Elections

Highlights Bond yields have room to move higher in the near run, but a move above 2% would represent a buying opportunity. U.S. elections are too close to call. Even if Trump wins, we caution that federal fiscal spending programs will have to work hard to offset the ongoing drag from sluggish state and local spending. Economic and inflation data will not stand in the way of a Fed rate hike in December. But heightened market volatility associated with the elections could still derail their plans. Feature October was a tough month for Treasuries, as the 10-year climbed 25 basis points since October 1. The sell-off puts Treasury yields closely in line with our bond strategists' estimate of fair value. This week, we review the factors that argue for or against a further rise in bond yields. Our conclusion is that the Treasury sell-off is likely to continue in the near run. Yields above 2% would represent a buying opportunity. The primary bearish driver for Treasuries in the next two months is the Fed. As we discuss below, recent economic data has been decent enough to meet the Fed's threshold for a rate hike and inflation indicators are moving towards the Fed's 2% target. Indeed, the FOMC statement released last Wednesday sent a mildly hawkish signal by highlighting that growth has improved, while both inflation expectations and realized inflation are tracking higher. The statement very much keeps a December rate hike in play, but it does not elevate the odds. In the FOMC meeting just prior to last year's rate hike, the Fed specifically mentioned the "next meeting" as a possibility for a rate increase. The Fed did not go as far this time around1 as policymakers are no doubt wary of spooking the markets when uncertainty is running high ahead of the U.S. election. Whether the Fed actually pulls the trigger in December will continue to hinge on the incoming economic data and the behavior of the markets following the election, but our base case remains that the Fed will follow through with a rate hike. The market is currently priced for a 65% chance of a rate move before the end of the year. This is roughly the same as the probability of a 2015 rate hike at this time last year (Chart 1). As long as the economic data remain reasonably firm, as we expect, then rate hike probabilities should follow last year's path and move to 100% by the December 13-14 FOMC meeting. Last year, the revision in the rate hike probability from November-December corresponded with a 35 bps rise in the 10-year Treasury. Chart 1Room For Expectations To Move Higher Room For Expectations To Move Higher Room For Expectations To Move Higher Since last year, the Fed has drastically downgraded its long-term rate projections. Recall that ahead of the December 2015 FOMC meeting, the Fed projected that the Fed funds rate would reach 1.4% in 2016. Since then, the Fed has revised downward its interest rate forecast to two rate hikes in 2017. Assuming the Fed does not revise these forecasts, it is unlikely that Treasuries respond as negatively as they did in 2015. Moreover, as we noted above, at 1.8% today, Treasuries are already roughly at fair value. During last year's sell-off, bond yields were starting from a substantially overbought level. This argues for a somewhat more muted reaction to a Fed rate hike, although we still expect yields could move higher. Beyond December, i.e. once the rate hike is priced in, our base case is that yields trend sideways for a time. The Fed's forecast for growth in 2017 is 2.0%, which would represent an increase of 0.5% from the first three quarters of 2016. If economic growth meets the Fed's expectation of 2%, then it is reasonable to expect that policymakers would increase twice next year, i.e. in line with their current forecasts. As shown in Chart 1, the Treasury market is not yet priced for this outcome: market participants currently assign only 80% odds to one rate hike by the end of 2017. The message is that the Fed, even with a reasonable (for the first time in years!) forecast for growth, will end up being a source of upward pressure on bond yields beyond 2017. There is nonetheless an important mitigating factor for bond yields: the U.S. dollar. A stronger currency represents a tightening of financial conditions that acts to depress expectations of future economic growth. This can spell trouble for risk assets and also lower the market-implied odds of future rate hikes. Indeed, a central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. In the current environment, the Fed knows that the process of normalizing interest rates will trigger bouts of volatility, because its actions will be exaggerated by movements in the currency. The bottom line is that we expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. Given that the bond market is not yet priced for this, the recent sell-off in bond yields will continue, perhaps to as high as 2%. Thereafter, we would expect Treasuries to trade in a fairly narrow range, with 2% representing the higher end of the band. A Coin Toss Election In the very near term, the U.S. elections pose an important risk to the view expressed above. For the past several months, market odds of a Trump Presidency have been positively correlated with the uncertainty index and negatively correlated with Treasury yields (Chart 2 and Chart 3). On the eve of the election, the race is once again too close to call. Our expectation has been that any flight-to-quality related to a Trump victory will be short-lived. However, with equity market multiples stretched and the earnings outlook still leaving much to be desired, equity markets are ripe for a correction. Chart 2Bond Market Tracks Uncertainty Bond Market Tracks Uncertainty Bond Market Tracks Uncertainty Chart 3Trump And Uncertainty bca.usis_wr_2016_11_07_c3 bca.usis_wr_2016_11_07_c3 In our September 26 Weekly Report, we warned that investors may be assigning too low odds of a Trump Presidential win. We posited that if the polls remained tight, the potential for further volatility was high. We followed up in mid-October, advising clients how to implement portfolio insurance against downside market risks, and specifically against a Trump election win. One recommended vehicle for insurance that we highlighted was the U.S. dollar, which is part of our Protector Portfolio (Chart 4 and Chart 5). We believe the currency will rally due to the combination of coming fiscal expansion and risk aversion flows on the back of a Trump win. True, this strategy has not held up in recent days, as the U.S. dollar has softened while Trump improves in the polls and risk assets have corrected. Still, the dollar's reputation as a safe-haven currency is well-deserved. It has consistently outperformed during times of crisis - even when the U.S. itself was the source, as most recently demonstrated during the summer 2011 budget impasse. Chart 4Protector Portfolio Components bca.usis_wr_2016_11_07_c4 bca.usis_wr_2016_11_07_c4 Chart 5Protector Portfolio Returns bca.usis_wr_2016_11_07_c5 bca.usis_wr_2016_11_07_c5 In a recent report,2 our geopolitical strategists outline several things to watch for on November 8, the day of the election, and in its immediate aftermath. The immediate developments most relevant for investors are anything that prolongs the period of uncertainty regarding voting. For example, the 2000 election is a reminder that the results may not be clear immediately. Although the 2000 election was held on November 7, the official result was not declared until November 26; Al Gore did not concede until December 12. This time, any number of things could delay declaring a winner, including a tie in the electoral college, or a "faithless elector," i.e. an electoral college member that does not cast his/her ballot for the candidate chosen by popular vote, and therefore causes the Supreme Court to intervene. A delay in declaring the election result would increase uncertainty and therefore be negative for risk assets. Longer term, the margin of victory has become important for policy. It is now clear that a Clinton win, if it were to happen, will be a narrow one. According to our Geopolitical Strategy team, it is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives are zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. The probability of a compromise between the White House and GOP in Congress is therefore declining and puts in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The likelihood of more fiscal spending in 2017 has become common lore among investors. Thus, a disappointment on that front would be negative for risk assets. Post-Election Government Spending Throughout the twists and turns of the U.S. election campaign, one higher conviction view that has endured at BCA is that popular sentiment is shifting away from fiscal austerity and that 2017 would feature more ambitious spending programs. That would be quite welcome, given that real government consumption and investment - at all levels of government - has been a drag on growth during most of the recovery since the Great Recession. Ongoing weakness at the Federal level is due to restraint in defense expenditure, while state and local spending has been weak due to a significant downtrend in tax revenues. It is notable that the decline in state tax revenues is not confined to oil-producing states. A recent report by the Rockefeller Institute compiled state tax revenue forecasts for 2017 and concludes that the decline in tax revenues from all sources (sales, income and corporate) will be slow to recover next year.3 Remember that states can only spend what they take in outside of infrastructure spending. If state and local governments can manage to cut the drag on real GDP to 0%, that would still leave a major onus for government spending on the federal government. Assuming the contribution to real GDP from state and local spending is zero, it would require a 6% annual growth in federal spending to return total government spending as a contribution to GDP back to its historic average of 0.4% (Chart 6). As Chart 7 shows, fiscal spending of that magnitude rarely occurs outside of recession. Chart 6(Part 1) How Much Fiscal Spending? (Part 1) How Much Fiscal Spending? (Part 1) How Much Fiscal Spending? Chart 7(Part 2) How Much Fiscal Spending? bca.usis_wr_2016_11_07_c7 bca.usis_wr_2016_11_07_c7 Importantly, how much long-term effect a fiscal boost will deliver depends on how well fiscal multipliers - which measure how much a dollar of increased government spending or reduced taxes raises output - are working. Indeed, the magnitude of fiscal multipliers continues to be a massive source of disagreement in policy circles. Recent work by the IMF suggests that the multiplier, in some economies and under certain interest rate settings, could be as high as four: for each dollar the U.S. government spends, it will generate another $4 dollars of GDP!4 Other academics put the fiscal multiplier at less than 0.5. The wide range of forecasts is due to several factors, but there are nonetheless some generally held principles: Fiscal stimulus tends to be more effective when the output gap is large: when output is well below its potential, the monetary policy response to an increase in spending is likely to be limited. In other words, fiscal multipliers are larger in recessions than in expansions.5 The type of fiscal stimulus matters, a lot. Table 1 shows a range of CBO estimates for different types of government activity. For example, income tax cuts on high income earners tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Multiplier effects tend to last no more than eight quarters when output is close to potential. Fiscal stimulus tends to have a more impressive impact, although short-lived (four quarters) when the output gap is large. Table 2 shows the CBO-estimated effect of an increase in demand over eight quarters under two different economic scenarios. The first is when monetary policy is constrained, and the second is when monetary policy responds to the increase in demand from government stimulus. Our guess is that we are currently somewhere in between the two economic scenarios presented: there is still an output gap and monetary policy is already off the zero bound. Thus, the fiscal multiplier is likely a little above than one, meaning that government spending does not "crowd out" private spending. Table 1Ranges For U.S. Fiscal Multipliers Policy, Polls, Probability Policy, Polls, Probability Table 2The Effect Of A $1 Increase In Aggregate Demand Over Eight Quarters Policy, Polls, Probability Policy, Polls, Probability Overall, government expenditures will contribute positively to GDP next year, though the amount of fiscal expansion is dependent on the political configuration in Washington after the elections. Similarly, the impact of any spending will depend on what form new fiscal measures takes. CBO research suggests that the fiscal multiplier will be slightly above 1. Business Sentiment: Neither Euphoria Nor Misery Without further participation from the government sector, the economy is likely to achieve above 2% real GDP growth. A more optimistic scenario could unfold if capex improves substantially and/or a Trump win significantly opens the fiscal taps. Recent private sector data shows that businesses are continuing on a mild expansion path. The ISM surveys of business confidence were little changed in October - sentiment among manufacturers is broadly unchanged, while respondents from the service sector were slightly less optimistic than the previous month (Chart 8). Still, the major indices remain above their boom/bust lines and respondents' comments suggest neither euphoria nor misery. Meanwhile, payrolls increased by 161,000 in October. Although this was slightly below the consensus forecast of 175,000, there was a cumulative 44,000 in upward revisions to the prior two months. Elsewhere, wages accelerated more than expected and average hourly earnings rose 0.4% m/m, pushing the annual growth rate to a new cyclical high of 2.8% (Chart 9). Chart 8ISM Surveys Are Steady bca.usis_wr_2016_11_07_c8 bca.usis_wr_2016_11_07_c8 Chart 9Wage Growth Is Perking Up bca.usis_wr_2016_11_07_c9 bca.usis_wr_2016_11_07_c9 To paraphrase from this week's FOMC statement, the employment report provides some further evidence that the U.S. economy is progressing towards the Fed's dual mandate. In itself, it reinforces the case for the Fed raise interest rates in December. It seems now that the only thing that could derail the Fed is an election surprise and related heightened market volatility. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/press/monetary/20151028a.htm 2 Please see Geopolitical Strategy Special Report "It Ain't Over 'Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com 3 http://www.rockinst.org/pdf/government_finance/state_revenue_report/2016-09-21-SRR_104_final.pdf 4 https://www.imf.org/external/pubs/ft/wp/2014/wp1493.pdf 5 "How Powerful Are Fiscal Multipliers In Recessions? Alan Auerbach and Yuriy Gorodnichenko, NBER Reporter 2015, http://www.nber.org/reporter/2015number2/auerbach.html

Highlights The U.S. presidential election is now too close to call. Hillary Clinton has a 61.6% chance of winning, according to our quant model. But Trump's real chances are approaching 50%, given momentum. Trump still trails in Virginia and Colorado, the two key swing states. A narrow Clinton win revives the fear of gridlock with a GOP-controlled House. Hedge against Trump by going long USD/SEK, long biotech stocks / short S&P 500 exporters, and long U.S. Treasurys. Feature After penning our latest missive on the U.S. election, "You've Been Trumped!" for our sister publication the Global Investment Strategy, a client complained that giving Trump 34.5% probability of winning the election was "laughable."1 To be fair to the client, our odds of a Trump victory were on average three times higher than that of other quantitative models.2 BCA's Geopolitical Strategy is not a stranger to receiving hate mail. Nor are we strangers to giving higher odds than the consensus to unexpected political events (see: Brexit).3 Since our October 21 report, Trump has narrowed Clinton's lead in the polls from 6.2% to 2.2%. Chart 1 shows that polls are retreating into their now-familiar oscillating pattern. In addition, FBI Director James Comey disclosed to Congress on October 28 that the law enforcement agency was reopening its investigation into Clinton's email practices while secretary of state. Chart 1Trump As The 'Comeback Kid' It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Needless to say, we are quite comfortable with the 38.4% Trump odds that our "polls-plus" model is forecasting.4 The reason it gives Trump such strong odds is because we do not only rely on the polls to make our forecast. Polls are a (poor) snapshot of reality, but predicting the future is about more than just "traveling with events." Forecasting requires a strong net assessment of structural factors through which one filters the incoming data, whether they be new polls or "October surprises." In this note, we revisit our quantitative model, review our qualitative "White Hype" model, and update our forecast. We suggest that clients hedge for a Trump victory. Quant Model: Trump Remains A Strong Candidate Our net assessment remains that this election is a much closer affair than the media narrative would have it. The FBI revelation is only important because it highlights that Hillary Clinton is a structurally weak candidate who is susceptible to "October surprises." This is best exemplified by Chart 2, which we have repeatedly published and shown to clients in meetings. It is simply difficult to take polls seriously when they are asking voters to choose between a "fire" and a "frying pan." Chart 2Clinton And Trump: The Least Charismatic Candidates Ever It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings To be clear, Secretary Clinton has several structural advantages: The Democratic party has a strong Electoral College lead over the GOP, a lead that Donald Trump has to overcome by winning a slew of large states that Mitt Romney lost in 2012; Hillary Clinton is polling well with minorities and women, both constituencies that preferred her to Bernie Sanders in the Democratic primary; Clinton is not a five-year-old trapped in the body of a 70-year-old. On the other hand, the "plus" in our polls-plus model reveals some structural weakness in the Clinton campaign: Two-Term Curse: It is notoriously very difficult for the incumbent party to retain the presidency after a successful multiple-turn run. Since the start of the twentieth century, this has happened only four times: William Taft (1908), Herbert Hoover (1928), Harry S. Truman (1948), and George H. W. Bush (1988). Only the last two examples are relevant in the modern context, and they happened in the wake of the monumentally popular presidencies of FDR and Ronald Reagan.5 We code for this factor in our model. Third Party: Our model also accounts for the presence of prominent third party candidates. At face value, this ought to hurt both Hillary Clinton and Donald Trump equally. However, Libertarian Gary Johnson has seen a dramatic drop in support, from nearly 10% in September to roughly just 5% today. The expanding correlation between Trump and Johnson's polling breaks negative in mid-October, suggesting that some Johnson fans are jumping the Mary Jane bus and getting on the Trump bandwagon (Chart 3). Meanwhile, Stein continues to take approximately 2% of the vote away from Clinton, which could make a difference in a close election in key swing states. Obama: Finally, we also code for the incumbent president's approval rating. While Obama's 52.5% is a solid number, it is not an "out of the ballpark" figure. Bill Clinton held a 58% approval rating in October 2000 as did Dwight Eisenhower in October 1960. Both saw their anointed successors lose in extremely tight races. Our model also relies on voting patterns and economic variables to "correct" the polling numbers for political cycles. First, we use each state's previous election results, going back to 1980, to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. In addition to the actual election data, we constructed two dichotomous variables to account for voter polarization and the presence of a strong third party. These structural forces favor the Republican challenger. Second, we use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Since the economy has definitely seen improvement in the last four years of Obama's presidency, the data give the edge to the Democrats. Chart 3Third-Party Voters##br## Shifting To Trump bca.gps_sr_2016_11_01_c3 bca.gps_sr_2016_11_01_c3 Table 1Probabilities Of Victory:##br## GPS Polls-Plus Model It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Our model gives 60% weight to the probabilities derived from state polling and 40% to our structural econometric model. At the moment, the model is giving Clinton a 61.6% chance of winning the election (Table 1). Chart 4 shows that Clinton has 260 electoral votes in states where she has more than a 70% chance of winning. These are strong figures for Clinton, but they still give Trump around 38.4% chance of winning the election. We think it is closer to 50% and we discuss below why. Chart 42016 U.S. Presidential Election: GPS Polls-Plus Model Full Results It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: Given our quantitative model, we give Clinton a very slight edge to win the election. But the actual election is likely too close to call at this point. As we pointed out in our latest missive, a 3% lead in the polls for Clinton would not be enough to give us any confidence in our forecast due to the potential for polls to underappreciate Trump's support. Are Polls Wrong? The risk that polls are "wrong" remains considerable. Voters could be lying about supporting Trump because of various social stigmas related to it. For that reason, we suspect that any Clinton lead of less than 3% turns this election into "too close to call" and any lead of less than 5% leaves us with only a "low conviction" view that Clinton will win. We did not pick these numbers randomly; recent U.S. elections reveal that polls can miss results by as much as 3% (Chart 5). Our concern about the quality of polling is not random. It is informed by three factors: Undecideds: At this point in the election cycle, one would expect only 6% of voters to remain undecideds. However, this year, that figure stands at 9% (Chart 6). Now, this is likely because both candidates are deeply unfavorable, as Chart 2 illustrates. However, it could be because many voters are responding to pollsters with the "undecided" answer instead of saying that they support the controversial and politically incorrect candidate Donald Trump. In other words, the large number of undecideds could be where the "shy Trump voters" are hiding and ought to worry Clinton supporters a lot. Chart 5Election Polls Usually Miss By A Few Points It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Chart 6More Undecided Voters This Time Around bca.gps_sr_2016_11_01_c6 bca.gps_sr_2016_11_01_c6 Libertarian Collapse: Our theory about the undecideds could already be playing out with the Johnson voters. As we pointed out above, Johnson's support has halved in just one month. Most of his support appears to have gone to Donald Trump, but some could be bolstering Clinton's support levels in the "Mountain West" states of Colorado and New Mexico. Johnson's support may be inflated by voters who are embarrassed to say that they support Trump yet may end up voting for him. Poll Oscillation: We modified Chart 1 into Chart 7 by adding some "chart chat" to indicate when Trump made controversial - read: stupid - comments about Hispanics, Muslims, or women, which prompted a huge outcry from the media and society in general. Each event caused Trump's support to fall by an average of 4.9% from peak to trough. What would have happened to his polls had he not made such comments? Or, in other words, what is the true Trump support trajectory ex-controversial comments? Thus Chart 7 shows our back-of-the-envelope "technical" analysis of Trump's support. The reason polls are constantly oscillating may be that, with each egregious comment, Trump's real fans become "shy fans" and decline to select him during polling. But his true level of support may be very much on par with Hillary Clinton. Chart 7Trump's Surprising Resilience It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: There is some anecdotal evidence that Trump's support is underestimated by the polls. Hillary Clinton has to carry a +3% lead in the polls on November 8 for us to have any confidence in our quantitative model's predictions that she is indeed the favorite to win. This is no longer the case. Qualitative Model: "White Hype" Is Still Not Enough Our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one.6 Our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, did so as early as September of last year.7 Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states. We also pointed out that getting a 5.7% swing in Iowa could be feasible. Chart 8 shows the result of our qualitative work on the White Hype model. It illustrates that while Florida and Ohio are well within Trump's grasp, Michigan, Pennsylvania and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. Chart 8Trump Needs X Percent Of White Voters To Switch To The GOP It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We used the