwound. You asked whether wind gusts will increase, threating to blow the economy off its tightrope. One potential gust that we already talked about is the potential for trade fights with the new U.S. administration. As we mentioned earlier, we are hopeful that nothing serious will occur, but all we can do is carefully monitor the situation. Trends in China's real estate sector represent a good bellwether for the overall economic situation. The massive reflation of 2008-09 unleashed a powerful real estate boom, accompanied by major speculative excesses. The authorities eventually leaned against this with a tightening in lending standards and the sector cooled off. Policy then eased again in 2015/16 as worries about an excessive economic slowdown developed, unleashing yet another real estate revival. The stop-go environment has continued with policy now throttling back to try and cool things off again. It is not a sensible way to run an economy and we need to keep a close watch on the real estate sector as a leading indicator of any renewed policy shifts. Over time, the Chinese economy should gradually become less dependent on construction and other credit-intensive activities. However, in the near-term, there is no escaping the fact that the economy will remain unbalanced, creating challenges for policymakers and a fragile environment for the country's currency and asset markets. Fortunately, the authorities have enough room to maneuver that a hard landing remains unlikely over the next year or two. There are fewer grounds for optimism about the long-run unless the government can move away from its stop-go policy and pursue more supply-side reforms. Mr. X: What about other emerging economies? Are there any developments particularly worth noting? BCA: Emerging economies in general will not return to the rapid growth conditions of the first half of the 2000s. Slower growth in China has dampened export opportunities for other EM countries and global capital will no longer pour into these economies in its previous, indiscriminate way. Nevertheless, the growth outlook is stabilizing and 2017 should be a modestly better year than 2016 for most countries. Chart 22India Has A Long Way To Go India Has A Long Way To Go India Has A Long Way To Go The rebound in oil and other commodity prices has clearly been positive for Russia, Brazil and other resource-dependent countries. Commodity prices will struggle to rise further from current elevated levels but average 2017 prices should exceed those of 2016. On the negative side, a firm dollar and trade uncertainty will represent a headwind for capital flows to the EM universe. The bottom line is that the growth deceleration in emerging economies has run its course but a major new boom is not in prospect. The Indian economy grew by around 7½% in 2016, making it, by far, the star EM performer. Growth will take a hit from the government's recent decision to withdraw high-denomination bank notes from circulation - a move designed to combat corruption. Fortunately, the impact should be relatively short-lived and growth should return to the 7% area during the coming year. Still, India has a long way to go to catch up with China. In 1990, India's economy was almost 90% as big as China's in PPP terms, but 20 years later, it was only 40% as large. Even though India is expected to keep growing faster than China, its relative size will only climb to 45% within the next five years, according to the IMF (Chart 22). Mr. X: Let me try and summarize your economic views before we move on to talk about the markets. The growth benefit from fiscal stimulus in the U.S. is more a story for 2018 than 2017. Nevertheless, a modest improvement in global growth is likely over the coming year, following several years of economic disappointments. The key risks relate to increased trade protectionism and increased inflation in the U.S. if the rise in demand is not matched by an increase in the economy's supply-side capacity. In that event, tighter monetary policy could trigger a recession in 2019. You do not expect any major changes in the underlying economic picture for Europe, Japan or China, although political shifts in Europe represent another downside risk. BCA: That captures our views quite well. Going back to our broad theme of regime shifts, it is important to re-emphasize that shifting attitudes toward fiscal policy and trade in the U.S. raise a red flag over the longer-term inflation outlook. And this of course feeds into the outlook for interest rates. Bond Market Prospects Mr. X: That is the perfect segue for us to shift the discussion to the investment outlook, starting with bonds. You already noted that you believe the secular bull market in bonds has ended, albeit with a drawn-out bottoming process. Given my concerns about the long-run inflation outlook, I am happy to agree with that view. Yet, yields have risen a lot recently and I am wondering if this represents a short-term buying opportunity. BCA: The late-2016 sell-off in bonds was violent and yields rose too far, too fast. So we recently shifted our tactical bond recommendation from underweight (short duration) to neutral. But obviously that is not the same as telling you to buy. The underlying story for bonds - especially in the U.S. - is bearish. The prospect of fiscal stimulus, rising short rates and a pickup in inflation suggests that U.S. yields will be higher over the next 12 months. Although yields may decline somewhat in the very near-term, we doubt the move will be significant enough or last long enough to warrant an overweight position. The outlook is not quite so bad in the euro zone given the ECB's ongoing bond purchases and a continued benign inflation outlook. But, even there, the market will remain highly correlated with trends in U.S. Treasurys so yields are more likely to rise than fall over the coming year. The story is different in Japan given the central bank's new policy of pegging the 10-year yield at zero. That will be a static market for some time. Although global yields may have bottomed from a secular perspective, the upturn will be gradual in the years ahead. A post-Debt Supercycle environment implies that private sector credit growth will remain subdued, and during 2018, the market may start to attach growing odds of a U.S. recession within a year or two. A more powerful bear trend in bonds awaits the more significant upturn in inflation that likely will follow the next economic downturn. Chart 23Treasurys Are High Yielders Treasurys Are High Yielders Treasurys Are High Yielders Mr. X: I am somewhat surprised at how much the spread between U.S. and euro area bonds has widened - it is now at the highest level since the late 1980s. Obviously, a positive spread makes sense given the relative stance of monetary policy and economic outlook. Yet, it is quite amazing how investors have benefited from both higher yields in the U.S. and a stronger dollar. If the dollar stays firm in 2017, will the spread remain at current high levels? BCA: Most of the increased spread during the past year can be attributed to a widening gap in inflation expectations, although the spread in real yields also spiked after the U.S. election, reflecting the prospects for fiscal stimulus (Chart 23). While the spread is indeed at historical highs, the backdrop of a massive divergence in relative monetary and fiscal policies is not going to change any time soon. We are not expecting the spread to narrow over the next year. You might think that Japanese bonds would be a good place to hide from a global bond bear market given BoJ's policy to cap the 10-year yield at zero percent. Indeed, JGBs with a maturity of 10-years or less are likely to outperform Treasurys and bunds in local currency terms over the coming year. However, this means locking in a negative yield unless you are willing to move to the ultra-long end of the curve, where there is no BoJ support. Moreover, there is more upside for bond prices in the U.S. and Eurozone in the event of a counter-trend global bond rally, simply because there is not much room for JGB yields to decline. Mr. X: O.K., I get the message loud and clear - government bonds will remain an unattractive investment. As I need to own some bonds, should I focus on spread product? I know that value looks poor, but that was the case at the beginning of 2016 and, as you showed earlier, returns ended up being surprisingly good. Will corporate bonds remain a good investment in 2017, despite the value problem? BCA: This a tricky question to answer. On the one hand, you are right that value is not great. Corporate spreads are low in the U.S. at a time when balance sheet fundamentals have deteriorated, according to our Corporate Health Monitor (Chart 24). After adjusting the U.S. high-yield index for expected defaults, option-adjusted spreads are about 165 basis points. In the past, excess returns (i.e. returns relative to Treasurys) typically were barely positive when spreads were at this level. Valuation is also less than compelling for U.S. investment-grade bonds. One risk is that a significant amount of corporate bonds are held by "weak hands," such as retail investors who are not accustomed to seeing losses in their fixed-income portfolios. At some point, this could trigger some panic selling into illiquid markets, resulting in a sharp yield spike. On a more positive note, the search for yield that propped up the market in 2016 could remain a powerful force in 2017. The pressure to stretch for yield was intense in part because the supply of government bonds in the major markets available to the private sector shrank by around $547 billion in 2016 because so much was purchased by central banks and foreign official institutions (Chart 25). The stock will likely contract by another $754 billion in 2017, forcing investors to continue shifting into riskier assets such as corporate bonds. Chart 24U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated Chart 25Government Bonds In Short Supply Government Bonds In Short Supply Government Bonds In Short Supply Weighing the poor valuation and deteriorating