figures from Chart 8 to create Trump's "ideal Electoral College map." Map 1 shows how our White Hype model grafts onto the Electoral College. Even if we give Trump Ohio, Florida, Iowa, and North Carolina (the latter because Mitt Romney won it in 2012), Trump still needs 11 Electoral College votes to win the election. Map 1Trump's Ideal Electoral College Map It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Where could he get those 11 votes? The answer is Virginia (13) or a combination of Colorado (9) and either Nevada (6) or New Hampshire (4). In other words, Virginia and Colorado are critical to Trump's chances of winning the election and he remains behind Clinton by 5.2% and 4% in the two respectively. In addition, while Trump has narrowed his lead on Clinton nationally, we have only noticed significant narrowing of the state polls in Florida, Ohio, Nevada, New Hampshire, and Michigan. In Michigan and New Hampshire, however, Clinton's lead remains 6.3% and 5.6%. Meanwhile, the narrowing has been either minor or non-existent in Colorado, Maine, Minnesota, Pennsylvania, Virginia, and Wisconsin (Chart 9). In each of these states, Clinton's lead is either around or above 5%. Unless the FBI investigation or some other surprise changes the dynamic, Trump's recent rally appears to be concentrated in states that are either GOP strongholds, are predicted to go to Trump by our "White Hype" model in Map 1, or are out of his reach anyway (like Michigan). Chart 9Trump's Comeback In The Swing States It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: State-by-state analysis of the polls shows that our White Hype model remains a cogent guide for this election. Trump can win both Ohio and Florida and he may still lose the election. This is because his White Hype electoral strategy works in those two critical states, but appears insufficient to overcome the Democrat advantage in white voters in the Midwest (Michigan, Pennsylvania, and Wisconsin). Ultimately, we stick to our call from March: this election will come down to Virginia and Colorado, two states where Clinton's lead remains 5.2% and 4% respectively. That said, Trump has momentum nationally and in swing states. Investment Implications: Hedging A Trump Victory Our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy pointed out in September 30 missive that volatility typically spikes in October of each U.S. presidential election.8 Charts 10 and 11, as well as Table 2, summarize the findings of his research that looked at the last seven presidential cycles going back to 1988. We agree and suspect that this year's election could see even more volatility in November given the narrowing in the polls and the ongoing FBI investigation into Clinton's email scandal. Chart 10October Surprises The Markets, 1988-96 bca.gps_sr_2016_11_01_c10 bca.gps_sr_2016_11_01_c10 Chart 11October Surprises The Markets, 2000-12 bca.gps_sr_2016_11_01_c11 bca.gps_sr_2016_11_01_c11 Table 2VIX Spikes The Month Before The U.S. Election It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We recommend that our clients read Anastasios research first, and then put on his volatility hedge by buying a VIX 20-25 bullish call spread for November 16th expiry (capturing the election result), and to sell a 13 strike November 16th VIX put in order to bring down the cash outflow. The total cost for this hedge is $0.80/contract with a maximum gain capped at $5/contract, as of intra-day trading at the time of writing November 1. There is downside risk with selling the put option, but Anastasios points out that the VIX is unlikely to fall below 10, thus the risk to the downside is losing the $0.80/contract plus $2.68/contract assuming the VIX collapses to the 2014 closing low. In addition, we would hedge for a Trump victory by initiating the following trades: Currencies: Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, recommends that we hedge a Trump win via a long USD/SEK trade. As our colleague Peter Berezin has posited before, the USD will rally if Trump wins due to the combination of coming fiscal expansion and risk aversion flows.9 Meanwhile, SEK would be hurt due to the realization by investors that globalization is at an end, given that Sweden is a small, highly open, economy. Trump's trade policies will be a nail in the coffin of globalization, proving our "Apex of Globalization" theme.10 Additionally, investors may want to do the obvious and short "NAFTA currencies" versus the USD. Sectors: Our favorite way to hedge a Trump victory via U.S. sectors would be to go long biotech / short S&P 500 exporters.11 Biotech would rally on the news that the risk of Clinton's regulatory action against pharmaceutical industry has dissipated. Meanwhile, major U.S. multinational exporters would be hurt by the twin effects of USD's likely appreciation and our "Apex of Globalization" theme, which would be supercharged following a Trump victory. Clients could alter this hedge by replacing biotech with financials, given that a Trump victory would allay investors' fears of further regulation against the financial industry. Fixed Income: BCA's U.S. Bond Strategy strategist, Ryan Swift, believes that a simple "buy-Treasurys" hedge is the best way to deal with the risk-off of a Trump presidency. A more long-term idea would be to underweight municipal bonds in a bond portfolio. A Trump tax-cutting administration would de-value the tax advantage in municipal bonds.12 Another hedge - this one courtesy of Rob Robis, Chief Strategist of BCA's Global Fixed Income Strategy - may be to consider a 2-year/30-year Treasury curve steepener. If the USD were to appreciate following a Trump victory, the Fed may think twice about a December rate hike, especially if the stock market sells off at the same time. The front end of the Treasury curve would rally in that environment. Meanwhile, the long end may react to the prospect of big deficit-financed fiscal expansion that Trump has promised, thus steepening the curve. The initial risk-off move after a Trump win may push the entire yield curve lower, but the bond market may quickly begin to price in the potential medium-term fiscal ramifications of a Trump presidency. What To Watch For On November 8? There are three things investors should watch on November 8, the day of the election, and in its immediate aftermath: Final results: In 2012, the statistical result was projected by the news networks around 11:30pm EST Nov. 6, according to the New York Times. Romney's concession speech occurred just after midnight on November 7. In the 2008 election, the result was projected by CNN as early as 7pm EST on election day (November 4), but that was due to the fact that the Obama win over Senator John McCain was a landslide. Obviously the 2000 election is a reminder that the results may not be clear immediately. The result in Florida was announced by 8pm EST on election day in favor of Gore, but the counting in the wee hours of the morning favored Bush. Gore conceded privately to Bush, then the tally went back to Gore, who withdrew his concession, and finally Bush was given the final tally several days later. The official result was not declared until November 26; Gore did not concede until December 12. The electoral college will vote on December 19, so states will have to resolve any recounts or disputes by December 13. Congress counts and certifies the result on January 6. Margin of victory: It is now clear that a Clinton win, if it were to happen, will be a narrow one. It is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives is at zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow Clinton win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. On top of the numbers, she will clearly have to deal with an unprecedented amount of investigations while in office. The chances of a compromise between the White House and GOP in Congress is therefore declining. Our "best-case scenario" of a Clinton-Paul Ryan compromise is therefore also very low. This will put in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The gridlock that will emerge from Congress under a Clinton presidency may, therefore, not be so sanguine after all. A Tie? What happens if the Electoral College vote is tied, or if by a fluke neither candidate wins a majority? There is a non-negligible probability that both Trump and Clinton could end up with 269 votes - i.e. one vote short of the 270 absolute majority required to win the White House. After all, Al Gore lost the 2000 election by only five electoral votes. How is the U.S. president chosen in that case? The House of Representatives convenes, allots one vote to each state (whose representatives must decide among themselves), and chooses the next president by a majority of the states. The presidential candidates in this case would be chosen from the top three recipients of electoral college votes.13 Here is the kicker: the vice-president would be chosen by the Senate from the top two candidates, meaning that Trump or Clinton would serve as the other's vice-president! Given the Republican majority in the House and among the states, Trump would likely prevail as president with 66% of the House vote, leaving Clinton to become vice-president. The United States would finally do what should always be done with squabbling children - force them to play on the same team! Faithless Electors: Another possibility is that an Electoral College member or "elector" could refuse to cast his or her ballot for the candidate chosen by popular vote in that elector's state. Electors are chosen by the political parties and are presumed to be staunch loyalists, but sometimes they deviate or make mistakes. Hardly more than half the states have passed laws to prevent or punish these so-called "faithless electors." No such elector has ever changed the outcome of a presidential race, but in an extremely tight race, abstentions, mistakes, or conscientious objection in the Electoral College could occur. The Supreme Court would have to settle any ensuing challenges, and would normally be expected to reassert the elector's independence to vote for any eligible candidate. Of course, the Supreme Court is currently undermanned at eight justices. If they were to split along ideological lines, any constitutional issues emanating from this election would remain gridlocked for a time, which would be a period of extreme uncertainty. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com David Boucher, Editor/Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "You've Been Trumped!" dated October 21, 2016, available at gps.bcaresearch.com. 2 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 31, 2016, available at fivethirtyeight.com. 3 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Of the four examples, only Bush Sr. in 1988 and Truman in 1948 are really relevant today. First, the Theodore Roosevelt transition to William Taft happened more than 100 years ago. Second, Hoover took over from eight years of Republican rule when the economy was at a peak, which is hard to compare with the post-financial crisis environments after 1929 and 2008. Thus the only relevant victories for the incumbent party following a multi-term presidency occurred after the reigns of two iconic presidents: Ronald Reagan and Frank D. Roosevelt, two of the greatest American presidents. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 8 Please see BCA's Global Alpha Sector Strategy Weekly Report, "Quarterly Review And Outlook," dated September 30, 2016, available at gss.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 11 The S&P 500 globally-exposed industry groups index is derived by BCA's U.S. Equity Strategy. 12 Please see BCA U.S. Bond Strategy, "Trading The Municipal Credit Cycle," dated October 18, 2016, available at usbs.bcaresearch.com. 13 Technically, then, Libertarian candidate Gary Johnson, the likeliest third-place candidate, would be eligible to become president under the House of Representative vote. Politically, however, it would be nearly impossible to orchestrate. The deadline for the House to decide this "contingent election" would be January 20, at which point the vice-president, elected by the Senate, would serve as acting president until the House resolved the issue. If the House and Senate have not chosen a president and vice-president by January 20, a new law must be passed to decide the outcome. Oh the humanity! Please see BCA Geopolitical Strategy Special Report, "U.S. Election Primer: Let's Get Ready To Truuuumble," dated February 29, 2016, available at gps.bcaresearch.com.

Highlights The U.S. presidential election is now too close to call. Hillary Clinton has a 61.6% chance of winning, according to our quant model. But Trump's real chances are approaching 50%, given momentum. Trump still trails in Virginia and Colorado, the two key swing states. A narrow Clinton win revives the fear of gridlock with a GOP-controlled House. Hedge against Trump by going long USD/SEK, long biotech stocks / short S&P 500 exporters, and long U.S. Treasurys. Feature After penning our latest missive on the U.S. election, "You've Been Trumped!" for our sister publication the Global Investment Strategy, a client complained that giving Trump 34.5% probability of winning the election was "laughable."1 To be fair to the client, our odds of a Trump victory were on average three times higher than that of other quantitative models.2 BCA's Geopolitical Strategy is not a stranger to receiving hate mail. Nor are we strangers to giving higher odds than the consensus to unexpected political events (see: Brexit).3 Since our October 21 report, Trump has narrowed Clinton's lead in the polls from 6.2% to 2.2%. Chart 1 shows that polls are retreating into their now-familiar oscillating pattern. In addition, FBI Director James Comey disclosed to Congress on October 28 that the law enforcement agency was reopening its investigation into Clinton's email practices while secretary of state. Chart 1Trump As The 'Comeback Kid' It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Needless to say, we are quite comfortable with the 38.4% Trump odds that our "polls-plus" model is forecasting.4 The reason it gives Trump such strong odds is because we do not only rely on the polls to make our forecast. Polls are a (poor) snapshot of reality, but predicting the future is about more than just "traveling with events." Forecasting requires a strong net assessment of structural factors through which one filters the incoming data, whether they be new polls or "October surprises." In this note, we revisit our quantitative model, review our qualitative "White Hype" model, and update our forecast. We suggest that clients hedge for a Trump victory. Quant Model: Trump Remains A Strong Candidate Our net assessment remains that this election is a much closer affair than the media narrative would have it. The FBI revelation is only important because it highlights that Hillary Clinton is a structurally weak candidate who is susceptible to "October surprises." This is best exemplified by Chart 2, which we have repeatedly published and shown to clients in meetings. It is simply difficult to take polls seriously when they are asking voters to choose between a "fire" and a "frying pan." Chart 2Clinton And Trump: The Least Charismatic Candidates Ever It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings To be clear, Secretary Clinton has several structural advantages: The Democratic party has a strong Electoral College lead over the GOP, a lead that Donald Trump has to overcome by winning a slew of large states that Mitt Romney lost in 2012; Hillary Clinton is polling well with minorities and women, both constituencies that preferred her to Bernie Sanders in the Democratic primary; Clinton is not a five-year-old trapped in the body of a 70-year-old. On the other hand, the "plus" in our polls-plus model reveals some structural weakness in the Clinton campaign: Two-Term Curse: It is notoriously very difficult for the incumbent party to retain the presidency after a successful multiple-turn run. Since the start of the twentieth century, this has happened only four times: William Taft (1908), Herbert Hoover (1928), Harry S. Truman (1948), and George H. W. Bush (1988). Only the last two examples are relevant in the modern context, and they happened in the wake of the monumentally popular presidencies of FDR and Ronald Reagan.5 We code for this factor in our model. Third Party: Our model also accounts for the presence of prominent third party candidates. At face value, this ought to hurt both Hillary Clinton and Donald Trump equally. However, Libertarian Gary Johnson has seen a dramatic drop in support, from nearly 10% in September to roughly just 5% today. The expanding correlation between Trump and Johnson's polling breaks negative in mid-October, suggesting that some Johnson fans are jumping the Mary Jane bus and getting on the Trump bandwagon (Chart 3). Meanwhile, Stein continues to take approximately 2% of the vote away from Clinton, which could make a difference in a close election in key swing states. Obama: Finally, we also code for the incumbent president's approval rating. While Obama's 52.5% is a solid number, it is not an "out of the ballpark" figure. Bill Clinton held a 58% approval rating in October 2000 as did Dwight Eisenhower in October 1960. Both saw their anointed successors lose in extremely tight races. Our model also relies on voting patterns and economic variables to "correct" the polling numbers for political cycles. First, we use each state's previous election results, going back to 1980, to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. In addition to the actual election data, we constructed two dichotomous variables to account for voter polarization and the presence of a strong third party. These structural forces favor the Republican challenger. Second, we use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Since the economy has definitely seen improvement in the last four years of Obama's presidency, the data give the edge to the Democrats. Chart 3Third-Party Voters##br## Shifting To Trump bca.gps_sr_2016_11_01_c3 bca.gps_sr_2016_11_01_c3 Table 1Probabilities Of Victory:##br## GPS Polls-Plus Model It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Our model gives 60% weight to the probabilities derived from state polling and 40% to our structural econometric model. At the moment, the model is giving Clinton a 61.6% chance of winning the election (Table 1). Chart 4 shows that Clinton has 260 electoral votes in states where she has more than a 70% chance of winning. These are strong figures for Clinton, but they still give Trump around 38.4% chance of winning the election. We think it is closer to 50% and we discuss below why. Chart 42016 U.S. Presidential Election: GPS Polls-Plus Model Full Results It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: Given our quantitative model, we give Clinton a very slight edge to win the election. But the actual election is likely too close to call at this point. As we pointed out in our latest missive, a 3% lead in the polls for Clinton would not be enough to give us any confidence in our forecast due to the potential for polls to underappreciate Trump's support. Are Polls Wrong? The risk that polls are "wrong" remains considerable. Voters could be lying about supporting Trump because of various social stigmas related to it. For that reason, we suspect that any Clinton lead of less than 3% turns this election into "too close to call" and any lead of less than 5% leaves us with only a "low conviction" view that Clinton will win. We did not pick these numbers randomly; recent U.S. elections reveal that polls can miss results by as much as 3% (Chart 5). Our concern about the quality of polling is not random. It is informed by three factors: Undecideds: At this point in the election cycle, one would expect only 6% of voters to remain undecideds. However, this year, that figure stands at 9% (Chart 6). Now, this is likely because both candidates are deeply unfavorable, as Chart 2 illustrates. However, it could be because many voters are responding to pollsters with the "undecided" answer instead of saying that they support the controversial and politically incorrect candidate Donald Trump. In other words, the large number of undecideds could be where the "shy Trump voters" are hiding and ought to worry Clinton supporters a lot. Chart 5Election Polls Usually Miss By A Few Points It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Chart 6More Undecided Voters This Time Around bca.gps_sr_2016_11_01_c6 bca.gps_sr_2016_11_01_c6 Libertarian Collapse: Our theory about the undecideds could already be playing out with the Johnson voters. As we pointed out above, Johnson's support has halved in just one month. Most of his support appears to have gone to Donald Trump, but some could be bolstering Clinton's support levels in the "Mountain West" states of Colorado and New Mexico. Johnson's support may be inflated by voters who are embarrassed to say that they support Trump yet may end up voting for him. Poll Oscillation: We modified Chart 1 into Chart 7 by adding some "chart chat" to indicate when Trump made controversial - read: stupid - comments about Hispanics, Muslims, or women, which prompted a huge outcry from the media and society in general. Each event caused Trump's support to fall by an average of 4.9% from peak to trough. What would have happened to his polls had he not made such comments? Or, in other words, what is the true Trump support trajectory ex-controversial comments? Thus Chart 7 shows our back-of-the-envelope "technical" analysis of Trump's support. The reason polls are constantly oscillating may be that, with each egregious comment, Trump's real fans become "shy fans" and decline to select him during polling. But his true level of support may be very much on par with Hillary Clinton. Chart 7Trump's Surprising Resilience It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: There is some anecdotal evidence that Trump's support is underestimated by the polls. Hillary Clinton has to carry a +3% lead in the polls on November 8 for us to have any confidence in our quantitative model's predictions that she is indeed the favorite to win. This is no longer the case. Qualitative Model: "White Hype" Is Still Not Enough Our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one.6 Our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, did so as early as September of last year.7 Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states. We also pointed out that getting a 5.7% swing in Iowa could be feasible. Chart 8 shows the result of our qualitative work on the White Hype model. It illustrates that while Florida and Ohio are well within Trump's grasp, Michigan, Pennsylvania and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. Chart 8Trump Needs X Percent Of White Voters To Switch To The GOP It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We used the figures from Chart 8 to create Trump's "ideal Electoral College map." Map 1 shows how our White Hype model grafts onto the Electoral College. Even if we give Trump Ohio, Florida, Iowa, and North Carolina (the latter because Mitt Romney won it in 2012), Trump still needs 11 Electoral College votes to win the election. Map 1Trump's Ideal Electoral College Map It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Where could he get those 11 votes? The answer is Virginia (13) or a combination of Colorado (9) and either Nevada (6) or New Hampshire (4). In other words, Virginia and Colorado are critical to Trump's chances of winning the election and he remains behind Clinton by 5.2% and 4% in the two respectively. In addition, while Trump has narrowed his lead on Clinton nationally, we have only noticed significant narrowing of the state polls in Florida, Ohio, Nevada, New Hampshire, and Michigan. In Michigan and New Hampshire, however, Clinton's lead remains 6.3% and 5.6%. Meanwhile, the narrowing has been either minor or non-existent in Colorado, Maine, Minnesota, Pennsylvania, Virginia, and Wisconsin (Chart 9). In each of these states, Clinton's lead is either around or above 5%. Unless the FBI investigation or some other surprise changes the dynamic, Trump's recent rally appears to be concentrated in states that are either GOP strongholds, are predicted to go to Trump by our "White Hype" model in Map 1, or are out of his reach anyway (like Michigan). Chart 9Trump's Comeback In The Swing States It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings Bottom Line: State-by-state analysis of the polls shows that our White Hype model remains a cogent guide for this election. Trump can win both Ohio and Florida and he may still lose the election. This is because his White Hype electoral strategy works in those two critical states, but appears insufficient to overcome the Democrat advantage in white voters in the Midwest (Michigan, Pennsylvania, and Wisconsin). Ultimately, we stick to our call from March: this election will come down to Virginia and Colorado, two states where Clinton's lead remains 5.2% and 4% respectively. That said, Trump has momentum nationally and in swing states. Investment Implications: Hedging A Trump Victory Our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy pointed out in September 30 missive that volatility typically spikes in October of each U.S. presidential election.8 Charts 10 and 11, as well as Table 2, summarize the findings of his research that looked at the last seven presidential cycles going back to 1988. We agree and suspect that this year's election could see even more volatility in November given the narrowing in the polls and the ongoing FBI investigation into Clinton's email scandal. Chart 10October Surprises The Markets, 1988-96 bca.gps_sr_2016_11_01_c10 bca.gps_sr_2016_11_01_c10 Chart 11October Surprises The Markets, 2000-12 bca.gps_sr_2016_11_01_c11 bca.gps_sr_2016_11_01_c11 Table 2VIX Spikes The Month Before The U.S. Election It Ain't Over Till The Fat Man Sings It Ain't Over Till The Fat Man Sings We recommend that our clients read Anastasios research first, and then put on his volatility hedge by buying a VIX 20-25 bullish call spread for November 16th expiry (capturing the election result), and to sell a 13 strike November 16th VIX put in order to bring down the cash outflow. The total cost for this hedge is $0.80/contract with a maximum gain capped at $5/contract, as of intra-day trading at the time of writing November 1. There is downside risk with selling the put option, but Anastasios points out that the VIX is unlikely to fall below 10, thus the risk to the downside is losing the $0.80/contract plus $2.68/contract assuming the VIX collapses to the 2014 closing low. In addition, we would hedge for a Trump victory by initiating the following trades: Currencies: Mathieu Savary, Chief Strategist of BCA's Foreign Exchange Strategy, recommends that we hedge a Trump win via a long USD/SEK trade. As our colleague Peter Berezin has posited before, the USD will rally if Trump wins due to the combination of coming fiscal expansion and risk aversion flows.9 Meanwhile, SEK would be hurt due to the realization by investors that globalization is at an end, given that Sweden is a small, highly open, economy. Trump's trade policies will be a nail in the coffin of globalization, proving our "Apex of Globalization" theme.10 Additionally, investors may want to do the obvious and short "NAFTA currencies" versus the USD. Sectors: Our favorite way to hedge a Trump victory via U.S. sectors would be to go long biotech / short S&P 500 exporters.11 Biotech would rally on the news that the risk of Clinton's regulatory action against pharmaceutical industry has dissipated. Meanwhile, major U.S. multinational exporters would be hurt by the twin effects of USD's likely appreciation and our "Apex of Globalization" theme, which would be supercharged following a Trump victory. Clients could alter this hedge by replacing biotech with financials, given that a Trump victory would allay investors' fears of further regulation against the financial industry. Fixed Income: BCA's U.S. Bond Strategy strategist, Ryan Swift, believes that a simple "buy-Treasurys" hedge is the best way to deal with the risk-off of a Trump presidency. A more long-term idea would be to underweight municipal bonds in a bond portfolio. A Trump tax-cutting administration would de-value the tax advantage in municipal bonds.12 Another hedge - this one courtesy of Rob Robis, Chief Strategist of BCA's Global Fixed Income Strategy - may be to consider a 2-year/30-year Treasury curve steepener. If the USD were to appreciate following a Trump victory, the Fed may think twice about a December rate hike, especially if the stock market sells off at the same time. The front end of the Treasury curve would rally in that environment. Meanwhile, the long end may react to the prospect of big deficit-financed fiscal expansion that Trump has promised, thus steepening the curve. The initial risk-off move after a Trump win may push the entire yield curve lower, but the bond market may quickly begin to price in the potential medium-term fiscal ramifications of a Trump presidency. What To Watch For On November 8? There are three things investors should watch on November 8, the day of the election, and in its immediate aftermath: Final results: In 2012, the statistical result was projected by the news networks around 11:30pm EST Nov. 6, according to the New York Times. Romney's concession speech occurred just after midnight on November 7. In the 2008 election, the result was projected by CNN as early as 7pm EST on election day (November 4), but that was due to the fact that the Obama win over Senator John McCain was a landslide. Obviously the 2000 election is a reminder that the results may not be clear immediately. The result in Florida was announced by 8pm EST on election day in favor of Gore, but the counting in the wee hours of the morning favored Bush. Gore conceded privately to Bush, then the tally went back to Gore, who withdrew his concession, and finally Bush was given the final tally several days later. The official result was not declared until November 26; Gore did not concede until December 12. The electoral college will vote on December 19, so states will have to resolve any recounts or disputes by December 13. Congress counts and certifies the result on January 6. Margin of victory: It is now clear that a Clinton win, if it were to happen, will be a narrow one. It is almost guaranteed at this point that the chances of a Democratic sweep in the House of Representatives is at zero. This is a positive development for the market as a Democratic sweep would mean a slew of anti-business regulation out of Congress. Nonetheless, a narrow Clinton win - with sub-50% of the vote - would give Hillary Clinton an extremely weak mandate. On top of the numbers, she will clearly have to deal with an unprecedented amount of investigations while in office. The chances of a compromise between the White House and GOP in Congress is therefore declining. Our "best-case scenario" of a Clinton-Paul Ryan compromise is therefore also very low. This will put in jeopardy any possibility of modest fiscal stimulus under a Clinton White House, or of corporate tax reforms. The gridlock that will emerge from Congress under a Clinton presidency may, therefore, not be so sanguine after all. A Tie? What happens if the Electoral College vote is tied, or if by a fluke neither candidate wins a majority? There is a non-negligible probability that both Trump and Clinton could end up with 269 votes - i.e. one vote short of the 270 absolute majority required to win the White House. After all, Al Gore lost the 2000 election by only five electoral votes. How is the U.S. president chosen in that case? The House of Representatives convenes, allots one vote to each state (whose representatives must decide among themselves), and chooses the next president by a majority of the states. The presidential candidates in this case would be chosen from the top three recipients of electoral college votes.13 Here is the kicker: the vice-president would be chosen by the Senate from the top two candidates, meaning that Trump or Clinton would serve as the other's vice-president! Given the Republican majority in the House and among the states, Trump would likely prevail as president with 66% of the House vote, leaving Clinton to become vice-president. The United States would finally do what should always be done with squabbling children - force them to play on the same team! Faithless Electors: Another possibility is that an Electoral College member or "elector" could refuse to cast his or her ballot for the candidate chosen by popular vote in that elector's state. Electors are chosen by the political parties and are presumed to be staunch loyalists, but sometimes they deviate or make mistakes. Hardly more than half the states have passed laws to prevent or punish these so-called "faithless electors." No such elector has ever changed the outcome of a presidential race, but in an extremely tight race, abstentions, mistakes, or conscientious objection in the Electoral College could occur. The Supreme Court would have to settle any ensuing challenges, and would normally be expected to reassert the elector's independence to vote for any eligible candidate. Of course, the Supreme Court is currently undermanned at eight justices. If they were to split along ideological lines, any constitutional issues emanating from this election would remain gridlocked for a time, which would be a period of extreme uncertainty. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com David Boucher, Editor/Strategist davidb@bcaresearch.com 1 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "You've Been Trumped!" dated October 21, 2016, available at gps.bcaresearch.com. 2 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 31, 2016, available at fivethirtyeight.com. 3 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Of the four examples, only Bush Sr. in 1988 and Truman in 1948 are really relevant today. First, the Theodore Roosevelt transition to William Taft happened more than 100 years ago. Second, Hoover took over from eight years of Republican rule when the economy was at a peak, which is hard to compare with the post-financial crisis environments after 1929 and 2008. Thus the only relevant victories for the incumbent party following a multi-term presidency occurred after the reigns of two iconic presidents: Ronald Reagan and Frank D. Roosevelt, two of the greatest American presidents. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 7 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 8 Please see BCA's Global Alpha Sector Strategy Weekly Report, "Quarterly Review And Outlook," dated September 30, 2016, available at gss.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 11 The S&P 500 globally-exposed industry groups index is derived by BCA's U.S. Equity Strategy. 12 Please see BCA U.S. Bond Strategy, "Trading The Municipal Credit Cycle," dated October 18, 2016, available at usbs.bcaresearch.com. 13 Technically, then, Libertarian candidate Gary Johnson, the likeliest third-place candidate, would be eligible to become president under the House of Representative vote. Politically, however, it would be nearly impossible to orchestrate. The deadline for the House to decide this "contingent election" would be January 20, at which point the vice-president, elected by the Senate, would serve as acting president until the House resolved the issue. If the House and Senate have not chosen a president and vice-president by January 20, a new law must be passed to decide the outcome. Oh the humanity! Please see BCA Geopolitical Strategy Special Report, "U.S. Election Primer: Let's Get Ready To Truuuumble," dated February 29, 2016, available at gps.bcaresearch.com.

Highlights Clinton has a 65% chance of victory. She wins the election with 334 electoral votes. Trump has low odds of winning key swing states Virginia and Colorado. A Trump win requires a shock; it is not impossible by the historical record. A Clinton win is initially bullish and could bring some compromise. However, the median voter is moving to the left. The 1990s are gone. Feature BCA's Geopolitical Strategy made its initial U.S. general election forecast thirteen months ago in September 2015.1 We argued that the two most likely outcomes were: GOP Sweep Scenario: a Republican sweep (presidency and Congress) with a moderate candidate at the head of the party ticket; Democratic President / GOP Sweep of Congress: a Democrat win in the White House and a GOP that holds onto the House and Senate. Both outcomes would be positive for the markets given that (1) a GOP sweep would entail pro-market reforms (corporate taxes, de-regulation, entitlement reform, and modest fiscal spending) and (2) a divided government has historically produced a market-positive outcome. In December, we updated our forecast with a call that Hillary Clinton was a clear frontrunner given that a Trump nomination would greatly reduce the probability of a GOP sweep.2 Our reasoning then was that an anti-establishment Republican would fail to gather enough votes in the ideological middle of the American electorate. Although Trump has given Clinton a hardly believable run for her money, we continue to believe that misogynistic, racist, and narcissistic rhetoric are off-putting to the median American voter and distract from Trump's policy message (such as it is).3 In this final extended forecasting effort ahead of the election, our intention is to add value on three fronts: Get the final forecast right. Introduce the investment implications of our forecast. Ask what we have learned from this election so far. Quant Election Model: Trump Is A Red Herring Until very recently, the electoral polls showed a close race between Secretary Hillary Clinton and Mr. Donald Trump (Chart 1). However, our "Polls-plus" model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time. Based on our latest forecast, Hillary Clinton will win the 2016 presidential election in a landslide, with a projected electoral vote count of 334 (Chart 2). bca.gps_mp_2016_10_12_s2_c1 bca.gps_mp_2016_10_12_s2_c1 King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution In the following section, we introduce our model, its results, and explain why the predicted Clinton victory is so comfortable. To be clear, our model has favored Clinton well before the most recent series of gaffes by Mr. Trump. Part I: Structural Econometric Model Our econometric work combines state-level election and economic data as well as trends in national politics and opinion. The model's dependent variable is the difference in the share of the vote received by the Republicans and Democrats in each state. The explanatory variables break down into the following categories: Voting Patterns: Each state's previous election results, back to 1980, are computed as the differential between Republican and Democratic vote share, and used to gauge voter predisposition. We also include a momentum variable which measures the change in the differential between the two previous elections. Economic Variables: We use changes in state and national economic conditions prior to the elections to capture the macroeconomic context. These include national GDP, oil prices, and state-level disposable income. Political Intangibles: We include three different qualitative variables to capture political attitudes. "Polarization" is computed to factor in the likelihood that the incumbent party will be voted out after staying in power for multiple terms. The "alternative choice" measures the presence of a prominent third party. We also include current presidential approval ratings. Using these variables, and strictly avoiding any advantage of hindsight, our model correctly predicted the winner of every election since 1984 (Table 1 and Appendix 1): King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution 2012 - Obama v. Romney: The model slightly overestimated President Obama's support in West Virginia, Arizona, Arkansas, Louisiana, Missouri, and Tennessee. 2008 - Obama v. McCain: The model produced an accurate forecast on an aggregate level, but again underestimated Obama's support. It misallocated electoral votes in 7 states. 2004 - Bush v. Kerry: Our analysis was only off by giving two extra electoral votes to Bush, but once more misallocated votes in 7 states. The Third Party Vote In 1992, 1996, and 2000: The model accurately predicted the winner in each contest but produced more volatile results as our sample started to shrink. In addition, the strong third-party candidacy in 1992 and 1996 distorted the results. These two elections were a key bellwether for the success of our model in 2016, as this year also features prominent third-party choices. Gary Johnson of the Libertarian Party is currently polling around 6.3%. 1984 and 1988: Our earliest set of elections produced results that were quite close to reality despite a limited sample size. Although this is somewhat surprising, it is to be expected given the landslide victories that occurred in both instances. Part II: Econometric Modeling Meets Polls Most of the components from our econometric model are slow-moving structural factors. Opinion polls, on the other hand, change based on periodical surveys. They are more volatile, but provide a good indication of the day-to-day pulse of the electorate. For this reason, we created an augmented version of our econometric model using probabilities constructed from polls. First, we transformed our econometric forecasts into probabilities by using two scenarios and the historical volatility of our estimates. The two scenarios are based on the potential impact of the third parties: one in which they gather 5-10% of the popular vote, and the other in which they fail to reach that threshold. From there, we calculated the historical standard deviations for each scenario, getting the lower and upper limits of the election forecasts. Giving the two limits equal chances of occurring, we calculated the GOP's chances to win each state. We then added opinion polls to this model. We used the election probabilities from FiveThirtyEight, which are computed using simulations from a collection of weighted and adjusted polls, to add a shorter-term dimension to our forecast.4 We give a 60% weight to the probabilities from the polls and 40% to our structural econometric model to ensure that we capture the momentum effect. Part III: 2016 Election - All Hype, No Fight Our polls-plus model suggests that Clinton has a 65.4% chance of winning the election (Table 2). This is somewhat lower than the probability derived by other polls-plus models - such as FiveThirtyEight and the New York Times. Further, our model shows that Clinton already has 279 electoral votes in states where she has more than a 70% chance of winning (Chart 3). By the same standards, Trump has secured only 170 votes. These results mean that even under the unlikely scenario where the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), if all else stays the same, the Democrats still win with 279 electoral votes. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Intriguingly, our "White Hype" model back in March produced the same result using an entirely different method (it asked simply what share of the white vote Trump needed to win the swing states). At that time we argued that Trump had a very good chance to win Florida, Ohio, and Iowa, but that it would still be insufficient to win the election.5 In other words, our White Hype model correctly forecast in March the ultimate probabilities that our polls-plus model is now gauging from the combination of econometric results and opinion polls in October. Put differently, after winning the swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), where the odds of winning are between 32% and 57%, the GOP would still need to steal the electoral votes in Virginia or Colorado (the latter in combination with Nevada or New Hampshire), away from the Democrats, where they are favored to win at 71.6% and 79.7%, respectively.6 This remains as unlikely now as it was in March.7 Bottom Line: Given the structural economic and political dynamics currently in place, our quantitative estimates show that Clinton is the clear favorite. Clinton has a 65.4% chance of winning the 2016 election, with an expected 334 electoral votes. Qualitative Election Model: Time To Dump Trump Thanks largely to the analysis of our colleague Peter Berezin, Chief Strategist of the BCA Global Investment Strategy, we took Donald Trump seriously long before most.8 We analyzed his electoral strategy - boosting the share of the white vote accruing to the GOP and away from the Democratic Party - and concluded that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy of increasing the Republican share of the white vote was mathematically the correct strategy for a GOP candidate to pursue, at least in 2016 when the white share of the total population remained large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable and feasible.9 We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1% respectively. At those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most feasible. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our model hold up in terms of state-by-state polling? It did quite well! As we predicted, Trump has been doing relatively well in Iowa, Florida, and Ohio (Chart 4). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle and even through the periods where the media narrative shifted against her (Chart 5). bca.gps_mp_2016_10_12_s2_c4 bca.gps_mp_2016_10_12_s2_c4 bca.gps_mp_2016_10_12_s2_c5 bca.gps_mp_2016_10_12_s2_c5 Bottom Line: Despite a narrowing in the polls in mid-September - particularly following Clinton's September 11 health scare - we still concluded in our September Monthly Report that "the presidential race is Clinton's to lose."10 This is because both our quant (polls-plus) and qualitative (White Hype) models have correctly predicted that Trump's path to victory is extremely narrow. He would have to hold all of the swing-states where the White Hype model makes him competitive, and then also win either Virginia or Colorado plus Nevada, where he has struggled in the polls. Risks To Our View - A Trump Surprise! What scenario could occur between now and November 8 that throws off our forecast of a Hillary Clinton victory? As we have claimed from the beginning of the contest, Trump requires an exogenous factor to push him over the finish line. Given that Clinton's lead is now 6% in the polls, and that Trump is running out of time, he may need an act of God. That said, Trump has come a lot closer to winning the election than our polls-plus model suggests. Were it not for his idiosyncratic personality, the Democrats would have been a lot more vulnerable in 2016 than our predicted election outcome indicates. Why? Research by Professor Allan Lichtman, who has accurately predicted every U.S. presidential election since 1984, is instructive. Lichtman has called the election for Trump.11 His so-called "Keys" method - first outlined in a 1981 article and in his 1990 book, The Thirteen Keys To The Presidency - is a simple true or false quiz with thirteen propositions. If six or more of the answers are "false," the incumbent party loses the Oval Office (Table 3). King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution For instance, if it is true that the average GDP growth per capita is higher in the past four years than the preceding four years, then that fact favors the incumbent. Today, this "long-term economic key" favors Hillary (Chart 6). bca.gps_mp_2016_10_12_s2_c6 bca.gps_mp_2016_10_12_s2_c6 In 2016, at least five of Lichtman's keys clearly favor the GOP: In the House of Representatives, the incumbent Democrats lost seats in the 2014 midterm elections, relative to the 2010 midterms (Chart 7). The Democrats do not have an incumbent candidate advantage. Obama achieved no major policy initiative in the second term. There was nothing comparable in effect to the Affordable Care Act, his signature legislation (Chart 8). Obama achieved no major foreign policy success. The Iran nuclear deal is too controversial to satisfy this key, although we suspect that history will judge it as a major success. Instead, the public focus has been on the disastrous intervention in Libya and the dithering in Syria. Hillary Clinton is not charismatic, which is an understatement (Chart 9). In addition, Gary Johnson, of the Libertarian Party, is a third-party candidate who could garner more than 5% of the vote (Chart 10). Under Lichtman's methodology, this is a key that hurts the incumbent. Of course, Libertarians may suck more votes away from Trump than Clinton. But Lichtman has signaled this issue as a crux of the election, and thinks it favors Trump. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution bca.gps_mp_2016_10_12_s2_c10 bca.gps_mp_2016_10_12_s2_c10 Moreover, in our view, Lichtman's keys could predict an even worse outcome for Clinton than Lichtman himself admits. Lichtman is very forthright about the fact that the keys require subjective judgment of the sort that professional historians make all the time. We would note, first, that the contest in the Democratic primary was serious. Sanders performed nearly as well as Clinton herself did in 2008, and better than other second-rank Democratic contenders going back to 1984 (Chart 11). Second, social unrest has likely risen in Obama's second term, or at least is perceived to have done so (Chart 12). King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Thus the primary contest and social unrest could trigger two more strikes against the incumbent party, without even debating whether Obama administration scandals or Trump's charisma qualify as keys against the Democrats.12 We think that Lichtman's model speaks volumes about the built-in vulnerability that the Democratic Party has faced throughout 2016. It also supports our initial September 2015 forecast, which gave largely even odds to both a moderate GOP presidential candidate and Hillary Clinton. As such, Trump's defeat will be a disaster for the Republican Party and will initiate a period of introspection - if not civil war - within the organization. Bottom Line: Trump does have good odds of winning the election if Clinton's lead in the polls drops below 3% between now and Election Day. If Trump gets back within striking distance, it will suggest that Clinton cannot shake him even after the media narrative and GOP establishment turned against him. With a 3% gap in the polls, the "turnout thesis" would become a lot more cogent. This is the thesis that Clinton will struggle to get members of the "Obama coalition" (millennials and minorities) to come out and vote, while Trump will motivate the registered but non-voting white population to turn out for him. At this point in the cycle, however, we doubt that Trump will re-test this level of competitiveness. Investment Implications: More Bullish Than Priced-In A Trump surprise would trigger a correction in equity markets, which is already due based on valuations, earnings, and other factors. We would expect the USD, as a key safe haven, to rally sharply both on Trump policy uncertainty and heightened geopolitical risk. We would also expect bond yields to fall initially, as part of a broad risk-off move, but then sell off due to the implication of more inflationary fiscal policies. Trump's policy proposals suggest a budget deficit blowout at least comparable to that under George W. Bush, which went from 2% to almost -4% of GDP. A combination of more spending and less tax revenue would blow the top off the bond market. What about the expected Clinton victory? First, markets love divided government (Table 4). Why? Because spending remains in check and no new onerous policies are likely. This will likely be the case if the GOP keeps the House of Representatives. However, we also think a Republican House could be conducive to dealing with Clinton, particularly on a modest fiscal stimulus: King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution Clinton is not Obama: She will enter the Oval Office unpopular and without a strong mandate. She may not win over 50% of the popular vote. The Senate is in play, with polls at RealClearPolitics suggesting that the Democrats would win at least the four seats they need (leaving Vice-President Tim Kaine to cast the tie-breaking vote on legislation). The House is unlikely to be in play. Thus, unlike Obama in 2009, she will have a slim Senate majority at best (not filibuster-proof) and a GOP-held House. She will have to cut deals to advance her agenda. The Grand Coalition Lives: In the past few years, Congress has passed a number of important bills because establishment Republicans voted alongside Democrats (Chart 13). This coalition would remain in place, cemented by the populist threat to both camps represented by Trump and Sanders. The Knives Will Be Out For The Tea Party: Trump's rise and fall would be seen as an infamous debacle that cost the Republicans a highly significant election well within their reach. The Republican establishment will be determined to regain the reins of the party apparatus and brand. The Tea Party and other populist or anti-establishment Republicans will be blamed not only for giving Clinton the keys to the White House but also for giving the Democrats the advantage on the Supreme Court for a generation. True, Republicans could take away a narrow reading of the election results. They could blame the entire loss on Trump, not the party, given that Trump and the party had a bad relationship and Trump endorsed various positions at odds with conservative platforms and principles. They could therefore draw the conclusion that the correct strategy for the future is not to change policies or compromise with Democrats, but simply avoid running inexperienced, flamboyant mavericks for president. This view would be supported by the fact that, with a Clinton victory, moderate Republicans in more competitive districts, not arch-conservatives in bright red ones, are more likely to lose seats in the House. Ironically, this means that House Republicans could be just as zealous in opposition as they were under Obama, or more, and thus poised to resume the game of obstruction. This is possible, but we think the anti-establishment will be on the defensive, at least initially. Clinton will receive some kind of honeymoon period after dealing a devastating blow to the GOP. There will be Republicans ready to compromise, under the leadership of Paul Ryan, who did not accept the House speakership in order not to compromise. And the far-right will have at least some waverers in their midst. As such, we can see the potential for modest corporate tax reform (broadening the tax base without lowering the effective corporate tax rate). Even though such reform is not extraordinary, it should boost economic growth by helping small and medium-sized businesses grow. We can also see the GOP under Paul Ryan agreeing to modest increases in fiscal spending in return. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, cogently argues that fiscal spending only comes amidst recessions. Chart 14 shows that mentions of "fiscal stimulus" in the news media are positively correlated with junk bonds and VIX, and negatively correlated with the yield curve. As such, fiscal stimulus only begins being contemplated when the pain of a recession hits. King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution bca.gps_mp_2016_10_12_s2_c14 bca.gps_mp_2016_10_12_s2_c14 Could this time be different? Yes. 55% of Americans think the economy has not recovered from the Great Recession, and some polls suggest that over half think the U.S. is still in recession. As such, while a recession may not be occurring in reality, it may as well be as far as politicians are concerned. Moreover, the public apparently cares less about the deficit and debt than in the recent past: the number of Americans naming deficits as the "top priority" has fallen from 72% to 56% in the past few years. And again, the populist groundswell will reinforce the need to lift growth through policy. Beyond an immediate relief rally, we would fade any idea that Clinton's victory means a return to the Bill Clinton-environment for corporate profits and stock performance. A structural shift to the left is underway in American politics, both generational and economic, as we argued in June.13 Clinton will not be able to betray her pledges to Bernie Sanders supporters if she wants to be a two-term president. Thus, on a sectoral basis, we would expect Clinton to have quite a few negatives (Table 5). First, she would portend greater state involvement in healthcare, especially Big Pharma, despite the idea that repealing the Affordable Care Act would cause more uncertainty than keeping and changing it. We also would not expect her to be as favorable to the financial community as her list of donors suggests, given the challenges she faces on her left regarding financial regulation. On energy, she will benefit renewable energy companies more so than conventional ones, given her commitment to turning the U.S. into a "twenty-first century clean energy superpower." King Dollar: The Agent Of Righteous Retribution King Dollar: The Agent Of Righteous Retribution We would expect her to be good for defense stocks, both because she has a lifetime of foreign policy hawkishness and because of the global trend of multipolarity, which increases both the number of global conflicts and the risks of additional conflicts.14 For Trump, there is little reason to speculate - he has no experience governing, has flip-flopped on many policy stances, and is generally unorthodox and impossible to predict (e.g. his healthcare "plan"). If we had to venture a guess, we would say that, like Clinton, he will be positive for defense stocks. His aggressively anti-regulatory positions on the financial and energy sectors should be a boon for both. A critical thing to remember is that recent American presidents do not have a bad track record of getting what they want (Box 1). Like all leaders, they are at the mercy of constraints and structural factors, whether political, military, economic, or social. Yet they also command a powerful (and increasingly so) executive branch of government in the world's most powerful country. If Clinton wants higher taxes on the wealthy and a stronger state hand in healthcare, she will most likely get them. If Trump wants tougher border security and deep corporate tax cuts, he will likely get those as well. Congress is a check, but only that. BOX 1 U.S. Presidents: Promises And Performance Over the past 28 years, each new president has generally succeeded in passing the signature items on his agenda. George Bush Sr. is the major exception. He took office in 1988 with a pledge of keeping growth rates constant, creating 30 million new jobs over eight years, keeping the peace abroad, and improving the budget deficit without raising taxes. Instead, after only one year in office, he faced a recession that caused a 1.2 percentage point drop in the growth rate from Reagan's average, resulting in only 2.6 million increase in the civilian labor force his first term, 12.4 million wide of the mark. He was famously forced to raise taxes, despite saying "read my lips: no new taxes," and the budget deficit expanded from 2.7% to 4.5%. Finally, Saddam Hussein's invasion of Kuwait drew him into the Gulf War. Bill Clinton got luckier. His chief pledge was to raise wages, shift government investment from defense to the domestic economy, make healthcare more affordable, and reform welfare. He failed in healthcare, but generally succeeded in other initiatives. Wages admit of some debate - average earnings grew faster than under Reagan-Bush, though median earnings did not. Still, Clinton presided over a longer more stable period of wage growth than his predecessors (Chart 1). Non-defense investment rose 19% (defense barely grew) and its share in federal spending rose from 10% to 12%. The participation rate in cash assistance and food stamp programs declined sharply, as did the length of time on the dole. George W. Bush came to power on the promise of reforming social policy - health, education, social security - and essentially transferring the Clinton budget surplus to voters through tax cuts. He succeeded in taxes, education (No Child Left Behind Act), and health (Medicare expansion), aided by Republican majorities and popular support after the September 11 attacks. He failed to partially privatize social security, however. Barack Obama promised to make the tax code more progressive, make healthcare accessible and affordable, reduce energy dependency on the Middle East, and phase out the wars in Iraq and Afghanistan. He has generally achieved these goals: the number of uninsured adults fell from 18% to 11%, healthcare price inflation has slowed from about 4% under Clinton and Bush to 3% per year, and U.S. energy imports have fallen from 33% to 25% of total consumption. However, while Obama succeeded broadly in withdrawing troops from the Middle East (Chart 2), he has failed to "finish" the war in Afghanistan. bca.gps_mp_2016_10_12_s2_c15 bca.gps_mp_2016_10_12_s2_c15 bca.gps_mp_2016_10_12_s2_c16 bca.gps_mp_2016_10_12_s2_c16 There are three chief takeaways: First, circumstances can overrule any president's plans, as occurred with George Bush Sr. Second, winning an election in reaction to a recession, as did Clinton and Obama, or suffering a crisis early in one's term, like Bush Jr., provides a tailwind for a president's initiatives. The flipside is that inheriting strong economic growth on the coattails of a popular two-term president may put an administration at risk of a cyclical downturn or general failure to meet expectations. (Warning for a Hillary Clinton administration!) Third, Congress can block some but probably not all of a president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed. Clinton lost on healthcare but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). For Bush Jr., the legislature switched after six years of his administration, yet social security had already proved to be the "third rail" of politics that he feared - he failed to reform it despite his own party's control of Congress. Final Thoughts: Lessons From 2016 The 2016 election has taught us some critical lessons. First, the world never would have believed, in the immediate aftermath of the global financial crisis, that populism would be more disruptive in the Anglo-Saxon countries than in continental Europe. But that is what has happened. The United States and the United Kingdom have both seen an explosion of pent-up forces as a result of decades - particularly the past 16 years in the U.S. - of declining middle classes, rising inequality, and weak median incomes.15 The consequences are only just beginning to be felt, and are of far greater global significance coming from the U.S. than the relatively small U.K. The chief of these is that, in the U.S., the median voter has clearly moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroot voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Rather, they want government to give them more goodies and protections. This fact, taken along with the demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters in a way that Bill Clinton and the "New Democrats" shifted to capture right-leaning centrist voters in the wake of Ronald Reagan and the collapse of the USSR. Part of this process will involve a political alignment in the U.S., now that the GOP's deep fractures have been exposed for all the world to see. Trump's candidacy could never have occurred if there had not first been a power vacuum at the center of the party. If Trump wins, it will be a veritable revolution for both parties. Fiscal conservatism (and social conservatism, for that matter) will have little to show by way of official party machinery. The global consequences will be highly disruptive as well since the executive branch has extensive power over all actions of the federal bureaucracy, trade, and foreign policy, and since the GOP will not obstruct Trump initially (whatever happens in the aftermath of any radical policy changes). If Trump loses, as mentioned above, the anti-establishment trend in the Republican Party will suffer the brunt of the blame - whether Tea Party or other. Though messy, this result could in fact be bullish for the U.S. in the long run, since it would discredit populism in the party and give a boost to reformers who seek to re-brand and redesign the party to respond to changes in the electorate. Thus, in 2020, either Clinton's policies will be working and Americans will not be demanding change, or they will not be working, and Americans will have a reformed GOP as an alternative. Alternatively, Trump's loss could fuel populism by showing the way for a similar candidate with similar policies yet who does not lack in charisma, oratory, and party backing. Trump's strategy of boosting white support for the GOP is demographically and mathematically possible at least until 2024. Or perhaps a different kind of Republican (or Democratic) candidate could attempt to capture aspects of Trumpism, given his left-tilt on economic policy, while appealing to the Democratic coalition of women, millennials, and minorities. The GOP shakeup should be watched closely. Lastly, the 2016 election has amplified a point that we have long emphasized: the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Similarly, it made the race competitive when Clinton's various scandals were "trending." As a result, investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. Trump's constraints, as we have contended, are too high. Appendix 1 shows the state-by state performance of the econometric model (without polls) for each of the past 8 elections. It compares the model's forecast (no hindsight bias) with actual results. APPENDIX 1 Back-testing GPS's Econometric Election Model Image Image Image Image 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election - Forecast & Investment Implications," dated September 9, 2015, available at gps.bcaresearch.com. 2 Please see Bank Credit Analyst Strategic Outlook, "Stuck In A Rut," dated December 17, 2015, available at gps.bcaresearch.com. 3 #shocker. 4 For a more detailed explanation of FiveThirtyEight's methodology, please see "A User's Guide To FiveThirtyEight's 2016 General Election Forecast," dated June 29, 2016, available at http://www.fivethirtyeight.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcareseach.com. 6 The Democrats' probability of winning Nevada and New Hampshire are 74.4% and 80% respectively. 7 Please see BCA Geopolitical Strategy, "U.S. Election: Is The Election Over?" in Monthly Report, "Who's Afraid Of Big Bad Trump?" dated August 10, 2016, available at gps.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," September 4, 2015, available at gis.bcaresearch.com. 9 The assumption being that the turnout, non-white vote share, and white turnout do not change from 2012. In other words, our model only focuses on the white share of the vote for the Republican candidate. We assume that Clinton will not benefit from an anti-Trump tailwind among minorities, which is a big assumption given the pernicious effects of the "White Hype" strategy on the minority support of a Republican candidate. On the other hand, we also do not change the white voter turnout, which is unfair to Trump as he would likely be able to boost the white turnout as he increases the GOP share of the vote. 10 Please see BCA Geopolitical Strategy, "U.S. Election Update - The Home Stretch," in Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 11 Please see our book review below for a discussion of Lichtman's latest book. See also Peter W. Stevenson, "Trump Is Headed For A Win, Says Professor Who Has Predicted 30 Years Of Presidential Outcomes Correctly," Washington Post, September 23, 2016, available at www.washingtonpost.com. 12 Lichtman addresses the issues of Sanders, scandals, and Trump's charisma in Peter W. Stevenson, "This Professor Has Predicted Every Presidential Election Since 1984. He's Still Trying To Figure Out 2016," Washington Post, May 12, 2016, available at www.washingtonpost.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, and "Annus Horribilis," dated January 20, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com.

Dear Client, This week, I am currently on the road visiting clients across Europe. We are sending you an abbreviated weekly report as well as a Special Report from our Geopolitical Strategy team entitled “U.S. Election: Final Forecast & Implications”. Not only does this report encompass a detailed analysis of the upcoming U.S. presidential election and its implications for the future of U.S. politics, it also introduces GPS’s poll-plus model, a model which currently forecasts a Clinton victory. I trust you will find this piece very informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights The U.S. dollar is consolidating its recent gains, but it offers more upside in the months ahead A Trump victory would supercharge any dollar strength, but is likely to hurt the dollar in the long-term. In Japan, no more fiscal drag and a tightening in the labor market will ultimately result in a lower yen, courtesy of higher inflation expectations and falling real rates. The Australian labor market points to weaknesses in the domestic economy. Any EM turmoil could launch an AUD bear phase. Feature The U.S. dollar continues to consolidate its recent gains. While the dollar is expensive, it still offers upside potential. Monetary divergences remain in favor of the U.S. economy. U.S. labor market slack is disappearing and the rising share of salaries and wages in the national income pie is likely to further support consumption. Shifting the distribution of economic gains toward workers signifies that the middle class is gaining ground relative to households at the summit of the income ladder. This process should help consumption because the middle class has a much higher marginal propensity to consume than the top 1% (Chart I-1). If consumption growth remains healthy, job creation is likely to fan additional wage pressures, creating a virtuous circle for U.S. households and consumption. This virtuous cycle is likely to help the Fed increase rates over the next two years, providing a source of support for the dollar (Chart I-2). Chart I-1Shifting Income To The Middle Class Will Support Consumption bca.fes_wr_2016_10_28_s1_c1 bca.fes_wr_2016_10_28_s1_c1 Chart I-2A Virtuous Cycle For The Dollar A Virtuous Cycle For The Dollar A Virtuous Cycle For The Dollar In terms of the presidential election outcome, the shift of the median voter to the left signifies that redistributionist policies are likely to become an ever growing part of the U.S. political discourse. This reality is likely to provide another source of support for the U.S. dollar, at least for now. While a Clinton victory will not halt these trends, a Trump victory would likely supercharge any dollar bull market. While vague in details, Trump's economic plan involves much more infrastructure spending financed with debt issuance, i.e. a large amount of fiscal stimulus that would remove the need for any dovish tilt to the Fed's stance. Moreover, by raising the specter of protectionism, a Trump victory could revive inflationary forces in the U.S. economy. Protectionism, while negative for profits, would decrease the trade deficit, temporarily lifting U.S. GDP. Since the supply side of the economy has been hampered by tepid levels of investment (Chart I-3), we could see a situation where demand is in excess of supply. This would prompt an even more hawkish Fed. However, although a Trump victory would be a dream for dollar bulls, caution is warranted. In the long-term, a Trump administration implies a falling fair value for the dollar. For one, by lifting inflation, a Trump victory would hurt the PPP value of the greenback. Second, a Trump victory would also ultimately lead to a degradation of the USD's role as the global reserve currency, making the -40% of GDP net international investment position of the U.S. more difficult to sustain (Chart I-4). Finally, by shielding the economy from the competitive pressures of globalization, a Trump victory would likely result in a deterioration of U.S. productivity vis-à-vis the rest of the world. Chart I-3Low Capital Stock Growth Would Crystalize The##br## Inflationary Effect Of A Trump Presidency bca.fes_wr_2016_10_28_s1_c3 bca.fes_wr_2016_10_28_s1_c3 Chart I-4The Dollar Needs Its ##br##Reserve-Currency Status bca.fes_wr_2016_10_28_s1_c4 bca.fes_wr_2016_10_28_s1_c4 Yen Signs pointing toward a strong wave of yen weakness are slowly coming together. In recent years, the yen has closely followed real rates differentials (Chart I-5). With the BoJ guaranteeing a limit on the upside for nominal rates, any improvement in the economy is likely to cause inflation expectations to increase, and thus real rates, to fall. What are the signals pointing toward higher inflation expectations and a lower yen? First, the labor market is tightening. The job-opening-to-applicants ratio is at a 15 year high and employment growth remains healthy (Chart I-6). Meanwhile, the participation rate of women in the labor force is at all-time highs, and at 73.5%, the employment-to-population ratio for prime-age women is already above U.S. levels. In fact, it is at similar levels to those experienced in the U.S. during the boom years of the late 1990s. Thus, the declining likelihood that more women will enter the labor force eliminates a wage-suppressing factor. Chart I-5USD/JPY: A Function Of##br## Real Rate Differentials USD/JPY: A Function Of Real Rate Differentials USD/JPY: A Function Of Real Rate Differentials Chart I-6Japan: Female Labor Participation Now Exceeds ##br##The U.S. Japanese Wages Can Now Rise bca.fes_wr_2016_10_28_s1_c6 bca.fes_wr_2016_10_28_s1_c6 Second, the Japanese shipment-to-inventory ratio is improving. Thanks to lean-inventory techniques, this ratio tends to be most elevated at the bottom of economic slowdowns, reflecting depressed sales rather than bloated inventories. Historically, growing shipments relative to inventories are associated with rising inflation expectations (Chart I-7). Third, the drag from fiscal policy is dissipating. Budget tightening is leveling off, lifting a big brake on domestic demand (Chart I-8). Moreover, we expect fiscal stimulus to gather momentum in 2017, especially in the form of wage policy. This provides an additional support for Japanese inflation expectations. If no further fiscal stimulus comes to fruition in Japan, we expect USD/JPY to rally toward 110-115 in the next 18-months. If aggressive fiscal stimulus and a wage policy are implemented, the upside for USD/JPY could be much greater, in the order of 120 or more. Chart I-7Japanese Shipment-To-Inventory##br## Ratio And CPI Expectations Japanese Shipment-To-Inventory Ratio And CPI Expectations Japanese Shipment-To-Inventory Ratio And CPI Expectations Chart I-8The Dissipating Japanese ##br##Fiscal Drag USD, JPY, AUD: Where Do We Stand? USD, JPY, AUD: Where Do We Stand? Yet, while the cyclical outlook for the yen is bearish, the shorter-term outlook is more nuanced. Any EM-selloff triggered by tightening global liquidity conditions could prompt downward pressures on Japanese inflation expectations. This would mechanically lift Japanese real rates and the yen. Hence, we recommend investors sell the yen on a long-term basis but hedge this position by buying JPY volatility over the next 3-6 months. Australian Dollar The Australian dollar is at a tricky spot. Technically, the AUD has been forming a tapering wedge, a pattern that often heralds a large move in this currency. How will this pattern resolve itself? We expect a bearish outcome. The domestic economy is displaying some worrying signs. Not only is full-time employment contracting, but so are total hours worked (Chart I-9). This is likely to weigh on household income and on consumption. This is especially problematic as Australian gross fixed capital formation continues to contract at a 4.5% annual pace. The result is that inflationary pressures in Australia will be kept at bay. In the process, the RBA could adopt a more dovish bias. Chart I-9Australian Domestic Conditions ##br##Are Deteriorating bca.fes_wr_2016_10_28_s1_c9 bca.fes_wr_2016_10_28_s1_c9 Chart I-10Australian Exports To ##br##China Are Still Falling... Australian Exports To China Are Still Falling... Australian Exports To China Are Still Falling... Additionally, despite a stabilization in Chinese growth, Chinese imports from Australia continue to contract (Chart I-10). Not only has this happened as iron ore prices have rebounded, but also, as economic conditions have improved in EMs that are highly levered to the Chinese cycle (Chart I-11). Our expectation is that the Chinese industrial sector is likely to experience a slowdown in the months ahead, courtesy of a falling fiscal impulse (Chart I-12), which begs a question: What does the future hold for Australian exports? Chart I-11...Despite Rising Taiwanese##br## Industrial Production bca.fes_wr_2016_10_28_s1_c11 bca.fes_wr_2016_10_28_s1_c11 Chart I-12Tightening Global Liquidity Is A Headwind##br## For EM Financial Conditions And Growth Tightening Global Liquidity Is A Headwind For EM Financial Conditions And Growth Tightening Global Liquidity Is A Headwind For EM Financial Conditions And Growth Finally, our bullish U.S. dollar stance is a tough hurdle for commodity prices to overcome (Chart I-13). Weakness in commodities would represent a negative terms-of-trade shock for Australia and the AUD. Moreover, the PBOC continues to use a lower RMB as an engine of reflation, and we stand by our bearish JPY forecast. Because of these two developments KRW, SGD, and TWD, are very likely to experience further downside. Historically, Asian currency weakness correlates closely with a weak AUD (Chart I-14). Chart I-13Commodities And The Dollar:##br## Joined At The Hip bca.fes_wr_2016_10_28_s1_c13 bca.fes_wr_2016_10_28_s1_c13 Chart I-14AUD Performs Poorly When ##br##Asian Currencies Sell Off bca.fes_wr_2016_10_28_s1_c14 bca.fes_wr_2016_10_28_s1_c14 We are already shorting AUD/USD in the context of a short commodity currencies trade. We are considering buying EUR/AUD, as the euro is less sensitive to the dollar, EM spreads, and commodity prices versus the AUD. Also, EUR/AUD is more attractive from a valuation perspective, trading 5% below its PPP fair value. This cross is also supported by a favorable balance-of-payments backdrop, with the euro area registering a 7.7% of GDP current-account differential relative to Australia. Buying EUR/AUD represents a way for investors to bet on a weaker AUD while decreasing their exposure to the U.S. dollar risk factor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_28_s2_c1 bca.fes_wr_2016_10_28_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_28_s2_c2 bca.fes_wr_2016_10_28_s2_c2 Policy Commentary: "There are risks of hanging around zero too long. And if the economy can withstand [a hike], I think it's appropriate to move" - Philadelphia Fed President Patrick Harker (October 26, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_28_s2_c3 bca.fes_wr_2016_10_28_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_28_s2_c4 bca.fes_wr_2016_10_28_s2_c4 Policy Commentary: "In the euro area, we have a long way to go before we exhaust the productivity improvements that have already taken place in the U.S" - ECB President Mario Draghi (October 25, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_28_s2_c5 bca.fes_wr_2016_10_28_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_28_s2_c6 bca.fes_wr_2016_10_28_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_28_s2_c7 bca.fes_wr_2016_10_28_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_28_s2_c8 bca.fes_wr_2016_10_28_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_10_28_s2_c9 bca.fes_wr_2016_10_28_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_28_s2_c10 bca.fes_wr_2016_10_28_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_28_s2_c11 bca.fes_wr_2016_10_28_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_28_s2_c12 bca.fes_wr_2016_10_28_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 bca.fes_wr_2016_10_28_s2_c13 bca.fes_wr_2016_10_28_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_28_s2_c14 bca.fes_wr_2016_10_28_s2_c14 Policy Commentary: ""Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_28_s2_c15 bca.fes_wr_2016_10_28_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_28_s2_c16 bca.fes_wr_2016_10_28_s2_c16 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 bca.fes_wr_2016_10_28_s2_c17 bca.fes_wr_2016_10_28_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_28_s2_c18 bca.fes_wr_2016_10_28_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 bca.fes_wr_2016_10_28_s2_c19 bca.fes_wr_2016_10_28_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_28_s2_c20 bca.fes_wr_2016_10_28_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We expect the U.S. House of Representatives to remain in GOP hands, but the Democrats could take razor-thin control of the Senate if Clinton wins the Presidency. The current, market-bullish status quo of divided government will continue. The chances of cooperation between a Clinton Administration and the House is actually quite good on some issues. We would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. There is now bipartisan support in the U.S. for removing the sequester, opening the door to some fiscal stimulus. A shift in focus from monetary to fiscal policy will be quite bullish for the dollar, which could rise by 10% in trade-weighted terms. The Japanese government appears to be preparing another shot of fiscal stimulus, which would be quite bearish for the yen and bullish for Japanese stocks when combined with the Bank of Japan's new yield curve policy. A number of headwinds that have held back U.S. growth this year will give way, generating 2½-3% real GDP growth in 2017. Positive growth surprises will encourage the FOMC to tighten in December and another five times over 2017/18. However, the speed of rate hikes will depend on how quickly the dollar appreciates. Dollar appreciation will undermine U.S. EPS growth next year. We view this as a headwind for stocks, but not something that will prevent modest gains in the S&P 500 next year. A key risk is that a surging dollar and a more hawkish FOMC sparks a correction in EM assets in the near term, spilling over into developed market bourses. Given elevated valuations, the risk/reward balance still favors a defensive strategy, with no more than a benchmark allocation to stocks. Several trends support our recommendation to maintain slightly below-benchmark duration within fixed- income portfolios. Among them, the annual growth rate in total central bank assets for the U.S., Euro Area, the U.K. and Japan is on the verge of peaking even assuming the ECB extends, which means that the period of maximum downward pressure on global term premia is over. Continue to overweight indexed bonds versus conventional issues. Oil prices should be able to hold up in the face of dollar strength given that we expect the tightening oil market will dominate. However, base metals will struggle. Feature As we go to press, Hillary Clinton is poised to win the Presidency of the United States following a tumultuous and divisive campaign. The key question now is the Senate race, where less controversial Republicans are contesting close elections. The GOP is at high risk of losing four Senate seats, with another three in play. Democrats need only four seats to take the Senate because, assuming that Clinton wins the presidency, Vice-President Tim Kaine would then cast the tie-breaking vote in that body. We expect the GOP to hold onto the House. This means that the current, market-bullish status quo of a divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate, the Clinton White House would be constrained on some of its most left-leaning policies. Unlike Obama, Clinton's victory will not be a popular sweep. She will likely receive less than 50% of the popular vote and will be the first candidate ever elected that has more voters saying they dislike her than like her (Chart I-1). Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting mandate as Obama did in 2008. Chart I-1Clinton And Trump: The Least Charismatic Candidates Ever November 2016 November 2016 Nonetheless, BCA's Geopolitical Strategy service believes that the chances of cooperation between a Clinton Administration and the House is actually quite good on some issues. On corporate tax reform, it is difficult to see a reduction in effective tax rates, but a deal could be struck to broaden the tax base by closing various loopholes. This would be negative for some S&P 500 multinational corporations, but would benefit America's small and medium-sized enterprises. Paul Ryan and moderate Republicans understand that there has been a paradigm shift in America and that the median voter has moved to the left. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. There is now bipartisan support for removing the sequester. Even a modest infrastructure plan could make a substantive difference for the economy given the high fiscal multipliers of government spending in an economy with low interest rates. The political shift to the left means that a Clinton-Ryan coalition will care less about the concerns of America's large corporations than previous governments, leading to policies that will result in higher effective tax rates on major corporations, a dollar bull market (in conjunction with tighter Fed policy, see below), and rising wages over the next four years. The election outcome will also be positive for bombed-out U.S. health care stocks. Even if the Democrats take the Senate, a Republican-held House will make it difficult for Clinton to push through legislation that does serious damage to the sector's pricing power. Health care stocks are oversold and cheap, at a time when consumer demand is solid and our pricing power proxy is rising much more quickly than overall corporate sector pricing. In terms of the macro implications, a shift in focus from monetary to fiscal stimulus will be quite bullish for the dollar. Below we discuss the important changes coming in the global investment landscape stemming from a renewed dollar bull phase. U.S. Growth: Expect Upside Surprises Any boost to U.S. infrastructure spending is unlikely to show up in GDP until the second half of next year. Nonetheless, there are other reasons to be more upbeat than the consensus on growth prospects for the first half as well. It is important to note that U.S. real final sales to private domestic purchasers, a good measure of underlying demand growth, has grown at almost 2½% over the past year, and was up 3.2% in the second quarter sequentially. A number of headwinds conspired to hold back the headline GDP growth figures, but these headwinds should moderate next year (Chart I-2): The five-quarter inventory correction is almost unprecedented in its length, but there are some high-frequency indicators (i.e. durable goods inventories and the inventory component of the ISM manufacturing index) that suggest that the correction is coming to an end (Chart I-3). Inventory destocking only needs to stabilize to boost GDP growth, since it is the change of the change in inventories that affects GDP growth. Chart I-2U.S. 2016 Growth Headwinds To Fade U.S. 2016 Growth Headwinds To Fade U.S. 2016 Growth Headwinds To Fade Chart I-3Inventory Rebuilding Has Commenced bca.bca_mp_2016_11_01_s1_c3 bca.bca_mp_2016_11_01_s1_c3 Some of this year's slowdown reflects a pullback in the contribution of federal and state & local government spending. Nonetheless, this will not last long because state and local government revenues are trending higher and this sector spends all it takes in. As noted above, we also expect a boost from infrastructure spending at the federal level. Housing starts and residential investment hit a soft patch this year. The second quarter dip was mainly due to a warm winter, which pulled forward home-improvement spending. The NAHB homebuilders index heralds a rebound in housing activity in the coming months, in line with the improvement in household formation. Indeed, housing starts are still 20-25% below estimates of the amount of construction necessary to keep up with population growth. We also expect a little more capital spending once the election is out of the way, profits begin to expand again and industrial production growth improves early in the New Year. Moreover, the oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. Overall corporate capital spending intentions have perked up (Chart I-4). The trade sector will be a drag on growth, especially if the dollar appreciates as we expect. Nonetheless, we believe that the unwinding of the other headwinds that have dogged the economy this year could provide real GDP growth of 2½-3% in 2017. Stronger-than-expected growth will have a positive impact on America's trading partners via import demand, but it is the response of the dollar that could really shake up global financial assets. The reasoning behind our strong dollar view is straightforward: interest rates differentials are the strongest predictor of currency trends on a 12-18 month horizon. Relative economic performance between the U.S. and the rest of the world suggests that interest rate differentials will move even further in favor the U.S. dollar. Chart I-5 highlights that the dollar tends to appreciate when U.S. interest rates are in the upper half of the interest rate distribution of the G10. With few central banks outside of the U.S. in a position to be able to lift interest rates, gently rising U.S. rates will keep the U.S. among the global developed market (DM) high-yielders for many years. Chart I-4Capex Plans Have Improved bca.bca_mp_2016_11_01_s1_c4 bca.bca_mp_2016_11_01_s1_c4 Chart I-5U.S. Sitting Atop The Global Interest Rate Distribution Buoys The Dollar bca.bca_mp_2016_11_01_s1_c5 bca.bca_mp_2016_11_01_s1_c5 Real interest rate differentials may shift even more than nominal rates in favor the dollar. Inflation expectations should rise in Europe and Japan to the extent that their respective currencies weaken and their economies receive a boost from improved U.S. import demand. But since neither central bank will allow much of an increase in local bond yields, rising inflation expectations will translate into lower real yields in the Eurozone and Japan. This will reinforce the dollar's bias to appreciate. The ECB could upset this forecast by announcing that it will taper the asset purchase program beginning in March of next year, but we believe it is more likely the central bank will extend the QE program for another six months. In Japan's case, the nominal yield curve is now fixed by the Bank of Japan out to 10-years. How Much Will The Dollar Appreciate? This is a difficult question. A central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. Our sense is that over the next couple of years the fed funds rate will need to rise to 2% in nominal terms (0% in real terms) and the dollar will appreciate by 10% in trade-weighted terms, to avoid an economic overheating and an overshoot of the inflation target. We expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. But, of course, an outsized dollar response to the initial rate hikes would temper the speed of Fed tightening. A 10% rise seems aggressive, but it would still leave the broad trade-weighted dollar index well below previous peaks. Wouldn't Such A Dollar Surge Kill Any Hopes Of A Recovery In U.S. Profits? Undoubtedly, dollar strength presents a direct and non-trivial risk to the earnings outlook. Our U.S. EPS model foresees a return to positive earnings growth early next year, and a full-year expansion of 5-6% (Chart I-6). This is based on three important assumptions: (1) industrial production returns to modest but positive growth next year; (2) oil prices are roughly unchanged from current levels, allowing profits in the energy patch to recover with a lag; and (3) nominal GDP growth accelerates modestly relative to labor compensation. Chart I-6The U.S. Profit Outlook bca.bca_mp_2016_11_01_s1_c6 bca.bca_mp_2016_11_01_s1_c6 However, we assumed in the base case scenario presented in May that the dollar is unchanged. Re-running the model with a 10% dollar appreciation over the next year would shave about 2-3 percentage points off of EPS growth next year (Chart I-6). In other words, EPS would rise next year, but only modestly. Can The S&P 500 Rally In The Context Of Dollar Strength? Chart I-7Stocks Can Appreciate With The Dollar bca.bca_mp_2016_11_01_s1_c7 bca.bca_mp_2016_11_01_s1_c7 An appreciating dollar is clearly a headwind, but it is the case that the S&P 500 rallied along with the dollar in the last three major dollar bull markets: 1978-1985, 1994-2002, and 2011 to today (Chart I-7). One could point to special factors in each episode. Nonetheless, our point is that if the dollar is appreciating because growth outside the U.S. is deteriorating, then the backdrop is negative for U.S. equities. But if the dollar is appreciating because the U.S. economic growth backdrop has brightened (with no deterioration elsewhere), then U.S. stocks can rally despite the negative impact of the dollar on profits. Indeed, the direction of causation reverses at times: it is the rally in U.S. risk assets (along with higher rates) that attracts foreign capital and pushes the dollar higher. A tax holiday on foreign retained earnings would also be positive for the dollar and risk assets. That said, the currency shifts we expect over the next year will favor Eurozone and Japanese stocks to the U.S. market in local currency terms. This is particularly so for Japan if more aggressive monetary and fiscal policies manage to sharply devalue the yen (see below). According to our models, a 5% depreciation of the euro and a 10% drop in the yen in trade-weighted terms would boost EPS growth next year by 3 and 5 percentage points, respectively, in the Eurozone and Japan (Chart I-8). Monetary policy divergence and relative valuation also support our recommendation to favor Japanese and Eurozone stocks versus the U.S. Chart I-8The Eurozone Profit Outlook The Eurozone Profit Outlook The Eurozone Profit Outlook What Does Our Dollar Outlook Mean For EM Assets? Continuing liquidity injections from the ECB and BoJ are positive for emerging market (EM) assets. Unfortunately, this will not shield emerging markets from a 10% dollar rise, especially if it is accompanied by another downleg in commodity prices (Chart I-9). A stronger greenback is likely to cause distress among over-leveraged EM borrowers given that 80% of EM foreign-currency debt is denominated in dollars. Chart I-10 illustrates that there have been no periods when EM share prices rallied amid strength in the trade-weighted U.S. dollar since the early 1980s. Meanwhile, the gap between EM and U.S. nonfinancials' return on equity (RoE) remains deeply negative, which historically has been associated with EM currency depreciation. Chart I-9Dollar Strength Is Negative For Commodities... bca.bca_mp_2016_11_01_s1_c9 bca.bca_mp_2016_11_01_s1_c9 Chart I-10...And Emerging Markets ...And Emerging Markets ...And Emerging Markets The implication is that the recent rally in EM risk assets and currencies will not last. Investors should avoid this space. A dollar rally would also be a headache for the People's Bank of China (PBoC). Allowing the RMB to depreciate aggressively versus the dollar to avoid an appreciation in trade-weighted terms could ruffle political feathers in the U.S. and spark capital flight. The PBoC will likely manage the RMB's decline versus the dollar and allow it to appreciate in trade-weighted terms, while tightening capital account controls to prevent capital from fleeing the country. This outcome is slightly negative for the economy and could generate some financial market volatility as the process unfolds. We believe that China will be able to maintain GDP growth of around 6½% next year and that there will be no financial crisis related to China's high debt levels. Nonetheless, China's transition away from an investment-led to a consumer-led expansion means that the tailwind for commodity demand and EM exports will not return. FOMC: Some Like It Hot The probability of a Fed rate hike in December eased a little in recent days due to some disappointing economic data, such as the September readings on retail sales and the CPI, along with comments from Fed Chair Yellen on the benefits of allowing the economy to "run hot". Some others on the FOMC share her views, but many do not. As we highlighted in last month's Special Report,1 Yellen will not overrule the consensus on the FOMC. The appetite to test the limits of the supply side of the economy is simply not broad enough, as visions of the inflationary 1970s still loom large in some policymakers' minds. The Fed may end up being too slow in tightening policy and generate an overheated economy by accident, but the idea of purposefully engineering a temporary inflation overshoot is off the table. The hawkish shift in the consensus can be observed in the latest FOMC minutes. Not only did three members vote for a rate hike in September, but "several" members felt that a rate hike was a "close call". The remaining doves often point out that the Fed's preferred measure of inflation, core PCE, is still below the 2% target. However, this measure is an outlier; all other popular measures of underlying inflation are near or above 2% and are in a clear uptrend. Wage growth, although somewhat mixed across the various measures, is also trending up (Chart I-11). The doves already lost two members this year (Williams and Rosengren). More will jump ship if core PCE moves up in the coming months as we expect, although a 10% dollar appreciation by itself could shave almost a half point off of inflation next year (Chart I-12). Chart I-11U.S. Wage Pressure Is Growing bca.bca_mp_2016_11_01_s1_c11 bca.bca_mp_2016_11_01_s1_c11 Chart I-12The Inflation Impact Of Dollar Strength bca.bca_mp_2016_11_01_s1_c12 bca.bca_mp_2016_11_01_s1_c12 Recent data disappointments are a concern, but the bounce in both the ISM manufacturing and nonmanufacturing surveys in September, especially in the new orders components, is a sign that the soft patch will not endure. It would require a significant disappointment in the October and November payroll reports for the FOMC to stand pat at the December meeting. Beyond this year, our base-case outlook calls for five quarter-point rate hikes over 2017 and 2018, compared to only two rate hikes currently discounted in money markets. This forecast is uncertain because an even larger portion of the overall tightening in monetary conditions than we expect could come via the dollar. Indeed, there is a significant risk that dollar strength and Fed tightening sparks a correction in risk assets. The TINA phenomenon (There Is No Alternative) has forced many investors to take more risk they are comfortable holding. Valuations are also rich. This is the main reason why our investment recommendation is cautious, including only a benchmark allocation to equities in a balanced portfolio. We maintain that stocks will outperform bonds and cash on a 1-2 year horizon, although total returns will be depressed by historical standards. Moreover, we would not be surprised to see a 10% correction in the major equity bourses in the coming months. Investors with a short-term horizon should consider buying some insurance against this risk. What would it take for us to upgrade stocks to overweight? We would like to see significant fiscal stimulus in some combination of the U.S., Eurozone and Japan. It would be particularly bullish if the stimulus occurs outside the U.S., because a pickup in global growth would allow the Fed to tighten without driving the dollar significantly higher. This scenario would improve the outlook for equities inside and outside of the U.S. Finally, a 10% equity correction would create enough value that we would be quite tempted to upgrade the sector. Japan Prepares For The Next Step The dollar's ascent will be particularly acute versus the yen if we are right that more aggressive policy action looms in Japan. We argued in last month's Overview that fiscal stimulus will be particularly powerful in the context of the Bank of Japan's (BoJ) new policy framework. Instead of targeting a pace of asset purchases, the central bank is effectively fixing the yield curve by promising to hold the 10-year yield near to zero. By fixing the yield curve and by committing to maintain this policy until Japanese inflation moves above the 2% target, the BoJ is hoping to raise inflation expectations and drive down real bond yields. Fiscal stimulus in this environment would be quite effective because nominal yields would not be allowed to rise in response. Any increase in inflation expectations would flow directly into lower real yields and weaken the yen, thus reinforcing the initial thrust of fiscal policy. The timing and amount of additional fiscal spending is not clear, but the Japanese Diet is currently deliberating the third revision to the second supplementary budget. Government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. Any efforts to boost income will add to upward pressure on actual inflation and inflation expectations. Given that the market is discounting inflation of only 0.26% per year on average over the next 20 years, the balance of risks favors an inflation rate that surprises to the upside. The resulting downward pressure on real interest rates, at a time when U.S. real rates will be rising, will depress