credit quality trend against the ongoing pressure to search for yield, we recommend no more than a benchmark weighting in U.S. corporate investment-grade bonds and a modestly underweight position in high-yield. There are better relative opportunities in euro area corporates, where credit quality is improving and the ECB's asset purchase program is providing a nice tailwind. We are slightly overweight in both investment-grade and high-yield euro area corporates. Finally, we should mention emerging market bonds, although we do not have much good to say. The prospect of further declines in EM currencies versus the dollar is a major problem for these securities. There is a big risk that global dollar funding will dry up as the dollar moves higher along with U.S. bond yields, creating problems for EM economies running current account and fiscal deficits. You should stay clear of EM bonds. Mr. X: None of this is helping me much with my bond investments. Can you point to anything that will give me positive returns? Chart 26Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low BCA: Not in the fixed-income market. Your concerns about inflation might lead you to think that inflation-indexed bonds are a good place to be, but prices in that market have already adjusted. Moreover, the case for expecting higher inflation rests a lot on the assumption that economic growth is going to strengthen and that should imply a rise in real yields, which obviously is bad for inflation-indexed bonds. Real yields currently are still very low by historical standards (Chart 26). A world of stagflation - weak real growth and rising inflation - would be a good environment for these securities, but such conditions are not likely in the next couple of years. Mr. X: After what you have told me, I suppose I will concentrate my fixed-income holdings in short-term Treasurys. But I do worry more than you about stagflation so will hold on to my inflation-indexed bonds. At the same time, I do understand that bonds will represent a hedge against downside risks rather than providing positive returns. So let's talk about the stock market as a more attractive place to invest. Equity Market Outlook Mr. X: I like to invest in equities when the market offers good value, there is too much pessimism about earnings and investor sentiment is gloomy. That is not the picture at the moment in the case of the U.S. market. I must confess that the recent rally has taken me by surprise, but it looks to me like a major overshoot. As we discussed earlier, the new U.S. administration's fiscal platform should be good for 2018 economic growth but the U.S. equity market is not cheap and it seems to me that there is more euphoria than caution about the outlook. So I fear that the big surprise will be that the market does much worse than generally expected. BCA: Obviously, the current market environment is nothing like the situation that exists after a big sell-off. You are correct that valuations are not very appealing and there is too much optimism about the outlook for earnings and thus future returns. Analysts' expectations of long-run earnings growth for the S&P 500 universe have risen to 12%, which is at the high end of its range over the past decade (Chart 27). And, as you suggested, surveys show an elevated level of optimism on the part of investors and traders. The outlook for earnings is the most critical issue when it comes to the long-run outlook for stocks. Low interest rates provide an important base of support, but as we noted earlier, rates are more likely to rise than fall over the next couple of years, possibly reaching a level that precipitates a recession in 2019. Investors are excited about the prospect that U.S. earnings will benefit from both faster economic growth and a drop in corporate tax rates. We don't disagree that those trends would be positive, but there is another important issue to consider. One of the defining characteristics of the past several years has been the extraordinary performance of profit margins which have averaged record levels, despite the weak economic recovery (Chart 28). The roots of this rise lay in the fact that businesses rather than employees were able to capture most of the benefits of rising productivity. This showed up in the growing gap between real employee compensation and productivity. As a result, the owners of capital benefited, while the labor share of income - previously a very mean-reverting series - dropped to extremely low levels. The causes of this divergence are complex but include the impact of globalization, technology and a more competitive labor market. Chart 27Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Chart 28Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? With the U.S. unemployment back close to full-employment levels, the tide is now turning in favor of labor. The labor share of income is rising and this trend likely will continue as the economy strengthens. And any moves by the incoming administration to erect barriers to trade and/or immigration would underpin the trend. The implication is that profit margins are more likely to compress than expand in the coming years, suggesting that analysts are far too optimistic about earnings. Long-term growth will be closer to 5% than 12%. The turnaround in the corporate income shares going to labor versus capital represents another important element of our theme of regime changes. None of this means that the stock market faces an imminent plunge. Poor value and over-optimism about earnings raises a red flag over long-term return prospects, but says little about near-term moves. As we all know, market overshoots can move to much greater extremes and last for much longer than one can rationally predict. And the fact remains that the conditions for an overshoot could well persist for another 12 months or even longer. Optimism about the economic benefits of the new administration's policies should last for a while as proposals for tax cuts and increased fiscal spending get debated. Meanwhile, although the Fed plans to raise rates again over the next year, the level of interest rates will remain low by historical standards, sustaining the incentive to put money into stocks rather than interest-bearing assets. Mr. X: So are you telling me to buy U.S. stocks right now? BCA: No we are not. The stock market is vulnerable to a near-term setback following recent strong gains, so this is not a great time to increase exposure. However, we do expect prices to be higher in a year's time, so you could use setbacks as a buying opportunity. Of course, this is with the caveat that long-run returns are likely to be poor from current levels and we have the worry about a bear market some time in 2018 if recession risks are building. Playing market overshoots can be very profitable, but it is critical to remember that the fundamental foundations are weak and you need to be highly sensitive to signs that conditions are deteriorating. Mr. X: I am very well aware of the opportunities and risks of playing market overshoots. I completely underestimated the extent of the tech-driven overshoot in the second half of the 1990s and remained on the sidelines while the NASDAQ soared by 130% between end-1998 and March 2000. But my caution was validated when the market subsequently collapsed and it was not until 2006 that the market finally broke above its end-1998 level. I accept that the U.S. market is not in a crazy 1990s-style bubble, but I am inclined to focus on markets where the fundamentals are more supportive. BCA: The U.S. market is only modestly overvalued, based on an average of different measures. It is expensive based on both trailing and forward earnings and relative to book value, but cheap compared to interest rates and bond yields. A composite valuation index based on five components suggests that the S&P 500 currently is only modestly above its 60-year average (Chart 29). Valuation is not an impediment to further significant gains in U.S. equities over the coming year although it is more attractive in other markets. Chart 29The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive If we use the cyclically-adjusted price-earnings ratio for non-financial stocks as our metric, then Japan and a number of European markets are trading at valuations below their historical averages (Chart 30). The picture for Japan is muddied by the fact that the historical average is biased upwards by the extreme valuations that existed during the bubble years and in the aftermath when earnings were exceptionally weak. Nonetheless, even on a price-to-book basis, Japan is trading far below non-bubble historical averages (Chart 31). Chart 30Valuation Ranking Of Developed Equity Markets January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 31Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market With regard to Europe, the good value is found in the euro area periphery, rather than in the core countries of Germany, France and the Netherlands. In fact, these core countries are trading more expensively than the U.S., relative to their own history. As you know, valuation is not the only consideration when it comes to investing. Nonetheless, the direction of monetary policy also would support a better outlook for Japan and the euro area given that the Fed is raising rates while the ECB and BoJ are still implementing QE policies. Exchange rate moves complicate things a bit because further gains in the dollar would neutralize some of the relative outperformance when expressed in common currency. Even so, we would expect the euro area and Japan to outperform the U.S. over the next 12 months. The one important qualification is that we assume no new major political shocks come from Europe. A resurgence of political uncertainty in the euro area would poses the greatest threat to the peripheral countries, which partly explains why they are trading at more attractive valuations than the core. Mr. X: There seem to be political risks everywhere these days. It is a very long time since I could buy stocks when they offered great value and I felt very confident about the economic and political outlook. I agree that value looks better outside the U.S., but I do worry about political instability in the euro area and Brexit in the U.K. I know Japan looks cheap, but that has been a difficult and disappointing market for a long time and, as we already discussed, the structural outlook for the economy is very troubling. Turning to the emerging markets, you have not backed away from your bearish stance. The long-run underperformance of emerging markets relative to the U.S. and other developed bourses has been quite staggering and I am glad that I have followed your advice. Are you expecting to shift your negative stance any time soon? BCA: The global underperformance of EM has lasted for six years and may be close to ending. But the experience of the previous cycle of underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound (Chart 32). Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors - materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors (Chart 33). Chart 32A Long Period Of EM Underperformance A Long Period Of EM Underperformance A Long Period Of EM Underperformance Chart 33EM Fundamentals Still Poor EM Fundamentals Still Poor EM Fundamentals Still Poor More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year's rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces. In sum, we expect EM equities to underperform DM markets for a while longer. If you want to have some EM exposure then our favored markets are Korea, Taiwan, China, India, Thailand and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil and Peru. Mr. X: None of this makes very keen to invest in any equity market. However, even in poor markets, there usually are some areas that perform well. Do you have any strong sector views? Chart 34Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot BCA: Our near-term sector views reflect the expectation of a pullback in the broad equity market. The abrupt jump in the price of global cyclicals (industrials, materials & energy) versus defensives (health care, consumer staples & telecom services) has been driven solely by external forces - i.e. the sell-off in the bond market, rather than a shift in underlying profit drivers. For instance, emerging markets and the global cyclicals/defensives price ratio have tended to move hand-in-hand. The former is pro-cyclical, and outperforms when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the cyclical/defensive price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debts. Meanwhile, the growth impetus required to support profit outperformance for deep cyclicals may be elusive. As a result, we expect re-convergence to occur via a rebound in defensive relative to cyclical sectors (Chart 34). On a longer-term basis, one likely long-lasting effect of the retreat from globalization is that "small is beautiful." Companies with large global footprints will suffer relative to domestically focused firms. One way to position for this change is to emphasize small caps at the expense of large caps, a strategy applicable in almost every region. Small caps are traditionally domestically geared irrespective of their domicile. In the U.S. specifically, small caps face a potential additional benefit. If the new administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Moreover, small companies would benefit most from any cuts in regulations. When it comes to specifics, our overweight sectors in the U.S. are consumer discretionary, telecoms, consumer staples and health care. We would underweight industrials, technology and materials. For Europe, we also like health care and would overweight German real estate. We would stay away from European banks even though they are trading at historically cheap levels. Commodities And Currencies Mr. X: A year ago, you predicted that oil prices would average $50/bbl over the 2016-18 period. As that is where prices have now settled, do you still stick with that prediction? Chart 35Oil Market Trends Oil Market Trends Oil Market Trends BCA: We have moved our forecast up to an average of $55/bbl following the recent 1.8 million b/d production cuts agreed between OPEC, led by Saudi Arabia, and non-OPEC, led by Russia. The economic pain from the drop in prices finally forced Saudi Arabia to blink and abandon its previous strategy of maintaining output despite falling prices. Of course, OPEC has a very spotty record of sticking with its plans and we expect that we will end up with a more modest 1.1 to 1.2 million b/d in actual output reductions. Yet, given global demand growth of around 1.3 million b/d and weakness in other non-OPEC output, these cuts will be enough to require a drawdown in inventories from current record levels. Even with the lower level of cuts that we expect, OECD oil inventories could drop by around 300 million barrels by late 2017, enough to bring down stocks roughly to their five-year average level (Chart 35). That is the stated goal of Saudi Arabia and the odds are good that the level of compliance to the cuts will be better than the market expects. Mr. X: How does shale production factor into your analysis? What are the odds that a resurgence of U.S. shale production will undermine your price forecast? BCA: We expect U.S. shale-oil production to bottom in the first quarter of 2017, followed by a production increase of around 200,000 b/d in the second half. However, that will not be enough to drive prices back down. The bigger risk to oil prices over the next year or two is for a rise, not a decline given the industry's massive cutbacks in capital spending. More than $1 trillion of planned capex has been cut for the next several years, which translates into more than seven million b/d of oil-equivalent (oil and natural gas) production that will not be developed. And increased shale production cannot fully offset that. In addition to meeting demand growth, new production also must offset natural decline rates, which amount to 8% to 10% of production annually. Replacing these losses becomes more difficult as shale-oil output increases, given its very high decline rates. Shale technology appears to be gaining traction in Russia, which could end up significantly boosting production but capex cuts will constrain the global supply outlook until after 2018. Mr. X: Non-oil commodity prices have shown surprising strength recently, with copper surging almost 30% in the space of a few weeks. Is that just Chinese speculation, or is something more fundamental at work? You have had a cautious long-term view of commodities on the grounds that changing technology and reduced Chinese demand would keep a lid on prices. Do you see any reason to change that view? BCA: Developments in China remain critical for non-oil commodity prices. China's reflationary policies significantly boosted real estate and infrastructure spending and that was the main driver of the rally in metals prices in 2016. As we discussed earlier, China has eased back on reflation and that will take the edge off the commodity price boom. Indeed, given the speed and magnitude of the price increases in copper and other metals, it would not be surprising to see some near-term retrenchment. For the year as a whole, we expect a trading range for non-oil commodities. Longer-run, we would not bet against the long-term downtrend in real commodity prices and it really is a story about technology (Chart 36). Real estate booms notwithstanding, economies are shifting away from commodity-sensitive activities. Human capital is becoming more important relative to physical capital and price rises for resources encourages both conservation and the development of cheaper alternatives. In the post-WWII period, the pattern seems to have been for 10-year bull markets (1972 to 1982 and 2002 to 2012) and 20-year bear markets (1952 to 1972 and 1982 to 2002). The current bear phase is only six years old so it would be early to call an end to the downtrend from a long-term perspective. Chart 36The Long-Term Trend In Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down Mr. X: You know that I can't leave without asking you about gold. I continue to believe that bullion provides a good hedge at a time of extreme monetary policies, political uncertainty and, now, the prospect of fiscal reflation. Can you see bullion at least matching its past year's performance over the coming 12 months? Chart 37A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion BCA: It is still a gold-friendly environment. The combination of political uncertainty, rising inflation expectations and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar: the strengthening of the dollar clearly was a factor undermining the gold price in the second half of 2016 (Chart 37). Nevertheless, a modest position in gold - no more than 5% of your portfolio - will give you some protection in what is likely to remain a very unsettled geopolitical environment. Mr. X: You mentioned the dollar so let me now delve into your currency views in more detail. The dollar has been appreciating for a few years and it seems quite a consensus view to be bullish on the currency. I know the U.S. economy is growing faster than most other developed economies but it surprises me that markets are ignoring the negatives: an ongoing large trade deficit, a looming rise in the fiscal deficit and uncertainty about the policies of the incoming administration. BCA: It is true that if you just looked at the U.S. economic and financial situation in isolation, you would not be very bullish on the currency. As you noted, the current account remains in large deficit, an increased federal deficit seems inevitable given the new administration's policy platform, and the level of short-rates is very low, despite the Fed's recent move. However, currencies are all about relative positions, and, despite its problems, the U.S. looks in better shape than other countries. The optimism toward the dollar is a near-term concern and suggests that the currency is ripe for a pullback. However, it will not require a major sell-off to unwind current overbought conditions. The main reasons to stay positive on