the yen. Our currency experts expect the yen to weaken to 125 versus the dollar, representing a decline of roughly 10% in trade-weighted terms. We estimate that this would add about a half point to Japanese headline consumer price inflation next year (Chart I-12). A successful policy push would ultimately be quite bearish for JGBs. However, a critical element in the plan is that the BoJ prevents a premature rise in nominal yields. We do not expect any JGB selloff for at least a year. This means that, while total returns for JGBs will be poor (or negative for some maturities), the market will outperform the other major government bond markets in currency hedged terms if global yields rise in the coming months as we expect. The implication is that investors should favor JGBs over Bunds and, especially, Treasuries within global hedged bond portfolios. Also, stay long inflation protection in Japan, overweight the Nikkei and underweight the yen. Reason To Be Bond Bearish Chart I-13Reasons To Keep Duration Short bca.bca_mp_2016_11_01_s1_c13 bca.bca_mp_2016_11_01_s1_c13 Our fairly hawkish view on the Fed is a key factor behind our recommendation to keep duration slightly short of benchmark within bond portfolios. More broadly, the global deflation beast is far from tamed, but the firming in selected commodity prices is reducing some of the downward pressure on inflation in the advanced economies. Oil prices have breached $50/bbl on hopes that OPEC-Russia talks will result in production cuts. Our commodity strategists do not expect any agreement to have much of a lasting impact on oil prices. Indeed, there is a risk that oil prices correct if the talks ultimately fail. However, we still expect WTI to trade between $40 and $65/bbl until 2020. The annual growth rate for the continuous commodity index has reached positive territory for the first time since 2014, which is translating into a more positive pricing environment for manufactured goods and overall headline inflation rates for both developed and emerging economies (Chart I-13, bottom panel). This has given inflation expectations a boost in the major markets, at a time when output gaps in developed countries are narrowing (the gap is near to being fully closed in the U.S.). Several other factors favor a below-benchmark duration stance at least for the near term (Chart I-13): Global growth is improving slowly. The global leading economic indicator (LEI) is rising and our diffusion index shows that 10 of 15 countries have rising LEIs. We expect the U.S. economy, in particular, to surprise to the upside. The prospect of even a little fiscal stimulus is bond bearish, following years of austerity in the major developed countries. The downward pressure on global term premia is dissipating as the BoJ has switched away from quantitative targets for asset purchases to fixing the yield curve. The ECB is likely to extend the QE program by another six months, but the central bank is unlikely to lift the pace of purchases from the current level. The annual percent change in total central bank assets for the U.S., Euro Area, the U.K. and Japan is on the verge of peaking even assuming the ECB extends, which means that the period of maximum downward pressure on global term premia is over (Chart I-14). Chart I-14Liquidity Growth Peaking Out bca.bca_mp_2016_11_01_s1_c14 bca.bca_mp_2016_11_01_s1_c14 The market expects that real short-term interest rates will stay in negative territory until at least the middle of the next decade, even in the U.S. There is plenty of room for the forward yield curve to reprice higher if growth turns out to be better than expected. This is particularly the case in the U.K., where fears of a post-Brexit economic bust and a fresh shot of stimulus from Bank of England sent the pound and gilt yields to extremely low levels. Our global bond and currency services recommend taking profits on overweight gilt/underweight sterling positions, and shifting in the opposite direction. Finally, bond sentiment indicators are still bullish, particularly in the U.S. Treasury market. Nonetheless, we are far from frothing bond bears. We do not believe that the fixed income market has moved into a secular bear phase, and would likely shift to benchmark or even above-benchmark duration if the 10-year Treasury yield reached 2%. Yields could eventually re-test the year's lows if there is a sharp equity correction. This is a market to be traded for now. Conclusions A more upbeat view on global and, especially, U.S. growth prospects is positive for risk assets, but the adjustment process could be painful as investors come to grips with what this means for the Fed. Extremely low Treasury yields imply that the consensus has "bought into" the Secular Stagnation thesis for the U.S., or at least to the view that America will never again be able to grow above 2%. The pickup in growth we expect will arrive at a time when there is accumulating evidence of an acceleration in wages, signaling that the labor market has reached full employment. A shift in focus away from monetary and toward fiscal stimulus, both inside and outside the U.S., is also bond-bearish. The bond market appears to be ignoring these trends so far, although rising inflation expectations suggest that we may be at the edge of a change in market expectations for growth, inflation and the Fed outlook. A significant shift up in the dollar would limit the bond market selloff, and it would be positive for the major economies outside of the U.S. Nonetheless, a 10% dollar appreciation would carry its own risks, including a hit to the U.S. profit outlook. On its own, dollar strength would not prevent the S&P 500 from rising, but there is a non-trivial risk that it wreaks havoc in the EM and commodity space for a time, reverberating back into developed markets. The bottom line is that investors should remain focused on capital preservation, with no more than an overall benchmark weighting in equities with a bias toward defensive sectors. Within bond portfolios, keep duration on the short side and favor high-quality spread product to government bonds in the major countries. High-yield bonds would benefit from stronger-than-expected economic growth in the U.S., but value is poor and balance sheets are deteriorating; the risk/reward balance is unattractive. European investment-grade bonds issued by domestic issuers are more attractive than the U.S. market because of improving balance sheet health. Favor real-return bonds to conventional issues in the major countries and add exposure to floating-rate notes. Our dollar view means that base metals should be avoided, despite the fact that we expect that China will be able to stabilize growth at around 6-7%. Oil should be able to hold up in the face of dollar strength given that we expect a tightening oil supply/demand backdrop. Both gold and silver would weaken if the dollar continues to appreciate and real bond yields rise in the near term. Nonetheless, rising inflation should overwhelm these negatives in the medium term. This implies that precious metals deserve a strategic place in investors' portfolios, although the near-term could be rough. Finally, we have received many questions on the risks posed by mushrooming U.S. student debt. This month's Special Report, beginning on page 19, takes an in-depth look. We conclude that student debt is a modest economic drag, but is not a source of risk to the government's finances and does not represent the next "subprime" crisis. Mark McClellan Senior Vice President The Bank Credit Analyst October 27, 2016 Next Report: November 24, 2016 1 Please see The Bank Credit Analyst, "Herding Cats at the Fed," October 2016, available at bca.bcaresearch.com II. Student Loan Blues: Can't Repay What I Borrowed Incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages. Some are comparing this trend to the housing subprime crisis, arguing that student debt is a major drag on growth at a minimum, and the source of another financial crisis at worst. Delinquency rates have surged and the 5-year cumulative default rate on student debt has reached almost 30%. Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%. Sticker prices at most institutions have mushroomed, although few students pay the full fare. Rising tuition fees only explain about half of the surge in student debt. Education still pays, although the benefits have waned versus the costs. Moreover, students with debt lag significantly those with no debt in terms of wealth accumulation and home ownership after graduation. The rise in default rates have been due to the influx of non-traditional student borrowers after 2007, who come from lower income families and have had poorer educational and employment outcomes. However, the wave of such borrowers has faded, which means that overall delinquency and default rates will decline in the coming years. Debt service payments, while onerous for many families, are not a major drag on overall real GDP growth. The increased propensity of 18-35 year-olds to live with their parents has trimmed annual real GDP growth by 0.14% per year since 2007, although student debt is only one of many underlying causes. The student loan program is at worst only a minor drain on the Federal government's coffer because of the high recovery rate. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Student debt is not the next subprime. "We are not doing these young people any favors by giving them loans that they cannot afford, that they cannot discharge in bankruptcy, and that could be a drag on their financial well-being even into retirement". - Sheila Bair, former FDIC chief, Bloomberg interview, September 26, 2016 Ms. Bair was one of the first to warn about the risks posed by the U.S. subprime MBS market, well before Lehman went bust. Few were listening then, but more are listening now as she sounds the alarm bell regarding student loans. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages (Chart II-1). Ms. Bair notes that, like the MBS market before 2007, cheap and freely available credit is fueling prices (tuition in this case). Banks handed out mortgage loans to many who could not afford them in the 2000s, just as the Department of Education (DoE) is doing today with student loans. It is difficult to assess borrowers' ability to repay student loans. Some argue that the DoE is not even trying. The trajectory of student debt is indeed alarming (Chart II-2). In inflation-adjusted terms, the total value of loans outstanding has quadrupled since 2000, representing an annual average compound rate of 9.4%. The rise reflects both an increase in the number of borrowers and more borrowing per person. Average debt/person has jumped from $17,300 in 2007 to almost $28,000 in 2015 (amounts vary across data sources). Rising debt levels occurred across the family income distribution. Chart II-1Student Debt: The Next Subprime? bca.bca_mp_2016_11_01_s2_c1 bca.bca_mp_2016_11_01_s2_c1 Chart II-2Student Loan Statistics bca.bca_mp_2016_11_01_s2_c2 bca.bca_mp_2016_11_01_s2_c2 These figures understate the true debt levels because they include only loans that are made under the federal loan program, representing 81% of the total. The remainder are private loans, mostly originated by banks. Private loans do not enjoy the same borrower protection afforded to federal loans, and carry a significantly higher interest rate (average of almost 14% in 2016, compared to federal loan rates of 3.76%). The data on private loans are sparse due to limited reporting, but a study based on 2012 data showed that the average amount of debt for students with private loans was almost $40,000 at that time.1 Sticker Shock It is easy to blame rising tuition fees given soaring "sticker prices" at most institutions. The average posted fee for tuition and room & board has increased by 30% in inflation-adjusted terms since 2007 at public universities, and by 23% at private non-profit institutions (Charts II-3A & II-3B). However, due to grants, tuition discounts and tax credits for education, only a small fraction of students pay the posted rate. For the 2015/16 school year, the net price that the average student paid at a private non-profit institution was $26,400, far less than the almost $44,000 sticker price. Chart II-3ATuition & Fees: Public Institutions bca.bca_mp_2016_11_01_s2_c3a bca.bca_mp_2016_11_01_s2_c3a Chart II-3BTuition & Fees: Private Institutions bca.bca_mp_2016_11_01_s2_c3b bca.bca_mp_2016_11_01_s2_c3b Chart II-4The Distribution Of Student Debt November 2016 November 2016 The Brookings Institute estimates that only about 50% of the escalation in student debt in the past two decades can be explained by rising tuition costs.2 Another quarter reflects rising educational attainment; kids are staying in school longer to get a leg up in the highly competitive workplace. The remainder of the total rise in debt was left unexplained in the study. Other possible contributing factors include policy changes that expanded eligibility for federal loans programs, and the housing bust that made it more difficult for families to borrow against the value of their homes for education purposes. There was also a change in the background characteristics of borrowers after the Great Financial Crisis (see below). The share of students suffering with an extraordinary amount of debt is growing, although they still represent a small portion of the total for federal loans (Chart II-4). Five percent of student debtors owe more than $100,000 each, up from 2% in 2007. Another 10% hold between $50,000 and $100,000. About two-thirds of student borrowers owe less than $25,000. A Student Debt Crisis? Another Brookings paper provides estimates for the debt service burden associated with federal student loans. The burden is calculated as the median debt service payment divided by median earnings of employed borrowers for two years after entering the repayment period (Chart II-5).3 This ratio rose from about 4½% in 2004 to 7.1% in 2013. Unfortunately, more recent data are not available. The average interest rate on the outstanding loans has moderated since 2011, although not nearly as quickly as the drop in market interest rates.4 Nonetheless, the continued escalation in the stock of debt per person in recent years means that the debt service-to-income ratio has likely continued to escalate since 2013, despite the moderation in the average interest rate paid. The jump in student loan delinquencies has raised red flags regarding the number of borrowers in financial distress, feeding concerns that a student loan debt crisis is on the horizon. The 90-day delinquency rate for student loans has increased from about 7% in 2007 to 11% in 2012, where it has hovered ever since according to the Federal Reserve Bank of NY data (Chart II-1). However, since only about 55% of all loans are in the repayment period, the actual delinquency rate among those in repayment is almost double the official figures. Loans are considered to be in default when they are more than 270 days past due. Brookings estimates that the 5-year default rate for student loans entering the repayment period five years earlier reached 28% in 2014, up from 16% for the five-year period ending in 2007 (Chart II-6).5 Perhaps surprisingly, the default rate is still far below the peak rate of more than 40% in the late 1990s. Chart II-5Debt Service Burden Is Rising bca.bca_mp_2016_11_01_s2_c5 bca.bca_mp_2016_11_01_s2_c5 Chart II-6Defaults Are Rising bca.bca_mp_2016_11_01_s2_c6 bca.bca_mp_2016_11_01_s2_c6 Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%.6 This is because borrowers are not able to discharge federal student debts during bankruptcy. Congress has passed legislation making it very difficult for borrowers to avoid repaying. The DoE has the authority to use a number of extraordinary collection means. These include garnishing a portion of borrower's wages or seizing any payment a borrower may receive from the federal government. Education Still Pays, But Not For Everyone Chart II-7Debt And Wages For 20-40 Year Olds bca.bca_mp_2016_11_01_s2_c7 bca.bca_mp_2016_11_01_s2_c7 The good news is that education still pays for the average or median borrower. Chart II-7 shows that, while the average amount of student loans has escalated, it is still well below the average wage for those borrowers in the 20 to 40-year age group.7 The gap between wages and debt has narrowed over the past 15 years, but the increase in lifetime earnings potential still far exceeds the rise in accumulated debt for the average or median student. Of course, student loans have not paid off for everyone. News reports have highlighted plenty of examples of students that have graduated with crushing debt burdens and poor job prospects. Nonetheless, the Brookings study found that, for the vast majority, "the increase in borrowing would be made up for relatively early in the career of a worker with mean earnings".8 The Digest of Education Statistics show that, in 2013, the median annual earnings for full-time workers with a Bachelor's degree in the 25 to 34 age group was $48,530, compared with $30,000 for workers with just a high-school diploma. The bad news is that it is taking much longer to repay these debts. The mean term of repayment has increased from 7½% in 1992 to about 13½ years in 2010.9 Extended repayment and income-driven repayment plans can increase the loan term to 20, 25 or even 30 years. In some cases, borrowers will still be paying for their education when their children enter college!10 There is also evidence that the debt burden is causing some young adults to delay marriage and live with their parents for longer than they otherwise would. More Debt And Less Wealth Young student debtors also lag significantly relative to their peers in terms of wealth accumulation. A Pew Research Center study found that households headed by a young, college-educated adult without any student debt obligations have about seven times the typical net worth ($64,700) of households headed by a young, college-educated adult with student debt ($8,700; Chart II-8).11 Net worth is lower for those with student loans not just because their overall debt levels are higher; the value of their assets trailed as well. This gap is despite the fact that those households with a degree had almost double the annual income of those in the study that did not. Even comparing only households headed by young adults that did not attain a degree, accumulated wealth for those with student debt fell far short of those who avoided debt. One explanation is that money being absorbed by student debt repayment is unavailable to accumulate assets. A Federal Reserve Bank (FRB) of Boston study12 estimated that a 10% increase in student loan debt per household is associated with a 0.9% decline in the value of total wealth. Student loan burdens also mean that households end up relying more on other types of debt, such as auto loans and credit cards, according to the Pew study. Chart II-8Higher Debt, Lower Wealth... November 2016 November 2016 Table II-1...And Lower Homeownership November 2016 November 2016 Student debtors are also less likely to own a home after 2009 (Table II-1). Before 2009, the FRB of Boston study found that 30-year olds with a history of student loans had a higher homeownership rate than those without student debt. This makes sense because the boost to household income from obtaining more education should make it easier to quality for a mortgage. However, the relationship between student debt and homeownership switched after the Great Recession. The economy-wide homeownership rate has fallen sharply since home prices peaked in 2006, but the drop was more severe for those with student loans. This is probably due to the erosion in future income expectations following the recession for those with student debt, as well as more limited access to additional credit based on these individuals' existing debt loads (i.e. lower credit scores). Alternatively, student debtors may simply be reluctant to add to their overall leverage in light of the more uncertain economic outlook. A Fed study estimated that every 10% increase in student debt per person now results in a 1 percentage point drop in the homeownership rate for the first five years after graduation.13 Non-Traditional Borrowers Led The Surge In Delinquencies... While student debt burdens are unlikely to ameliorate anytime soon, the default rate should moderate in the coming years. Brookings (2015) conducted a detailed assessment of the characteristics of student loan borrowers and how they changed after 2007, by matching administrative data on federal student borrowers with earnings data from tax records. The study split the sample into "traditional" and "non-traditional" borrowers. Traditional borrowers are defined to be those attending 4-year public and private institutions because they tend to be typical in nature; they start college in their late teens, soon after completing high school, are dependent on their parents for aid purposes, pursue 4-year degrees and, frequently, head on to graduate study. This group historically represented the majority of federal borrowers and loan amounts. Non-traditional borrowers historically made up only a small portion of the total. These are defined to be those borrowing for 2-year programs (primarily community college) or to attend for-profit schools. The study found that non-traditional borrowers have largely come from lower-income families, tended to be older (i.e. not supported by parents), attended institutions with relatively low completion rates and faced poor labor market outcomes after leaving school (Chart II-9). Lower median wages and higher rates of unemployment meant that non-traditional borrowers tended to default on their student loans at a higher rate than traditional students. Student borrowing is counter cyclical; it tends to accelerate during recessions as unfavorable labor market conditions encourage people to return to school or to stay in school longer. The flow of new borrowers accelerated particularly sharply during the Great Recession, as intense pressure on State budgets led to cuts in scholarships by public institutions. Access to alternative credit markets was also curtailed during and after the Great Financial Crisis. Chart II-9Non-Traditional Students Had Poor Labor Market Experience November 2016 November 2016 Chart II-10Surge In Non-Traditional ##br##Borrowers After 2007 bca.bca_mp_2016_11_01_s2_c10 bca.bca_mp_2016_11_01_s2_c10 Student loan inflows (i.e. the number of new borrowers) and outflows (the number paying off loans) are shown in Chart II-10. Inflows trended higher from 2000 to 2007, while outflows were fairly flat, leading to an upward trend in the net inflows. Inflows subsequently surged during the recession, reaching a peak in 2010. The jump in new borrowers was concentrated among non-traditional students. The number of non-traditional borrowers grew to represent almost half of all new borrowers soon after the recession. The wave of students who had begun to borrow during the recession entered the repayment period in increasingly large numbers from 2011 to 2014. The early years of repayment are the most precarious because debtors are just starting their careers and their earnings are the most variable. The rise in the share of non-traditional borrowers largely explains the surge in the overall default rate since 2011. In contrast, the majority of traditional borrowers have experienced strong labor market outcomes and relatively low rates of default. Of all the students who left school, started to repay federal loans in 2011, and had fallen into default by 2013, about 70% were non-traditional borrowers. ...But The Worst Is Over The situation has since begun to reverse. Inflows and the net change in the number of borrowers has declined since 2012, particularly at 2-year and for-profit institutions. The moderation of the pace of inflows, the change in the composition of borrowers (less non-traditional), and efforts by the DoE to expand the use of income-based repayment programs will put downward pressure on delinquency and default rates in the coming years. Economic Impact Of Student Debt There are several channels through which rising student debt can affect overall economic growth. Spending by households with student debt will be curtailed both by the need to service the loans and by the fact that these households have lower levels of net worth. They are also less likely to own a home or form a small business. (1)Debt Service Burden And The Wealth Effect Table II-2 presents estimates of the value of aggregate debt service payments as a percent of GDP. This is based on the median debt service-to-earnings estimates from the Brookings Institute and median income for households where the head is less than 35 years of age in the Survey of Consumer Finances. If we assume that every dollar paid to service student loans is a dollar not spent on goods and services, then Table II-2 implies that the resulting drag on the level of real GDP has doubled from 0.17% of GDP in 2004 to 0.34% in 2013 (latest year available). However, it is the increase over time that matters for GDP growth, not the level. The rise of 0.17% was spread over nine years, suggesting that the drag on GDP growth was minimal. Moreover, this represents an overestimate of the actual drag, because households with student debt have leaned more heavily on other types of debt in an attempt to maintain their living standards. Table II-2The Debt Service Drag On GDP November 2016 November 2016 Lower levels of asset accumulation and net worth will also undermine consumer spending. However, we believe that accounting for both the "wealth effect" and the debt-service effect on GDP would be double counting. Chart II-11Spending On Education ##br##Not A Growth Driver bca.bca_mp_2016_11_01_s2_c11 bca.bca_mp_2016_11_01_s2_c11 Education spending also provides a possible offset to the negative impact of debt service on GDP growth. However, in terms of household spending on education, in inflation-adjusted terms there has been virtually no growth in consumer spending on higher education over the past 15 years despite all the extra spending in nominal dollars (Chart II-11). Data on government spending specifically on higher education is not available, but spending on all levels of education including primary and secondary schools has declined as a fraction of real GDP since the early 2000's. The implication is that total spending on higher education by households and governments has not provided any offset to the drag on GDP growth from student debt since 2007. (2)Housing Market Earlier, we cited Fed estimates that every 10% increase in student debt per person results in a 1 percentage point drop in the homeownership rate for the first five years after graduation. The economy-wide homeownership rate has fallen by 5.5 percentage points since the beginning of 2007, reaching 62.9% in the second quarter of 2016. We estimate that rising student indebtedness could account for as much as 1½ percentage points of the total 5½ percentage point drop. This is based on the Fed's estimates, the rise in the share of student loan borrowers among the total number of households and the increase in student debt-per-person. Again, this estimate likely overstates the impact because we are implicitly assuming that every new student borrower since 2007 ultimately forms a new household upon graduation. Undoubtedly, a portion of student borrowers formed a household with other student borrowers. Even if this estimate is close to the truth, it is not clear that there is a large impact on GDP growth. The formation of new households will result in an expansion in the housing stock one-for-one (assuming no change in inventories). Whether they decide to rent or buy, this will boost the residential investment portion of GDP. Buying a home or condo often results in home renovation and purchases of new furnishings, thus providing the economy with a larger boost compared to new households that rent. Nonetheless, the difference is difficult to estimate and is probably small enough to ignore. Another way to approach the issue is to gauge the impact on the housing market of the greater propensity of 18-35 year olds to live with their parents. Those living at home jumped from 19.2 million in 2007 to 23.0 million in 2015. The proportion of those living at home of the total population of 18-35 year olds rose from 28% to 32%. If the ratio had not increased over the period, it would have resulted in an extra 2½ million young people leaving home. If we assume that one-quarter of them move in with someone else who is also leaving home, then it would result in an increase in the housing stock of more than 1.8 million units since 2007 (condos or single family homes). We estimate that the resulting boost to residential construction growth would have added an average 0.14 percentage points to real GDP growth each year since 2007. Of course, it is not clear how much of the "living at home" trend is due to student loans as opposed to low earnings or poor job prospects. This estimate thus overstates the direct impact of student loans on the housing market. Nonetheless, it is instructive that the living-at-home phenomenon has been a non-trivial drag on economic growth via new home construction. (3) New Business Creation Academic research has also linked rising student indebtedness to a slower pace of new business creation. Research by the Federal Reserve Bank of Philadelphia points out that approximately 60% of new jobs in the private sector are created by small business.14 The U.S. Small Business Administration states that small firms receive approximately three-quarters of their capital needs in the form of loans, credit cards and lines of credit, which often have a personal liability attached. Having student loans reduces one's debt capacity and thus the ability to obtain small business loans. The Fed study compared student loan data and new business formation across U.S. counties. The Fed estimates that an increase of one standard deviation in student debt results in a decrease of 70 in the annual pace of new small business creation, representing a decline of approximately 14½%. Chart II-12 shows the inverse correlation between student debt and new business formation across U.S. states. Chart II-12Student Debt Hinders Small Business Creation November 2016 November 2016 The impact of a slower pace of new business creation on overall economic growth is unclear. A student that does not create a new business for whatever reason will likely end up working for an already existing company that is growing, expanding the supply side of the economy anyway. True, small businesses create a lot of jobs, but they lose a lot too because the failure rate for these firms is high in the early years. Some claim that the less vibrant new business environment since 2007 reflects a less dynamic economy, helping to explain the dismal productivity record since that time. However, this flies in the face of the fact that the small business sector is less productive overall than large businesses. Chart II-13 demonstrates that there is a rough correlation between the new firm creation rate and real GDP growth per capita at the state level. However, it is not clear which one is driving the other. Our sense is that, while a less vibrant new business backdrop likely contributed to the poor post-Lehman economic record, it is far from the major driving factor. Chart II-13GDP Growth And Small Business Creation: Which One Is The Driver? bca.bca_mp_2016_11_01_s2_c13 bca.bca_mp_2016_11_01_s2_c13 (4) The Federal Budget Could the surge in delinquency rates wind up costing the taxpayer a bundle? Eighty percent of all student loans are either made directly by or are backed by the federal government, generating a potentially large contingent liability. Fortunately for the taxpayer, the recovery rate on student loans is extremely high. Moreover, the Federal government makes money on the spread between the student loan rate and the rate at which it finances these loans (Treasury yields). Congress sets the loan rates and they are kept well above Treasury yields. Under Congressional accounting rules, the cost of a student loan is recorded in the federal budget during the year the loan is disbursed, taking into account the amount of the loan, expected payments to the government over the life of the loan, and other cash flows, all discounted to the present value using interest rates on U.S. Treasury securities. By this accounting rule, the Congressional Budget Office estimates that the Federal government will make a net profit of almost $200 billion over the 2013-2023 period.15 However, a more reasonable "fair value" accounting method, which includes the costs of collection and other items, shows that the student loan program will cost the taxpayer roughly $100 billion over the same period. Either way, the bottom line is that the student loan program is at worst only a minor drain on the Federal government's coffer. Delinquency and default rates are likely to moderate in the coming years. But even if default rates were to surge to new highs for some reason, the recovery rate is so elevated that the impact on the Federal budget balance would be lost in the rounding. Conclusion It seems clear that incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. There has been a vicious circle in which increased federal loan limits supported institutions' ability to raise tuition fees, resulting in a greater need for federal loans. Some for-profit institutions have been criticized for offering shoddy education, for graduating too many students in disciplines for which job prospects are poor, and for encouraging students to load up on high-cost debt. The U.S. spends almost 80% more per pupil on higher education than the OECD average, and yet some argue that this has not resulted in better educational outcomes. The social impact of student leveraging is clearly negative. The benefits of education have narrowed relative to the costs. Financial stress has increased along with debt service burdens, especially for non-traditional borrowers, and repayment periods have been extended to an average of over 13 years. These trends have caused young people to delay marriage and home purchases. This is a serious political and social issue that needs to be addressed. That said, we do not agree with Ms. Bair that student debt is the next "subprime" crisis. Delinquency and default rates are likely to fall in the coming years. These loans have not been packaged into opaque financial instruments and distributed throughout the investment world. The vast majority of the loans are federally backed and the recovery rate is very high. Even if there is a wave of mass defaults, the federal deficit might rise slightly but there is no channel through which the shock can propagate through the financial system. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Mark McClellan Senior Vice President The Bank Credit Analyst 1 "Student Debt and the Class of 2015," Annual Report of the Institute for College Access & Success, October 2016. 2 Beth Akers and Matthew Chingos, "Is a Student Loan Crisis on the Horizon?" Brown Center on Education Policy at Brookings, June 2014. 3 Adam Looney and Constantine Yannelis, "A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults," Brookings Papers on Economic Activity, Fall 2015. 4 Most federal student loans are at a fixed rate set by Congress. 5 Brookings (2015). 6 http://www.edcentral.org/edcyclopedia/federal-student-loan-default-rate… 7 The data are only available to 2010, but we have estimated figures to 2013. 8 Brookings (2014). 9 Brookings (2014). 10 Student loans generally have a 10-year term, but loans consolidated with the federal government are eligible for extended repayment terms based on the outstanding balance, with larger debts eligible for longer repayment terms. 11 "Young Adults, Student Debt and Economic Well-Being," Pew Research Center, May 14, 2014. 12 Daniel Cooper and J.Christina Wang, "Student Loan Debt and Economic Outcomes," Federal Reserve Bank of Boston, October 2014. 13 Alvaro Mezza, Daniel Ringo, Shane Sherlund and Kamila Sommer, "On the Effect of Student Loans on Access to Homeownership," Finance and Economic Discussion Series of the Federal Reserve Board. 2016-2010. 14 Brent Ambrose, Larry Cordell, and Shuwei Ma, "The Impact of Student Loan Debt on Small Business Formation," Federal Reserve Bank of Philadelphia Working Paper, July 2015. III. Indicators And Reference Charts Equity markets ended the month slightly lower as investors come to grips with the economic and profit implications of the pending Fed rate hike and Brexit. While TINA is still in play, caution abounds, as highlighted by waning investor sentiment and continued weakness in our Equity Technical indictor. Rising bond yields and a stronger dollar contributed to a weakening in our Monetary Indictor, trends that no doubt contributed to the overall diminished appetite for risk over the month. Our Equity Valuation Indicators have improved somewhat, but still remain in overvalued territory. Net earnings revisions have become constructive and positive earnings surprises increasingly outpaced negative ones. Despite this, we would need to see a close to 10% price depreciation for U.S. equities to appear attractive, as outlined in Section 1. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. At the moment, the low levels of the WTP indicators suggest that flows have been stronger into bonds than into stocks. From a contrary perspective, this means that there is "dry powder" available if investors decide to move more aggressively into equity markets. The U.S. and Eurozone indicators appear to have bottomed out last month and continue their ascent. This should be bullish for both U.S. and Eurozone equities. The U.S. dollar notched a strong month with a gain of more than 3%. This has tightened financial conditions as can be seen in the decline of our Financial Conditions Index. The deviation from its 12-month moving average is even more pronounced, turning negative after several months of treading water in "easing" territory. Our Dollar Composite Technical indicator displayed a violent move higher, but has yet to breach a level consistent with previous episodes of overextension; the USD can rally further. The yen is showing signs of entering an extended period of depreciation. Net speculative positions are extremely elevated and the 40-week rate of change appears to have formed a trough, rebounding from all-time lows. In a similar vein, the euro is also displaying weakness as its 40-week rate of change is crossing into negative territory. As outlined in Section 1, we expect a 10% appreciation in the U.S. dollar, a 10% depreciation in the yen and a 5% depreciation of the euro in trade-weighted terms. The commodity complex ended the month flat, with a more robust global growth backdrop offsetting the negative impact of a strong U.S. dollar and higher rates. While the advance/decline line ticked up, a positive sign for a potential broad-based gain across currencies, gold had a less than stellar month. The outsized impact of financial variables (U.S. dollar strength and higher real rates) on the yellow metal led to a more than 5% price decline. Our Commodity Composite Technical Indicator surged deeper into overbought territory, indicating that it might be time to take some risk off the table. The balance of risks for commodities excluding oil is to the downside. As mentioned in Section 1, an appreciating U.S. dollar and elevated yields will eventually feed through to weakness in the space. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Dear Client, I am on the road visiting clients in Toronto, Chicago, and Wisconsin this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. In this report, Marko argues that Hillary Clinton has not yet sealed the election, despite her high odds of winning. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Clinton has a 65.5% chance of winning the presidency. A Trump win requires a surprise - such as in voter turnout. Still, we doubt Trump can punch more than 3% above his polling. Regardless of the outcome, multinational corporate profits will suffer. Go long the USD. Feature With the conclusion of the final presidential debate on October 19, the U.S. election is now in its final inning. Donald Trump's chances of mounting a comeback are slipping away (Chart 1). Could there be a Brexit-like surprise for the markets on November 8? And what are the investment implications of this year's unprecedented election? Chart 1 How Trump Can Still Win... Paddy Power, one of the world's biggest bookies, has begun to pay out bets to people who had wagered on Secretary Hillary Clinton winning the election. Meanwhile, according to Nate Silver, America's statistical Geek-in-Chief, Donald Trump has a meager 13.7% chance of winning the election.1 While our own model gives Clinton a 65.5% chance of winning, we have not forgotten Yogi Berra's wisdom: "It ain't over till it's over." There are three reasons why we would have held onto the pay-outs if we ran Paddy Power: Turnout assumptions could be wrong: Silver's quant model - and ours - is based on the assumption that the publically available opinion polls are high-quality data points. To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." The problem is that this method is mathematically the same as combining bad mortgages into securities. The idea is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening.2 If there is a bias that is common to a large part of the data, then you are in real trouble. And why would there be a bias in election polls? For one, polling is not a science. It is an art. To extrapolate the results of an opinion survey of ~1,000 individuals to the general election of ~130 million people, polling professionals have to make turnout assumptions that are based partly on previous elections and partly on guesswork. This year, these assumptions are notoriously difficult to make as both candidates are extremely unpopular (Chart 2). This is bound to throw off pollsters' assumptions and may partially explain the regular gyrations that can be gleaned in Chart 1. For Secretary Hillary Clinton, the problem is compounded by the fact that she requires a high turnout to win. She needs the "Obama Coalition" of minorities and Millennial voters to show up as they did for President Barack Obama in 2008 and 2012. But we know that she struggled with the latter, with Senator Bernie Sanders picking up 70% of the youth vote in the Democratic primaries (Chart 3). If the 2016 turnout resembles the turnout from mid-term elections - which Republicans have generally won this century - then Trump could still have a chance. Chart 2 Chart 3 People may be lying: Another concern for Clinton is that she may be the 21st century Tom Bradley. Bradley was an African-American Mayor of Los Angeles who lost the 1982 California governor's race despite being ahead in the polls right up until election day. The "Bradley effect" theory goes that white voters lied when answering the polls in 1982 for fear of appearing racially prejudiced. Today, voters may be telling pollsters what they think is "politically correct," thus favoring Clinton in the polls. In the same vein - but ideologically opposite - the former Imperial Wizard of the Knights of the Ku Klux Klan, David Duke, outperformed expectations in both the 1996 U.S. Senate election and the 1999 special election for Louisiana's First Congressional District. He lost both elections, but he managed to garner double-digit support both times. More recently, the June 23 Brexit vote surprised markets. In our view, investors and betting markets underestimated Brexit largely in spite of polls, which had been close throughout the campaign stage (Charts 4 and 5). BCA's Geopolitical Strategy outlined the case for why the probability of Brexit was much higher than the market assumption as early as March.3 Our concerns began to manifest in the polls with the "Leave" camp comfortably ahead throughout June. And then, from June 16 (one week before the vote) to June 23, the "Stay" vote surged ahead in the polls, garnering a 4% lead the day before the election. This surge in the last week was clearly false, as the "Leave" camp won by a 3.8% margin, a 7.8% swing on the day of the election. So, what happened? The vertical line in Chart 5 shows the day that Member of Parliament Jo Cox was murdered by a British ultra-nationalist. Our guess is that the stunning political assassination - an extremely rare event in the U.K. - created a "Cox effect" in the Brexit polling. Those who were polled may have mourned for Cox, or resisted being associated with the extreme views of a self-professed neo-Nazi, yet they silently stuck to their legitimate concerns regarding EU membership on the day of the referendum. Chart 4Online Betting Got Brexit Wrong... bca.gps_sr_2016_10_21_c4 bca.gps_sr_2016_10_21_c4 Chart 5...So Did Prominent Opinion Polls bca.gps_sr_2016_10_21_c5 bca.gps_sr_2016_10_21_c5 The Brexit example illustrates that lying to pollsters is not something that only happens in the past. It has happened as recently as June. Given Donald Trump's controversial statements - and particularly his misogynist rants going back to 2005 - American voters may be lying to pollsters when it comes to their choice for president. Chart 6Media Narratives Are Cyclical bca.gps_sr_2016_10_21_c6 bca.gps_sr_2016_10_21_c6 Media narratives: As our geopolitical team has stressed throughout this election, the news media work through narratives (Chart 6). These narratives appear to have influenced polls, leading to regular gyrations in support levels for the two candidates. Will the media have another "comeback kid" narrative for Trump in store ahead of the election? It cannot be discounted. And if the polls tighten to the 0-3% range again, the turnout concerns and the "Bradley/Cox effect" from above could be enough to swing the election for Trump. Bottom Line: Clinton remains the favorite to win the election, but her probability of winning is closer to 65.5% than the 85% that appears to be "priced in the market." ...And Why He Will Not Win While we are not comfortable calling the election a "done deal," we do believe that Clinton is a favorite. The BCA Geopolitical Strategy quantitative model predicts that she has about a 65.5% probability of winning.4 And the team's qualitative analysis of Trump's electoral strategy suggests that the hurdles to his victory are considerable, particularly in swing states Virginia and Colorado. Before we introduce the quantitative and qualitative models that underpin our election forecast, let us address the above concerns about turnout and the "Bradley/Cox effect" head on. In our view, the polls are telling the truth. We concede that Trump's support level may be underestimated by approximately 3%, which would not be out of line with the last five presidential elections (Chart 7). However, a Clinton lead greater than ~3% the day of the election will be insurmountable for four reasons: Chart 7 GOP primary: It was not the polling that got Trump wrong during the Republican primary race, but the pundits. The polls were generally accurate, particularly those in the swing states where polls tend to be frequent and sophisticated (Chart 8). Polls only underestimated Trump by more than 3% in Illinois, Massachusetts, New York and Pennsylvania. Some of Trump's most controversial statements were made in late 2015 and early 2016 and yet they prompted no shame from his supporters when answering pollsters' questions. Turnout seesaw: Trump's strategy - which we dubbed "The Great White Hype" back in March - is a serious and mathematically viable electoral strategy.5 The effort focuses on boosting the GOP share and overall turnout of the white, blue-collar voter. The problem with this strategy, as executed by Trump, is that its effect could be a seesaw. Trump's rhetoric and policy proposals may appeal to less-educated, lower-income white voters, but may also reduce his support among well-educated, upper-income voters. This is a serious problem for Trump given that the 2012 exit polls indicate that Romney won college graduates by 4 points and voters earning $100k or above by 10 points. In other words, upper-income, well-educated voters are a key constituency of the Republican Party. And just as Clinton may have trouble getting Millennials and minorities to vote for her by the same margin as they did for Obama, Trump could be struggling to get key conservative constituencies out as well. Debates: All scientific polls taken after the debates have Hillary Clinton as a clear winner (Chart 9). This may seem surprising given the reaction of many pundits that Trump outperformed the very low expectations for him in the debates. Many analysts scored the debates close, but voters did not. Why? Because independent and undecided voters are just now tuning into the election and want to see candidates discuss serious policy issues and show leadership. Chart 8 Chart 9 Political science research shows that the direct influence of party identification decreases in presidential elections over time, but issues gain importance, especially after the presidential debates.6 As such, voters tuning into the debates were not discounting Trump's fiery rhetoric and behavior, they were appalled by it. We can't say we were surprised, as we have been showing Chart 10 to clients since February. Chart 10 Senate: If voters are hiding their true support level for Donald Trump, then their genuine preference should be revealed in Senate races where less controversial Republicans are contesting close elections. Instead, Republicans are on a path to lose four of their Senate seats, with another three in play (Democrats need four to take the Senate, assuming that Clinton wins the presidency, since Vice-President Tim Kaine would then cast the tie-breaking vote in that body). Democrats are ahead in Indiana, Illinois, Wisconsin, and Colorado. Nevada is also expected to stay blue. Missouri, New Hampshire, North Carolina, and Pennsylvania are all still in contention, despite the GOP incumbent advantage in all three. Bottom Line: Despite the challenges that this election presents - two highly disliked candidates, questions about turnout, and concerns about polling quality - we doubt that Donald Trump can surprise his poll numbers by more than ~3%. With Hillary Clinton up by 6.4% in the latest RealClearPolitics poll of polls, this means that Trump has to start rallying now if he is going to have a chance on November 8. What Do Our Quantitative & Qualitative Models Say? Our geopolitical team's quantitative model predicts that Hillary Clinton will win the election with 335 electoral votes. The model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time.7 It currently shows that Clinton already has 279 electoral votes from states where she has more than a 70% chance of winning (Chart 11). These results mean that even under the unlikely scenario in which the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), Clinton will still win the election, all other things being equal. Chart 11 Meanwhile, our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable. We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1%, respectively. With those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most achievable. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our qualitative model hold up in terms of state-by-state polling? It did really well! As we predicted, Trump has led the race or nearly led the race in Iowa, Florida, and Ohio (Chart 12). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle, even when the media narrative shifted against her (Chart 13). Chart 12The 'White Hype' Model Works Here bca.gps_sr_2016_10_21_c12 bca.gps_sr_2016_10_21_c12 Chart 13White Hype' Does Not Work Here bca.gps_sr_2016_10_21_c13 bca.gps_sr_2016_10_21_c13 If Trump were to win all the states that our White Hype model predicts as competitive, he would still be short of the necessary 270 electoral votes. Map 1 shows the ideal distribution of states for Trump, one that ignores the polls and assigns swing states to Trump or Clinton based on whether the White Hype model is feasible or not. Notice that the two remaining major states are Virginia and Colorado. For Trump to win this election, we believe that he needs to win one of the two (Colorado in combination with either Nevada or New Hampshire), in addition to all of Florida, Ohio, North Carolina, and Iowa. This is a tall order! Particularly given that his polling in Virginia and Colorado is poor (Chart 14). Chart Chart 14Two Critical Swing States bca.gps_sr_2016_10_21_c14 bca.gps_sr_2016_10_21_c14 Bottom Line: BCA's Geopolitical Strategy quantitative and qualitative models both show that Hillary Clinton is a clear favorite to win the election, a view we have held since December 2015.8 Investment Implications: MNCs Vs. SMEs Our colleague Peter Berezin has already discussed the implications of a Trump victory: a stronger USD and a sell-off in stocks.9 We agree and would add that a rally in Treasurys would be likely in the event of a surprise Trump win (Chart 15). Chart 15Trump's Success Helps Safe-Haven Assets bca.gps_sr_2016_10_21_c15 bca.gps_sr_2016_10_21_c15 The rally in safe-haven assets would eventually give way, however, to a bear market in Treasurys as investors realized that Trump has no intention of controlling public spending or reining in the (already growing) budget deficit. Growth, and likely inflation, would surprise to the upside, allowing the Fed to hike rates beyond the 48 bps expected by the market through the end of 2018. We do not foresee that a Republican-held Congress would stand in Trump's way, despite the clear dislike between the Speaker of the House, Representative Paul Ryan, and Trump. Ryan would not go against a sitting president from the same party who just pulled off a revolutionary election. The entire House will face re-election in 2018 and moderate Republicans will be wary of standing up to Trump, lest he campaign against them in GOP primaries in a short two years. Investors are putting way too much faith in America's checks-and-balances to keep Trump from enacting his policies, at least in the short term. These are constitutional, legal, and technical checks, and political expediency often overrules all three. In case of a Clinton win, we would expect the House to remain controlled by the GOP. There are only about 38 truly competitive electoral districts in this race, according to The Cook Political Report.10 Given that the Republicans have a 60-seat majority in the House, a Democratic takeover would require Democratic candidates to defeat Republican Representatives in 30 out of 38 competitive districts. At best, this means that the current, market- bullish status quo of divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate (vulnerable to a post-Trump Republican comeback in 2018), the Clinton White House would be constrained on some of its most left-leaning policies.11 And what are the chances of cooperation on modest reforms? We think they are actually quite good. Unlike Obama, Clinton's victory will not be a popular sweep. She will not control Congress, she will likely receive less than 50% of the popular vote (due to the presence of two notable third-party candidates), and she will be the first candidate ever elected that has more voters saying they dislike her than like her. Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting vision as Obama did in 2008. Instead, we see two potential avenues for modest cooperation with the GOP-controlled House: Chart 16Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate tax reform: It is unlikely that we will see reform that lowers the already historically-low effective tax rates (Chart 16). However, broadening the tax base by closing various loopholes could be feasible. This will hurt S&P 500 multi-national corporations that have been able to lobby for special treatment over the past three decades. However, it will benefit America's SMEs, which are the backbone of employment and growth. Fiscal spending: Paul Ryan and moderate Republicans understand that there is a paradigm shift in America and that the median voter is moving to the left.12 After all, Donald Trump won the GOP primary with an unorthodox economic message that combined both left- and right-wing economic policies. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. Even a modest plan could make a substantive difference for the economy given the high fiscal multipliers of infrastructure spending in an economy with low interest rates. This in turn would allow the Fed to surprise the markets with more than two rate hikes by the end of 2018 and thus sustain the USD bull market. If there is one trend that we are certain will end with the 2016 U.S. election, it is the dominance of American economic policy by the S&P 500, or perhaps the S&P 100. What Trump and Senator Bernie Sanders have shown is that challenging for the presidency no longer requires a cozy relationship with either Wall Street or the large multinational corporations (MNCs). We therefore do not expect a Clinton-Ryan coalition to care as much about the concerns of America's large corporations as otherwise might be the case. Policies that lead to higher effective corporate tax rates on major S&P 500 corporations, a dollar bull market, and higher wages are likely over the course of the next four years. The political pendulum is shifting in the U.S. and it should marginally favor growth, inflation, the USD, and SMEs.13 Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 20, 2016, available at fiverthirtyeight.com. 2 "You mean like the 2008 Global Financial Crisis?" Yes. Like that. 3 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 6 Please see Andreas Graefe, "Issues and Leader Voting in U.S. Presidential Elections,"Electoral Studies 32:4 (2013), pp.644-657. 7 For the assumptions underpinning our model, we encourage clients to read BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 8 Please see The Bank Credit Analyst Strategy Outlook, "Stuck In A Rut," dated December 17, 2015, available at bca.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see "House: Recent Updates," accessed October 20, 2016, available at cookpolitical.com 11 We believe that it will be very difficult, if not impossible, for the Democrats to retain a razor-thin majority in the Senate if they get one in November. First, Democrats will have to defend 25 Senate seats (including two allied independent seats) out of 33 in contention in 2018. Second, Democrats always see a drop-off in voter turnout and enthusiasm in mid-term elections. 12 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Muni Credit Cycle: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. Issuance: State & local government investment spending will increase in 2017, as will muni issuance for new capital. Pensions: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. Election: Muni/Treasury yield ratios have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Feature The financial crisis marked a major inflection point in the municipal bond market. Not only did the economic fall-out from the housing crash lead to historically large state & local government budget gaps, but the end of bond insurance and a growing realization that municipal default is possible have focused investor attention on credit quality more than ever before. In this Special Report we zero-in on the Municipal/Treasury (M/T) yield ratio.1 We identify its major short-run and long-run drivers, and assess where it is headed in the context of the municipal bond credit cycle. The Longer-Run Outlook For Yield Ratios An important input to our understanding of the municipal credit cycle is our Muni Health Monitor (MHM). The MHM is a composite of eight indicators of state & local government budget health. Full details of the indicator and its components can be found in the Appendix to this report. The MHM has an excellent track record of signaling the major inflection points in muni ratings migration (Chart 1). We observe that the MHM bottomed in 2006, one year before the previous trough in ratings migration. The MHM also crossed into "deteriorating health" territory six months before municipal downgrades started to outpace upgrades in 2008. More recently, the MHM crossed back into "improving health" territory in Q4 2012. Muni ratings migration also peaked in Q4 2012 and upgrades began outpacing downgrades in Q4 2014. Chart 1The Municipal Health Monitor Leads Ratings bca.usbs_sr_2016_10_18_c1 bca.usbs_sr_2016_10_18_c1 We pay attention to the trends in muni ratings because ratings and state & local government net borrowing explain more than 50% of the variation in the average M/T yield ratio since 1997 (Chart 2). Further, increased investor focus on the creditworthiness of municipal issues has made the yield ratio even more responsive to ratings and net borrowing since the Great Recession. So where are we currently situated in the muni credit cycle? The MHM remains in "improving health" territory, but appears to have entered an extended bottoming-out phase. Given the re-leveraging that has already occurred in the corporate sector, it would be extremely unusual for the MHM to improve further during this cycle. In fact, our Corporate Health Monitor tends to lead the MHM by about two years (Chart 3). This squares with what we know about the behavior of state & local governments throughout the economic cycle. Chart 2The Muni Credit Cycle Illustrated I bca.usbs_sr_2016_10_18_c2 bca.usbs_sr_2016_10_18_c2 Chart 3The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II Typically, the corporate sector will increase debt loads when times are good and will then be forced to de-lever when the economy enters recession, profits contract and those debt loads become unsustainable. State & local government budget gaps, on the other hand, will tend to narrow during an economic recovery as rapid income growth translates into increased tax revenue. It is only during a recession that state & local government budget gaps widen, since tax revenue plummets while expenditure growth - particularly for social benefits - remains firm. The end result is that the municipal credit cycle tends to lag the corporate credit cycle. This is also apparent in the ratings data (Chart 3, bottom panel), which suggest that we should expect to see muni downgrades (and hence yield ratios) head higher near the end of next year. The typical lag between the corporate credit cycle and the municipal credit cycle suggests that M/T yield ratios should remain well behaved until late-2017, and then begin to move higher. However, the extraordinary length of the current economic recovery gives us some cause to believe that the lags in this cycle may be somewhat longer. We turn to a macro analysis of net state & local government borrowing to shed some further light on this issue. Net borrowing is simply the difference between revenues and expenditures. On the revenue side of the ledger, state & local governments have already seen a significant deceleration in tax receipts during the past year (Chart 4). Every source of tax revenue - except for property taxes - has slowed alongside what has been disappointing overall economic growth so far in 2016. While a return to the 10% revenue growth that was seen in the mid-2000s is unlikely, we expect most of the recent deceleration will soon be reversed. Aggregate weekly hours bounced sharply in September (Chart 5), and federal income tax withholdings also continue to grow rapidly. Both indicators suggest that income growth will be stronger during the next few months, which will support state & local tax receipts. On the expenditures side, while spending on social benefit programs has increased, state & local governments have largely dealt with budget gaps by cutting back severely on discretionary spending (Chart 6). Investment spending has also collapsed and, as a result, gross municipal bond issuance has been dominated by refinancing (Chart 6, bottom two panels). Chart 4S&L Government Revenue S&L Government Revenue S&L Government Revenue Chart 5Income Growth Will Rebound bca.usbs_sr_2016_10_18_c5 bca.usbs_sr_2016_10_18_c5 Chart 6S&L Government Expenditures bca.usbs_sr_2016_10_18_c6 bca.usbs_sr_2016_10_18_c6 This could all be about to change. Both U.S. Presidential candidates have prioritized infrastructure spending as part of their platforms. Hillary Clinton plans to increase infrastructure spending by $500 billion. This consists of $250 billion of federal infrastructure spending over the next five years and $25 billion of seed money to create a national infrastructure bank. The bank would also accept an additional $225 billion in direct loans. Clinton's plan would also bring back the Build America Bonds (BABs) program. Donald Trump has also expressed a desire to invest heavily in infrastructure, and has floated figures in the range of $1 trillion, although he has been less specific about the details. Historically, about 70% of public investment has occurred at the state & local government level (Chart 7). This suggests that if infrastructure spending became a priority it would lead to a large increase in state & local government investment and hence municipal bond issuance. However, with Clinton's plan it is still unclear whether the bulk of infrastructure spending would be financed through the Treasury market or the muni market. Certainly, to the extent that increased spending is financed through the BABs program, then tax-exempt muni issuance would not be impacted. In our view, state & local government investment spending will head higher in 2017 even without any support from the new President. The need for state & local governments to invest in infrastructure has been evident for some time, but only recently have budgets become healthy enough for governments to consider it. There is a strong correlation between state & local government investment spending and the net percentage of states with a total balance (general fund plus rainy day fund) that exceeds 5% of expenditures (Chart 8). This figure has just recently moved into positive territory and, not coincidentally, more than $200 billion worth of infrastructure spending will be on ballots requesting voter approval in November.2 Chart 7State & Local Government ##br##Drives Investment bca.usbs_sr_2016_10_18_c7 bca.usbs_sr_2016_10_18_c7 Chart 8Healthy Enough##br## To Invest bca.usbs_sr_2016_10_18_c8 bca.usbs_sr_2016_10_18_c8 The combination of resilient, but not surging, revenue growth and increased investment spending in 2017 is consistent with the idea that the muni credit cycle will follow the lead of the corporate cycle and start to turn near the end of next year. Bottom Line: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. The Pension Problem Of course, the elephant in the room with regards to the long-run outlook for municipal credit quality is pensions. So far pensions have only entered our discussion of the muni credit cycle tangentially, since the pension funded ratio is a component of the MHM (see Appendix). However, large unfunded pension liabilities - should they persist - have the potential to be severely destabilizing for the muni market at some point in the future. According to the U.S. National Accounts, aggregate defined benefit pension entitlements at the state & local government level total $5.6 trillion, only 65% of which are currently funded by assets. However, this aggregate figure masks large divergences between a few municipalities with unsustainable pension liabilities and the majority of municipalities where pension liabilities are probably manageable. Chart 9Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions In a recent report,3 the Center for Retirement Research at Boston College found that 36 states should be able to fund their existing liabilities by making annual payments that total less than 15% of revenue. However, five states - Illinois, New Jersey, Connecticut, Hawaii and Kentucky - require annual payments in excess of 25% of revenue. The breakdown is found to be similar at the city level, where pension costs were found to be manageable for the majority of cities, although Chicago, Detroit, San Jose, Miami, Houston, Baltimore, Wichita and Portland all face annual pension costs that exceed 40% of revenue. Unfortunately, while the pension situations of most municipalities are currently manageable, they are only likely to get worse. Changes in the aggregate pension funded ratio closely track returns from a portfolio that is 50% invested in the S&P 500 and 50% invested in the Barclays Treasury index (Chart 9). Based on current equity valuations, it is probably only reasonable to expect 6% annual nominal returns from the equity market during the next 10 years,4 and the 10-year Treasury yield suggests that 1.8% is a reasonable expectation for annual nominal Treasury returns. Taken together, annual nominal investment returns from a 50/50 portfolio during the next decade could be close to 4%, far below the historical average of 8.9% and also below the 7.6% average return assumed by state & local pension plans in 2014. The two main points are that: The pension problem is likely to get worse, not better Given that large under-funded pensions are concentrated in only a few states, inter-state muni allocations are very important On this second point, we observe that states with lower pension funded ratios have higher General Obligation (GO) bond yields (Chart 10), and also that not all of the difference is reflected in credit ratings. We ran a cross-sectional regression of GO bond yields against credit rating and found that a correlation remains between the residual from that regression and the pension funded ratio (Chart 11). In other words, credit rating does not adequately control for the risk presented by under-funded pensions. Chart 10Municipal Bond Yields Vs. Pension Funded Ratios Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Chart 11Municipal Bond Yields Vs. Pension Funded Ratios: Controlling For Credit Rating Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Bottom Line: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. The Short-Run Outlook For Yield Ratios So far we have discussed the muni credit cycle and noted that M/T yield ratios should begin to move higher on a sustained basis at some point near the end of 2017. However, the near-term drivers of M/T yield ratios suggest that an overweight allocation to municipal bonds remains appropriate for the time being. We have found that the bulk of near-term volatility in M/T ratios can be explained by four factors (Chart 12): The Global Policy Uncertainty Index5 Gross municipal bond issuance Net municipal mutual fund flows Ratings migration The Brexit shock to policy uncertainty has now mostly been reversed. Meanwhile, our Muni Excess Supply Indicator (Chart 12, panel 4) shows that gross issuance has been outpacing fund inflows of late. This should put upward pressure on yield ratios, although this pressure has been largely offset by still supportive ratings migration (Chart 12, bottom panel). Considering all factors, this short-term model shows that the average M/T yield ratio is close to fair value. A reading close to fair value is consistent with muni returns that should exceed those from duration-equivalent Treasuries most of the time (Table 1), even before adjusting for the muni tax advantage. In fact, Table 1 shows that the odds of muni underperformance only really increase once the M/T ratio appears more than one half standard deviation expensive on our model. Chart 12A Short-Term Muni Model A Short-Term Muni Model A Short-Term Muni Model Table 1Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle The other near-term factor that supports a continued overweight allocation to municipal debt is the prospect of a Clinton victory in next month's election. Since the beginning of the year, the average M/T ratio has closely tracked the probability of a Trump election victory (Chart 13). The reasoning is entirely logical. Trump has promised large tax cuts for the highest earners. Such tax cuts would significantly de-value the tax advantage of municipal bonds and pressure yield ratios higher. In contrast, Clinton promises to raise taxes on high income individuals. This would make the tax advantage of municipal debt more valuable, and pressure yield ratios lower. Chart 13Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios The average M/T yield ratio has not yet discounted Trump's recent plunge in the polls. This argues for the maintenance of an overweight allocation to municipal debt in the near term. Bottom Line: M/T yield ratios appear fairly valued in the near-term, and have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Appendix: The BCA Municipal Health Monitor The BCA Municipal Health Monitor is an equal-weighted composite of eight indicators meant to quantify trends in state & local government budget gaps and debt service capability. The components consist entirely of data that are publicly available from the Bureau of Economic Analysis, Federal Reserve, Bureau of Labor Statistics and the National Association of State Budget Officers. The eight components are described below, and shown graphically in Charts A1 & A2. Chart A1Muni Health Monitor Components I Muni Health Monitor Components I Muni Health Monitor Components I Chart A2Muni Health Monitor Components II bca.usbs_sr_2016_10_18_c15 bca.usbs_sr_2016_10_18_c15 Leverage: The ratio of total state & local government liabilities (excluding unfunded pension liabilities) to total financial assets. Interest Coverage: State & local government current budget surplus (excluding interest expenditures) divided by interest expenditures. The current surplus is calculated as the difference between current revenues and current expenditures (i.e. investment spending is excluded). Pension Funded Ratio: Total assets of state & local government pension funds divided by total pension liabilities. Revenue: State & local government current revenue in nominal terms, as a deviation from its 18-quarter trend. Surplus Margin: State & local government current budget surplus as a % of current revenue. Liquidity: State & local government total financial assets less short-term liabilities, as a % of total financial assets. Employment Growth: Year-over-year % change in state and local government employment. Total Balance: Aggregate state government total year-end balance. The total balance is the general fund balance plus the rainy day fund, as a % of total expenditures. 1 The average M/T yield ratio shown in this report is calculated by taking an equal-weighted average of M/T yield ratios for 2-year, 5-year, 10-year and 30-year maturities. For each maturity point the yield ratio is calculated as the ratio between the Bloomberg Fair Value Aaa Municipal bond yield and the Federal Reserve's constant maturity Treasury yield. 2 http://www.bloomberg.com/news/articles/2016-09-13/mega-deals-lead-ballo… 3 http://crr.bc.edu/briefs/will-pensions-and-opebs-break-state-and-local-… 4 Please see Global Investment Strategy Special Report, "Global Equity Valuations: Risks And Opportunities", dated July 1, 2016, available at gis.bcaresearch.com 5 The index was created by Professors Scott Baker, Nick Bloom and Steven Davis and is driven by the number of times terms related to economic and policy uncertainty are found in newspaper articles. Full details of the methodology are available at www.policyuncertainty.com

Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions bca.usis_wr_2016_10_17_c1 bca.usis_wr_2016_10_17_c1 Chart 2Earnings Set To Disappoint? bca.usis_wr_2016_10_17_c2 bca.usis_wr_2016_10_17_c2 Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Protector Portfolio Enhances Performance Since 2011 Protector Portfolio Enhances Performance Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 bca.usis_wr_2016_10_17_c4 bca.usis_wr_2016_10_17_c4 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work bca.usis_wr_2016_10_17_c5 bca.usis_wr_2016_10_17_c5 As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio bca.usis_wr_2016_10_17_c6 bca.usis_wr_2016_10_17_c6 As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) bca.usis_wr_2016_10_17_c7 bca.usis_wr_2016_10_17_c7 Chart 8Small Business Concerns (Part 2) bca.usis_wr_2016_10_17_c8 bca.usis_wr_2016_10_17_c8 Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.