the dollar on a cyclical basis are the relative stance of monetary policy and the potential for positive U.S. economic surprises relative to other countries. Ironically, if the administration follows up on its threat to impose trade barriers, that also would be positive for the currency, at least for a while. Longer-run it would be dollar bearish, because the U.S. probably would lose competiveness via higher inflation. The dollar is enjoying its third major upcycle since the era of floating rates began in the early 1970s (Chart 38). There are similarities in all three cases. Policy divergences and thus real interest-rate differentials were in the dollar's favor and there was general optimism about the U.S. economy relative to its competitors. In the first half of the 1980s, the optimism reflected President Reagan's pro-growth supply-side platform, in the second half of the 1990s it was the tech bubble, and this time it is the poor state of other economies that makes the U.S. look relatively attractive. Chart 38The Dollar Bull Market In Perspective January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bull market in the first half of the 1980s was the strongest of the three but was cut short by the 1985 Plaza Accord when the leading industrial economies agreed to coordinated intervention to push the dollar back down in order to forestall a U.S. protectionist response to its soaring trade deficit. The second upturn ended when the tech bubble burst. There is no prospect of intervention to end the current cycle and policy divergences will widen not narrow over the next year. Thus, the dollar should continue to appreciate over the next 12 months, perhaps by around 5% on a trade-weighted basis. The fiscal policies being promoted by the Trump team promise to widen the U.S. trade deficit but that will not stand in the way of a dollar ascent. The problems will occur if, as we discussed earlier, an overheating economy in 2018 and a resulting Fed response trigger a recession in 2019. At that point, the dollar probably would plunge. But it is far too soon to worry about that possibility. Mr. X: I was very surprised with the yen's strength in the first half of 2016 given Japan's hyper-easy policy stance. What was driving that? Also, I would be interested in your views on sterling and commodity and emerging currencies. BCA: The yen often acts as a safe-haven at times of great economic and political uncertainty and that worked in the yen's favor for much of the year. However, it lost ground when U.S. bond yields headed higher. Also, the U.S. election result did not help because Japan would be a big loser if the U.S. imposed trade restrictions. The policy settings in Japan are indeed negative for the yen and while the currency is oversold in the very short run, we expect the structural bear market to persist in 2017 (Chart 39). Sterling's trade-weighted index fell to an all-time low after the Brexit vote so it does offer good value by historical standards. However, with so much uncertainty about how Brexit negotiations will proceed, we remain cautious on the currency. The economy has performed quite well since the vote, but it is far too soon to judge the long-term consequences of EU departure. And the prospect of increased government spending when the country already has a large trade deficit and high public debt poses an additional risk. Turning to the commodity currencies, the rebound in oil and metals prices has stabilized the Canadian and Australian dollars (Chart 40). With resource prices not expected to make much further headway over the next year, these currencies likely will be range bound, albeit with risks to the downside, especially versus the U.S. dollar. Chart 39More Downside In The Yen More Downside In The Yen More Downside In The Yen Chart 40Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Finally, we remain bearish on emerging currencies given relatively poor economic fundamentals. And this is particularly true for those countries with chronically high inflation and/or large current account deficits, largely outside of Asia. Mr. X: What about the Chinese currency? The renminbi has dropped by 13% against the dollar over the past three years and president-elect Trump has threatened to label China as a currency manipulator. You already noted that the Chinese authorities have intervened to prop the currency up, but this does not seem to be working. Chart 41Renminbi Weakness Renminbi Weakness Renminbi Weakness BCA: The trend in the USD/RMB rate exaggerates the weakness of the Chinese currency. On a trade-weighted basis, the currency has depreciated more modestly over the past year, and the recent trend has been up, in both real and nominal terms (Chart 41). In other words, a good part of the currency's move has reflected across-the-board strength in the dollar. The Chinese authorities are sensitive to U.S. pressures and have taken some measures to contain private capital outflows. The next step would be to raise interest rates but this would be a last resort. With the dollar expected to rise further in 2017, the RMB will drift lower, but policy interventions should limit the decline and we doubt the U.S. will follow through with its threat to label China as a manipulator. Geopolitics Mr. X: Last, but certainly not least, we must talk about geopolitics. In addition to the new political order in the U.S. we have a very unstable political situation in Europe, most notably in Italy. We cannot rule out an anti-euro party taking power in Italy which would presumably trigger massive volatility in the markets. With elections also due in France, Germany and the Netherlands, 2017 will be a crucial year for determining the future of the single currency and the EU. What is your take on the outlook? Chart 42Europeans Still Support The EU Europeans Still Support The EU Europeans Still Support The EU BCA: Europe's electoral calendar is indeed ominously packed with four of the euro area's five largest economies likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As BCA's Geopolitical Strategy has argued since 2011, global multipolarity increases the logic for European integration. Crises such as Russian assertiveness, Islamic terrorism, and the migration wave are easier to deal with when countries act together rather than individually. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro or the EU (Chart 42). Despite all of its problems, the single currency should hold together, at least over the next five years. Take the recent Spanish and Austrian elections. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the more-establishment candidate for president, Alexander Van der Bellen, won the election despite fears to the contrary. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. We expect more of the same in the three crucial elections in the Netherlands, France, and Germany. Mr. X: What about Italy? BCA: The country certainly has its problems: it has lagged badly in implementing structural reforms and support for the euro is low compared to the euro area average. Yet, if elections were held today, polls show that the ruling Democratic Party would gain a narrow victory. There are three key points to consider regarding Italy: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum. The market will punish Italy the moment it sniffs out even a whiff of a potential "Itexit" referendum. This will bring forward the future pain of redenomination, influencing voters' choices. Benefits of EU membership for Italy are considerable, especially as it allows the country to integrate its unproductive, poor, and expensive southern regions. Outside the EU, the Mezzogiorno is Rome's problem, and it is a big one. The larger question is whether other euro area countries will be content for Italy to remain mired in its fragile and troubling status quo. We think the answer is yes, given that Italy is the definition of "too-big-to-fail." Mr. X: During the past few years you have emphasized the importance of the shift from a unipolar to multipolar world, reflecting the growing power of China, renewed Russian activism and a decline in U.S. influence. How does the policy platform of the incoming Trump administration affect your view of the outlook? It seems as if the U.S. may end up antagonizing China at the same time as it tries to improve relations with Russia. How would that play out? Chart 43Asia Sells, America Rules Asia Sells, America Rules Asia Sells, America Rules BCA: The media is overemphasizing the role of president-elect Trump in Sino-American relations. Tensions have been building between the two countries for several years. The two countries have fundamental, structural, problems and Trump has just catalyzed what, in our mind, has been an inevitable conflict. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were instrumental: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 43). For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its umbrella. Japan's economic model and large trade surpluses led it into a confrontation with the U.S. in the 1980s. President Ronald Reagan's economic team forced Japan to reform, but the result ultimately was a financial crisis as the artificial supports of its economic model fell away. Many investors have long suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it hinders U.S. access to its vast consumer market. There is a critical difference between the "Japan bashing" of the 1980s and the increasingly potent "China bashing" of today. In the 1980s, the U.S. had already achieved strategic supremacy over Japan as a result of WWII, but that is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the U.S. to preserve its security. Far from it - China has no greater security threat than the U.S. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. That means that when the Trump administration tries to "get tough" on long-standing American demands, these demands will not be taken as well-intentioned or trustworthy. Sino-American rivalry will be the chief geopolitical risk to investors in 2017. Mr. X: Are there any other geopolitical issues that might affect financial markets during the coming year? BCA: Investors are underestimating the risks that the defeat of the Islamic State Caliphate in the Middle East will pose. While the obvious consequence is a spread of terrorism as militants return home, the bigger question is what happens to the regional disequilibrium. In particular, we fear that Turkey will become embroiled in a conflict in both Syria and Iraq, potentially in a proxy war with Iran and Russia. The defeat of Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. The Turkish foray into the Middle East poses the chief risk of a shooting war that could impact global markets in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. Conclusions Mr. X: I think we should end our discussions here before you make me more depressed. A year ago, I was very troubled about the economic and financial outlook, and you did not say very much at that time to ease my concerns. And I feel in a similar situation again this year. I do not believe we are at the edge of a major economic or financial crisis, so that is not the issue. The problem for me is that policymakers continue to distort things with excessively easy monetary policies. And now we face fiscal expansion in the U.S., even though the economy is approaching full employment and wages are picking up. Meanwhile, nobody seems worried about debt anymore despite debt-to-GDP ratios that are at all-time highs throughout the world. And if that was not enough, we face the most uncertain political environment that I can remember, both in the U.S. and Europe. It would not be so bad if markets were cheap to compensate for the various risks and uncertainties that we face. But, as we discussed, that is not the case. So I am left with the same dilemma as last year: where to invest when most assets are fully valued. I am sure that you are right when you say that stock prices are well placed to overshoot over the coming year, but that is not a game I like to play. So I am inclined to stay with a cautious investment stance for a while longer, hoping for a better entry point into equities and other risk assets. BCA: We understand your caution, but you risk missing out on some decent gains in equities over the coming year if you remain on the sidelines. The equity market is due for a near-term pullback, but we would use that as a buying opportunity. Markets are not expensive everywhere and the policy backdrop will remain supportive of risk assets. And although we talked about an overshoot, there is plenty of upside before we need to be concerned that valuations have become a major constraint. We are certainly not trying to persuade you to throw caution to the wind. We have not changed our view that long-term returns from financial assets will be a pale shadow of their historical performance. The past 33 years have delivered compound returns of 10.3% a year from a balanced portfolio and we cannot find any comparable period in history that comes even close (Table 3). As we discussed at length in the past, these excellent returns reflected a powerful combination of several largely interrelated forces: falling inflation and interest rates, rising profit margins, a starting point of cheap valuations and strong credit growth. None of these conditions exist now: inflation and interest rates are headed up, profit margins are likely to compress, valuations are not cheap, and in a post-Debt Supercycle world, the days of rapid credit growth are over. Thus, that same balanced portfolio is likely to deliver compound returns of only 4% over the coming decade. Table 3The Past Is Not A Guide To The Future January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bottom line is that the economic and policy regime that delivered exceptional markets is shifting. The end of the Debt Supercycle a few years ago represented one element of regime shift and now we face several other elements such as the end of the era of falling inflation and interest rates, a rebalancing of the income shares going to labor and capital, and politically, in attitudes and thus policies regarding globalization. A world of modest returns is one where it is very important to get the right country and sector allocation, and ideally, catch shorter-term market swings. Of course, that is much more challenging than simply enjoying a rising tide that lifts all boats. As the year progresses, we will update you with our latest thinking on market trends and investment ideas. Mr. X: I am sure we are about to have a very interesting year and I will rely on your research to highlight investment opportunities and to keep me out of trouble. Once again, many thanks for spending the time to take me through your views and let's end with a summary of your main views. BCA: That will be our pleasure. The key points are as follows: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end-point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time-lags in implementing policy mean that the fiscal plans of president-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. They key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely to avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given president-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors December 20, 2016

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

Highlights The FOMC statement was somewhat more hawkish than expected. The Fed is on course to raise rates two to three times next year. Trump's policy views are squarely bearish for bonds, but more mixed for stocks. Investors are focusing too much on the positive aspects of Trump's agenda, while ignoring the glaringly negative ones. The 35-year bond bull market is over. Deep-seated political and economic forces will conspire to lift inflation over the coming years. For now, rising wages and prices are welcome news given that inflation remains below target in most economies. However, with productivity and labor force growth still weak around the world - and likely to stay that way - reflation will eventually morph into stagflation. Feature A Fork In The Road Charlie Wilson, the former CEO of General Motors, once famously declared that "what is good for GM is good for the country." There is little doubt that policies that boost economic growth can benefit both Wall Street and Main Street alike. On occasion, however, what is good for one may not be good for the other. Consider Donald Trump's campaign promise to curb illegal immigration and crack down on firms that move production abroad. Reduced immigration means fewer potential customers, and hence weaker sales growth. Fewer immigrant workers and less outsourcing also means higher wages for native-born workers. Bad news for Wall Street, but arguably good news for Main Street. Chart 1Diminished Labor Market Slack Boosting Wages bca.gis_wr_2016_12_16_c1 bca.gis_wr_2016_12_16_c1 The distinction between Wall Street and Main Street is critical for thinking about how various policies affect bonds and stocks. Bond prices tend to be more influenced by what happens to the broader economy (the key concern for Main Street), whereas equity prices tend to be more influenced by what happens to corporate earnings (the key concern for Wall Street). Corporate earnings have recovered much more briskly over the past eight years than the overall economy. Thus, it is no surprise that stock prices have surged while bond yields have tumbled. Things may be changing, however. A tighter U.S. labor market is pushing up wages, and this is starting to weigh on corporate profit margins (Chart 1). Meanwhile, bond yields are finally rebounding after hitting record low levels earlier this year. A Somewhat Hawkish Hike This week's FOMC statement reinforced the upward trajectory in yields. Both the median and modal "dot" in the Summary of Economic Projections shifted from two to three hikes next year. While Chair Yellen mentioned that a few participants "did incorporate some assumption about the change in fiscal policy," we suspect that many did not, reflecting the lack of clarity about the timing, composition, and magnitude of any fiscal package. As these details are fleshed out, it is probable that both growth and inflation assumptions will be revised up, helping to keep the Fed's tightening bias in place. The key question is whether U.S. growth will be strong enough next year to allow the Fed to keep raising rates. Our view is that it will. As we argued in October in "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"1 a recovery in business capex, a turn in the inventory cycle, a pick-up in spending at the state and local government level, and continued solid consumption growth driven by rising real wages will all support demand in 2017. Indeed, it is likely that the Fed will find itself a bit behind the curve, allowing inflation to drift higher. The Structural Case For Higher Inflation The cyclical acceleration in U.S. and global inflation that we will see over the next few years will be buttressed by structural trends. As we first spelled out in this year's Q3 Strategy Outlook entitled "The End Of The 35-Year Bond Bull Market,"2 a number of political and economic forces will conspire to lift inflation and nominal bond yields over time. Let us start with the politics. Here, three inflationary forces stand out: The retreat from globalization; The rejection of fiscal austerity; The continued will and growing ability of central banks to push up inflation. Globalization Under Attack Globalization is an inherently deflationary force. In a globalized world, if a country experiences an idiosyncratic shock which raises domestic demand, this can be met with more imports rather than higher prices. In addition, the entry of millions of workers from once labor-rich, but capital-poor economies such as China, has depressed the wages of less-skilled workers in developed economies.3 Poorer workers tend to spend a greater share of their incomes than richer workers (Chart 2). To the extent that globalization has exacerbated income inequality, it has also reduced aggregate demand. It is too early to know to what extent Donald Trump will try to roll back globalization. So far, his cabinet appointments - perhaps with the exception of immigration hawk Jeff Sessions - are little different from what a run-of-the-mill Republican like Jeb Bush would have made. Yet, as we noted last week, it will be difficult for Trump to backtrack from his protectionist views because his white working-class base will abandon him if he does.4 As Chart 3 shows, the share of Republican voters who support free trade has plummeted from over half to only one-third. For better or for worse, the Republican Party has become a populist party. Davos Man beware. Chart 2The Rich Save, The Poor Not So Much bca.gis_wr_2016_12_16_c2 bca.gis_wr_2016_12_16_c2 Chart 3Republican Voters Are Rejecting Free Trade Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks In any case, even if populist pressures do not cause global trade to collapse over the coming years, the period of "hyperglobalization," as Arvind Subramanian has called it, is over. As we discussed three weeks ago,5 many of the things that facilitated globalization over the past 30 years were one-off developments: China cannot join the WTO more than once; tariffs in most developed countries cannot fall much more because they are already close to zero; there is nothing on the horizon that will match the breakthrough productivity gains in global shipping that stemmed from containerization; the global supply chain is already highly efficient, etc. Thus, at the margin, globalization will be less of a deflationary force than it once was. Back To Bread And Circuses After a brief burst of fiscal stimulus following the financial crisis, governments moved quickly to tighten their belts. Now, however, the pendulum is starting to swing back towards easier fiscal policy, as nervous politicians look for ways to thwart the populist backlash (Chart 4). The U.K. is a good example of this emerging trend. Prior to the Brexit vote, the Conservative government had planned to tighten fiscal policy by a further 3.3% of GDP over the remainder of this decade. This goal has been thrown out the window, with Theresa May now even hinting about the prospect of some fiscal stimulus. Elsewhere in Europe, governments continue to flout their fiscal targets. Not only has the European Commission turned a blind eye to this development, but a recent report by the Commission actually suggested that a "desirable fiscal orientation" would entail larger budget deficits next year than what member states are currently targeting (Chart 5). Chart 4The End Of Austerity Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Chart 5The European Commission Recommends Greater Fiscal Expansion Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks In Japan, Prime Minister Abe has scrapped plans to raise the sales tax next year. The supplementary budget announced in August will boost annual spending by 0.5% of GDP over the next three years. Our geopolitical team thinks that further spending measures will be introduced, especially on defense. For his part, Donald Trump has pledged massive fiscal stimulus consisting of increased infrastructure and defense expenditures, along with a whopping $6.2 trillion in tax cuts over the next 10 years even before accounting for additional interest costs. Investors shouldn't rejoice too much, however. Effective tax rates for S&P 500 companies are already well below statutory levels on account of the numerous loopholes in the tax code (Chart 6). Small businesses rather than large corporations will disproportionately benefit from Trump's tax measures. Chart 6The U.S. Effective Corporate Tax Rate Is Already Quite Low bca.gis_wr_2016_12_16_c6 bca.gis_wr_2016_12_16_c6 Moreover, it is doubtful that the maximum fiscal thrust from Trump's policies will be reached before 2018. By that time, the economy is likely to have reached full employment. As such, much of the stimulus is likely to show up in the form of higher wages rather than increased real corporate sales. More Monetary Ammo The global financial crisis set off the biggest deflation scare the world has seen since the Great Depression. Eight years later, central banks are still struggling to raise inflation. The conventional wisdom is that central banks are "out of bullets." This view, however, is much too pessimistic. Even if one excludes the use of such radical measures as helicopter money, it is still the case that traditional monetary policy becomes more effective as spare capacity is reduced. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to keep interest rates at zero, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, another adverse economic shock, etc. In contrast, if the output gap is already quite small, as is the case in the U.S. today, a promise to let the economy run hot is more likely to be taken seriously. Chart 7 shows that the level of the U.S. core PCE deflator, the Fed's preferred inflation gauge, is nearly 4% lower than it would have been if inflation had remained at its 2% target since 2008. Given that the Fed has a symmetric target - meaning that inflation overshoots should be just as common as undershoots - aiming for an inflation rate above 2% over the next few years makes some sense. If inflation does move up to the 2.5%-to-3% range, the Fed might be reluctant to bring it back down since this would require slower growth and higher unemployment. In fact, a case could be made that the Fed and other central banks should simply raise their inflation targets. Both private and public debt levels are still quite elevated all over the world (Chart 8). Higher inflation would be one way to reduce the real value of those liabilities. Chart 7Inflation Has Undershot the Fed's Target Inflation Has Undershot the Fed's Target Inflation Has Undershot the Fed's Target Chart 8Elevated Debt Levels Elevated Debt Levels Elevated Debt Levels The difficulty in pushing nominal short-term rates much below zero is another reason to aim for a higher inflation rate. Back in 1999 when the FOMC first broached the idea of introducing a 2% inflation target, the Fed's simulations suggested that the zero lower bound would only be reached once every 20 years, and even on these rare occurrences, interest rates would be pinned to zero for only four quarters (Table 1). In reality, the U.S. economy has spent more than half of the time since then either at the zero bound or close to it. While we do not expect any central bank to raise their inflation targets anytime soon, long-term investors should nevertheless prepare for this possibility. Table 1The Fed Underestimated The Probability Of Rates Being Stuck At Zero Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Slow Potential Growth: Deflationary At First, Inflationary Later On The narrowing of output gaps around the world has given central banks more traction over monetary policy. However, there has been a dark side to this development - and one that also leans in the direction of higher inflation. As Chart 9 shows, spare capacity has declined in every major economy not because demand has been strong, but because supply has been weak. Chart 9AWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_12_16_c9a bca.gis_wr_2016_12_16_c9a Chart 9BWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_12_16_c9b bca.gis_wr_2016_12_16_c9b The decline in potential GDP growth reflects both slower productivity and labor force growth. As we have discussed in past reports, while cyclical factors have weighed on potential growth, structural factors also loom large.6 The former include falling birth rates, flat-lining labor participation, plateauing educational attainment, and a shift in technological innovation away from business productivity and towards consumer-centric applications such as social media. Chart 10A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Critically, slower potential GDP growth tends to be deflationary at the outset but becomes inflationary later on. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households react to the prospect of slower real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 10). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period when productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 11). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11An Aging Population Eventually Pushes Up Interest Rates Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Japan provides a good example of how this transition might occur. Chart 12 shows that the household savings rate has fallen from over 14% in the early 1990s to only 2% today. Meanwhile, the ratio of job openings-to-applicants has reached a 25-year high. Amazingly, the tightening in the labor market has occurred despite anemic GDP growth and a huge surge in female employment. Prime-age female labor participation has already risen above U.S. levels (Chart 13). As participation rates stabilize, labor force growth in Japan will decline from a cyclical high of around 0.8% at present to -0.2%. That may be enough to precipitate a sharp labor shortage, leading to higher wages and an end to deflation. Chart 12Japan: Declining Household Savings ##br## Rate And A Tightening Labor Market Japan: Declining Household Savings Rate And A Tightening Labor Market Japan: Declining Household Savings Rate And A Tightening Labor Market Chart 13Japan: Female Labor Force ##br## Participation Now Exceeds The U.S. bca.gis_wr_2016_12_16_c13 bca.gis_wr_2016_12_16_c13 What will the Bank of Japan do when this fateful day arrives? The answer is probably nothing. The BoJ would welcome a virtuous circle in which rising inflation pushes down real rates, leading to a weaker yen, a stronger stock market, and even higher inflation expectations. Such a virtuous circle almost emerged in 2012 had the Japanese government not short-circuited it by tightening fiscal policy by 3% of GDP. It won't make the same mistake again. Investment Conclusions Global assets have swung wildly in the weeks following the U.S. presidential election. The selloff in bonds and the rally in the dollar make perfect sense to us - indeed, we predicted as much in our September report entitled "Three Controversial Calls: Trump Wins, And The Dollar Rallies."7 In contrast, the surge in U.S. equities seems overdone. Yes, certain elements of Trump's political agenda such as deregulation and lower corporate tax rates are good news for stocks. But other aspects such as trade protectionism and tighter immigration controls are not. Others still, such as increased government spending, are good in theory but carry sizeable side-effects, the chief of which is that the stimulus may arrive at a time when the economy no longer needs it. Some commentators have argued that the good aspects of Trump's agenda will be implemented before the bad ones, giving investors a reason to focus on the positive. We are not so sure. If Trump gives the Republican establishment everything it wants on taxes and regulations, he will lose all his remaining leverage over trade and immigration. Rather than waiting to be stabbed in the back by Paul Ryan, strategically, Trump is likely to insist that Congress implement his populist platform before he hands it the keys to the economy. Even if one ignores the political intrigue, it is still the case that global stocks have tended to suffer following major spikes in bond yields such as the one we have just experienced (Table 2). We suspect that this time will not be any different. As such, investors would be wise to adopt a more defensive tactical posture over the next few months. Table 2Stocks Tend To Suffer When Bond Yields Spike Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Chart 14Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating Things look better over a one-to-two year cyclical horizon. Outside of the U.S., much of the global economy continues to suffer from excess spare capacity. Recent data suggesting that global growth is accelerating is welcome news in that regard (Chart 14). Not only will stronger growth boost corporate earnings, but with the ECB, BoJ, and many other central banks firmly on hold, any increase in inflation expectations will translate into lower real rates, providing an additional fillip to spending. We continue to prefer European and Japanese stocks over their U.S. counterparts, on a currency-hedged basis. Emerging markets are a tougher call. The real trade-weighted dollar probably has another 5% or so of upside from current levels. Historically, a stronger greenback has been bad news for EM equities. On a more positive note, faster global growth should give some support to commodity prices. BCA's commodity strategists remain quite bullish on crude and natural gas, a view that has been further reinforced by both Saudi Arabia and Russia's announcements to restrict oil supply beginning in January. Still, on balance, we recommend a slightly underweight position in EM equities. Looking beyond the next two years, the outlook for global risk assets is likely to darken again. We are skeptical that Trump's much lauded supply-side policies will boost productivity to any great degree. Against a backdrop of rising budget deficits and brewing populist sentiment around the world, reflation may begin to give way to stagflation. In such an environment, bond yields could rise substantially from current levels, taking stocks down with them. Enjoy it while it lasts. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 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. 2 Please see Global Investment Strategy, "Strategy Outlook Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 8, 2016, available at gis.bcaresearch.com. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "Trade Adjustment: Worker-Level Evidence," The Quarterly Journal of Economics (2014). 4 Please see Global Investment Strategy Weekly Report, "Trump And Trade," dated December 9, 2016, available at gis.bcaresearch.com. 5 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 6 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, and Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015, available at gis.bcaresearch.com. 7 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Recommendation Allocation Quarterly - December 2016 Quarterly - December 2016 Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up bca.gaa_qpo_2016_12_15_c1 bca.gaa_qpo_2016_12_15_c1 Chart 2U.S. Earnings Growing Again bca.gaa_qpo_2016_12_15_c2 bca.gaa_qpo_2016_12_15_c2 The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 bca.gaa_qpo_2016_12_15_c3 bca.gaa_qpo_2016_12_15_c3 Chart 4Will This Trigger Inflation Pressures? bca.gaa_qpo_2016_12_15_c4 bca.gaa_qpo_2016_12_15_c4 As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Quarterly - December 2016 Quarterly - December 2016 Chart 9GDP Impact Of U.S. Fiscal Stimulus Quarterly - December 2016 Quarterly - December 2016 Chart 10A Lot of Stimulus, And Extra Debt bca.gaa_qpo_2016_12_15_c10 bca.gaa_qpo_2016_12_15_c10 Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings bca.gaa_qpo_2016_12_15_c11 bca.gaa_qpo_2016_12_15_c11 Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? What's Up Brexit? What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish bca.gaa_qpo_2016_12_15_c13 bca.gaa_qpo_2016_12_15_c13 Chart 14An Oversold Bounce bca.gaa_qpo_2016_12_15_c14 bca.gaa_qpo_2016_12_15_c14 Chart 15Policy Tightening = Underperformance bca.gaa_qpo_2016_12_15_c15 bca.gaa_qpo_2016_12_15_c15 Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside bca.gaa_qpo_2016_12_15_c16 bca.gaa_qpo_2016_12_15_c16 Chart 17Growth Picks Up In##br## Most DMs And China bca.gaa_qpo_2016_12_15_c17 bca.gaa_qpo_2016_12_15_c17 Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched bca.gaa_qpo_2016_12_15_c18 bca.gaa_qpo_2016_12_15_c18 Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook bca.gaa_qpo_2016_12_15_c19 bca.gaa_qpo_2016_12_15_c19 It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence bca.gaa_qpo_2016_12_15_c20 bca.gaa_qpo_2016_12_15_c20 Chart 21Global Equities: No Style Bet bca.gaa_qpo_2016_12_15_c21 bca.gaa_qpo_2016_12_15_c21 Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration bca.gaa_qpo_2016_12_15_c22 bca.gaa_qpo_2016_12_15_c22 Chart 23Inflation Uptrend Intact bca.gaa_qpo_2016_12_15_c23 bca.gaa_qpo_2016_12_15_c23 Chart 24Overweight JGBs bca.gaa_qpo_2016_12_15_c24 bca.gaa_qpo_2016_12_15_c24 Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 26Still Accommodative bca.gaa_qpo_2016_12_15_c26 bca.gaa_qpo_2016_12_15_c26 Chart 27Expensive Valuations bca.gaa_qpo_2016_12_15_c27 bca.gaa_qpo_2016_12_15_c27 Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue bca.gaa_qpo_2016_12_15_c28 bca.gaa_qpo_2016_12_15_c28 Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance bca.gaa_qpo_2016_12_15_c29 bca.gaa_qpo_2016_12_15_c29 Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth bca.gaa_qpo_2016_12_15_c30 bca.gaa_qpo_2016_12_15_c30 Chart 31Commodities: A Secular Bear Market bca.gaa_qpo_2016_12_15_c31 bca.gaa_qpo_2016_12_15_c31 Chart 32Structured Products Outperform In Recessions bca.gaa_qpo_2016_12_15_c32 bca.gaa_qpo_2016_12_15_c32 Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex bca.gaa_qpo_2016_12_15_c33 bca.gaa_qpo_2016_12_15_c33 Chart 34Policy Uncertainty Is High bca.gaa_qpo_2016_12_15_c34 bca.gaa_qpo_2016_12_15_c34 Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Dollar Already Above Fair Value Dollar Already Above Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? bca.gaa_qpo_2016_12_15_c36 bca.gaa_qpo_2016_12_15_c36 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights The rise in both bond yields and the U.S. dollar represents significant tightening in monetary conditions, which will be difficult for stock prices to digest. Technical indicators suggest that the rally could persist in the near term, but investors should nonetheless prepare a shopping list once prices correct. Both consumer discretionary and health care stocks are appealing longer-term plays that are less expensive than the broad market. Feature The current rally in equity prices is high risk. Since the summer, our main worry for the stock market has been the likelihood of profit disappointments, given that corporations lack pricing power and that the outlook for top-line growth is lackluster. That worry has not gone away, but now the more pressing issue has become the impact on equity prices of the swift and aggressive tightening in monetary conditions via both the bond market sell-off and rise in the dollar (Chart 1). The 10-year Treasury yield is now trading above fair value. True, in the past, equity prices have sustained gains until yields rose much further into undervalued territory, but the big difference this time is that the dollar is rising in tandem. Simultaneous powerful rises in the currency and yields are rare, and typically result in steep market pullbacks. Investors should be on high-alert for this outcome. The possibility that equity market euphoria persists for another month or two should not be ruled out, i.e. until the Fed's next meeting and until there is more clarity on the course of fiscal and trade policy. Indeed, a simple read of technical indicators and market sentiment suggest that the rally could continue, but the risk/reward balance is poor (Chart 2). Chart 1Monetary Conditions Have Changed bca.usis_wr_2016_12_05_c1 bca.usis_wr_2016_12_05_c1 Chart 2Technicals: Not Flashing A Warning Yet Technicals: Not Flashing A Warning Yet Technicals: Not Flashing A Warning Yet With that in mind, one of the most frequently asked (and difficult) questions we receive is, Where is the value in U.S. equities? Presently, this is akin to looking for deals on New York's Upper 5th Avenue.1 As Chart 3 shows, U.S. equity multiples remain near or at historic (ex. TMT mania) highs. This is true for both small and large caps. And relative to global equity valuations, U.S. stocks appear even more expensive. There are few sectors that we believe offer compelling absolute value today. However, on a relative basis, the Trump rally has caused a flight out of traditional safe havens that has gone too far. For instance, consumer products stocks (household products, beverages and packaged food) are now trading below the broad market P/E multiple, in aggregate, on a trailing 12-month basis (Chart 4). According to our U.S. Equity Strategy service, forward relative returns are typically very robust when the group trades at a discount to the market. Importantly, consumer products stocks have a positive correlation with the U.S. dollar, which means that recent share price weakness represents a buying opportunity. Chart 3No Deals Here bca.usis_wr_2016_12_05_c3 bca.usis_wr_2016_12_05_c3 Chart 4Good Entry Point To Consumer Products? bca.usis_wr_2016_12_05_c4 bca.usis_wr_2016_12_05_c4 As highlighted above, we are on high-alert for an equity shakeout, triggered by the rapid rise in bond yields, and reinforced by profit disappointment. Still, we have assembled a short shopping list of sectors that we believe offer long-term upside. Health care and consumer discretionary stocks already offer better value than other areas of the market. Consumer Discretionary Will Last Longer This Cycle We have recommended favoring domestic over global exposure within U.S. equities and, in-line with our U.S. Equity Strategy service, we have favored non-cyclical holdings. But the cyclical interest rate-sensitive consumer discretionary sector deserves more attention, especially given good relative valuations. The recent back-up in bond yields has sent the relative performance of consumer discretionary stocks to a four-year low, once heavyweight Amazon is excluded (Chart 5). Admittedly, this comes on the back of an almost uninterrupted run higher since 2010. Still, since we believe it unlikely that the current back-up in yields can continue much longer, any cooling in bond yields could start a rotation back into consumer discretionary stocks. In last week's Special Report,2 we outlined the case as to why structural headwinds make it highly unlikely that the Fed will need to aggressively tighten in the coming year. In our view, the interest rate backdrop is unlikely to be an insurmountable headwind for this sector. Most importantly, fundamentals for consumer spending have been slowly improving. The labor market is now tight enough that consumers have job security (Chart 6). Incidentally, consumer confidence is now back to historically buoyant levels. The greatest ramification of this is that higher job security historically goes hand in hand with greater demand for credit. Until this point of the cycle, consumption growth has been capped by income growth trends because there has been no appetite to borrow in the aftermath of the Great Recession. We highly doubt that a new debt-fuelled spending spree will get underway, but rising job security should help fuel some credit growth. Chart 5Consumer Discretionary Stocks##br## Should Resume Outperformance bca.usis_wr_2016_12_05_c5 bca.usis_wr_2016_12_05_c5 Chart 6Consumers: The Future##br## Is Brighter Consumers: The Future Is Brighter Consumers: The Future Is Brighter Alongside improved job security, consumers are enjoying a tailwind from a historically light drag on their finances (Chart 6). Consumer spending on essential items, which includes energy costs, interest expense, insurance, taxes, etc. is at multi-decade lows. If BCA's benign forecast for energy prices (around $50 per barrel) and rate backdrop pans out, then there should continue to be ample spending room on discretionary items. The bottom line is that consumer discretionary stocks are one of the few sectors that are trading at historically reasonable valuations. We believe that a combination of a benign rate backdrop, better consumer confidence and a strong dollar will help this sector outperform late into the business cycle. Particular emphasis should be placed on industry groups and companies that can maintain positive pricing power. This includes movie & entertainment and restaurant stocks. Retailers should be de-emphasized until deflationary pressures ease, as we discuss on page 9. Follow The Baby Boomers To...Health Care Stocks In our Special Report last week, we explained how the aging population will continue to have implications for the labor market and wages. We also believe that demographics will eventually have important implications for equity sector outperformance. BCA Research periodically puts forward investment mania candidates. Charles Kindleberger described three conditions that must be met in order to create a financial mania and bubble: a powerful theme that captures the imagination of investors which is often the result of a major economic displacement; low interest rates; and finally, investment vehicles that allow rampant speculation (Chart 7). We believe that the aging of the population and the need for increased resources to service that population could be a powerful theme that captures investors' attention in the coming years. Chart 7A History Of Manias A History Of Manias A History Of Manias Since the baby boomers came of age (in the 1960s), their massive numbers relative to other age cohorts has given this generation an outsized influence on political, social and economic trends. Put simply, the baby boom generation has had the most clout because of their sheer numbers. And what do baby boomers want now? This age cohort is now focused on prolonging good health for as long as possible! It makes sense, then, any coming pent-up demand for goods and services will focus on health-related spending. As Chart 8 shows, spending on health care increases significantly for the 65-year and over cohort. This massive increase in health care spending has already begun but is likely to increase much more in the coming years. Chart 8Spending On Health Care Accelerates With Age Bargain Hunting Bargain Hunting To further highlight this point, in a Special Report last year,3 we made the case that health care will be one of the greatest sources of innovation this cycle. As we highlighted then, government R&D spending on basic research tends to lead practical applications, such as in the 1950s innovation boom after WWII (Chart 9). Currently, government R&D spending is growing much faster in healthcare than in tech. The private sector is also in agreement with tech VC investment still well below its 2000 peak, whereas healthcare is hitting new highs. Chart 9Health Care R&D Spending Is An Outlier bca.usis_wr_2016_12_05_c9 bca.usis_wr_2016_12_05_c9 Health care relative valuations are significantly below their post-2008 mean (Chart 10). We will explore the potential for health care as a mania candidate in an upcoming Special Report, but our preliminary work suggests that health care stocks should be on the top of investors' shopping lists. Chart 10Long-Term Value In Health Care Stocks bca.usis_wr_2016_12_05_c10 bca.usis_wr_2016_12_05_c10 Economic Momentum Heating Up? The surprising election results have stolen the financial media's focus away from economic and profit fundamentals in the past few weeks. Admittedly, investors who were focused on the elections did not miss much: the overall picture of economic growth has not changed in recent weeks. Indeed, the Fed's Beige Book of anecdotes on the state of the U.S. economy, released last week, indicates that growth remains mediocre, although sufficient enough for the Fed to raise rates later this month. Nevertheless, we have been monitoring consumer and business confidence closely, as we believe that this will be a key gauge to the likelihood that a more virtuous economic cycle is underway. There is some improvement: Consumer Confidence: A missing ingredient thus far in the recovery has been optimism among households. But that may be finally changing. Surveys of consumer sentiment ticked up markedly in November. As discussed above, this appears mainly to be attributed to better job security as the labor market tightens. If sustained, we view this as a very positive development, since a rising confidence in the outlook allows consumers to take on debt - or at least reduce their savings rate (Chart 6). Business Confidence: Business confidence has mirrored - and even lagged - soggy consumer confidence throughout this cycle. This makes sense, since optimism about a company's future hinges on prospects for demand for its products. In an economy where 70% of GDP is consumption, it is rational that businesses take their cue from consumer sentiment. The most recent ISM manufacturing survey was positive; new orders are rising. Respondent comments were particularly sunny. The bulk of survey responses were collected after the November 8 election and so should be reflective of business attitudes toward the new political administration. Consumer Spending: Black Friday/Cyber Monday sales were reported as lackluster relative to last year, according to the National Retail Federation (NRF). Apparently, about 3 million more shoppers than in 2015 were enticed into stores and onto their computers, but they spent about 3.5% less, while overall sales were down about 1.5% over last year. But the survey also picked up on one of our critical themes: deflation in the retailing sector is still rampant. Price discounting remains a dominant tactic to entice shoppers and over half of the NRF survey respondents reported that deals were "too good to pass up." In real terms, annual consumer spending growth has trended sideways at 2.5%. We see little risk of a slowdown, and in fact as highlighted above, now that consumer confidence has improved, any modest wage gains could lead to an improved spending outlook. All in all, the modest growth backdrop that has characterized the economic recovery since to date is still intact. We are closely watching consumer and business confidence for signs that the economy can or cannot handle the rise in bond yields and dollar: if recent optimism can be maintained, the odds of a more virtuous economic cycle will improve. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 According to Cushman & Wakefield, New York's Upper 5th Avenue had the highest average rents of any shopping street in the world in 2015. A square foot of retail space cost $3,500. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com 3 Please see U.S. Investment Strategy Special Report "The Next Big Thing: How To Profit From Disruptive Innovation," dated March 9, 2015, available at usis.bcaresearch.com