Energy

Highlights Weekly swings in U.S. inventories notwithstanding, we believe global storage is on track to draw ~ 10% by early- to mid-3Q17, which will have achieved the goal of the OPEC - Russia production Agreement negotiated late last year. This will not require an extension of the pact beyond June, based on our modeling. Unexpectedly high compliance by OPEC producers to agreed cuts is being offset somewhat by increased production in those states exempted from the deal. Strong oil consumption on the back of a synchronized global uptick in GDP growth, which started to emerge late last year, provides the impetus for sustained storage draws. Markets are overestimating offshore production's resilience, particularly in the U.S. Gulf, where we see material declines beginning to set in next year. Backwardation likely persists in 2018, absent a U.S. policy-induced USD rally that crimps EM demand and spurs production ex U.S. Energy: Overweight. The return of contango in the WTI forward curve gives us the opportunity to reset our strategic front-to-back position (long Dec/17 vs. short Dec/18) at tonight's close. Our balances assessment supports our view backwardation will return in the deferred part of the curve. Our Dec/19 short WTI vs. long Brent spread buy stop was elected at $0.07/bbl. Base Metals: Neutral. We remain neutral base metals, but are keeping a close watch on copper. Unions working at BHP's Escondida mine, the world's largest, are set to strike today. Negotiations resumed this week, following BHP's request for government mediation. Precious Metals: Neutral. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. Grain fundamentals remain unsupportive for a rally. We remain underweight. Feature Chart of the WeekGlobal Oil Storage On Track For 10% Drop Global Oil Storage On Track For 10% Drop Global Oil Storage On Track For 10% Drop Global oil storage levels remain on track to hit the ~ 10% draw targeted in last year's OPEC - Russia production Agreement by early- to mid-3Q17, weekly gyrations in U.S. inventories notwithstanding. This means an extension of the agreement beyond its June expiry will not be required. Early reports suggest compliance with the deal is unexpectedly high by OPEC states that agreed to cut production by up to 1.2mm b/d - exceeding 80% by various accounts. However, OPEC states not required to cut - Libya, Nigeria, and Iran - have increased production and partially offset those declines, which took total reductions in OPEC output to ~ 840k b/d, based on a Bloomberg tally last week.1 This brought total Cartel compliance to ~ 60% of the agreed cuts, which, as we noted in our 2017 Commodity Outlook in December, would be sufficient to achieve the Agreement's goal of pulling inventories in the OECD down by ~ 10% by 3Q17.2 Non-OPEC producers also appear to be complying with the Agreement. Notable among them is Russia, which is ahead of its commitment with cuts of close to 120k b/d in January, due partly to extreme cold in Siberian fields. We expect cuts in Russia to average 200k b/d in 1Q17, going to 300k b/d in 2Q17. These cuts will allow demand to outstrip supply in 1H17 and into year-end. By early- to mid-3Q17, draws to OECD storage of 300mm bbl can be expected, without extending the OPEC - Russia production agreement (Chart of the Week). We expect to see these cuts show up in OECD inventory data this month and next and continue into the end of 2017. For non-OECD states, the draws will show up in JODI data beginning in March.3 The physical deficits - i.e., supply less than demand - will force storage to draw, backwardating the WTI forward curve later this year (Chart 2).4 If markets are not surprised by a policy-induced rally in the USD on the back of a U.S. border-adjustment tax (BAT), or a too-aggressive tightening by the Fed as it seeks to normalize monetary policy, we expect the drawdown in inventories to continue keeping markets backwardated. Even with production returning to pre-Agreement levels in 2H17 in states with the capacity to expand and reliably sustain production - Gulf Arab producers, Russia and U.S. shales - we expect storage to continue to draw through the year and into 2018 (Chart 3). Chart 2We Continue To Expect Backwardation We Continue To Expect Backwardation We Continue To Expect Backwardation Chart 3Storage Drawdown On Track Storage Drawdown On Track Storage Drawdown On Track In 4Q16 the impact of the higher Kuwaiti and UAE output is apparent, along with higher Russian production. This put more crude on the market, which found its way into storage late in 4Q16 and early 1Q17, reversing the trend in draws seen earlier in 2H16. This put the market back in a temporary surplus condition, with the result being more storage will have to be worked off in 1H17 than our earlier estimates indicated. But these draws will occur, following the implementation of the production accord. Extending The KSA - Russia Deal Beyond June Is Unnecessary In our estimates, OPEC crude production increases by ~ 850k b/d in 2H17 versus 1H17 levels. Despite this recovery, the storage drawdown continues. Our modeling assumes Gulf OPEC will account for slightly more than +1mm b/d growth, and non-Gulf OPEC will see production continue to fall by 170k b/d. Russia's total liquids production goes from 10.95mm b/d in 1H17 to 11.34mm b/d in 2H17. We estimate U.S. shale production grows at an average rate of ~ 300k b/d in 2H17, while total U.S. liquids production increases 720k b/d over the same interval. Setting aside the possibility of a policy-induced rally in the USD on the back of too-aggressive Fed tightening or a border-adjusted tax becoming the law of the land, both of which would depress demand and raise production ex U.S., we expect the crude-oil market to remain backwardated next year. The globally synchronized upturn in GDP will keep demand robust, with growth coming in close to even with this year's rate of ~ 1.50mm b/d. We have global liquids production and OPEC crude output growing less than 1.0% next year. We believe the market is overestimating the resilience of offshore production next year, particularly in the U.S. Gulf, based on the stout performance put in last year and expected for this year. Our colleague Matt Conlan notes in BCA's Energy Sector Strategy, U.S. production growth since October has almost exclusively been from the Gulf of Mexico's new projects. Output in the Gulf continues to increase due to the lagged effect of final investment decisions made during 2012 - 2014, when WTI prices were consistently trading above $100/bbl. GOM production will peak in 2017 then decline in 2018 due to lack of new investments made since 2014. Indeed, as "increasing decline rates overwhelm a shrinking inventory of new projects, GOM production should peak sometime in 2017 and then start decreasing. The EIA's estimate for another 200,000 b/d increase in GOM production in 2017 seems overly-optimistic."5 Once this becomes apparent to the market, we believe backwardation will reassert itself and persist into 2018. The backwardation of the forward curve structure will affect U.S. shale production economics in 2018. However, our base case is for U.S. shale-oil production in the "Big Four" basins - Permian, Eagle Ford, Bakken and Niobrara - to grow 700k b/d next year, given the current structure of the WTI forwards, which were taken higher along with the WTI price rally at the front of the curve. This triggered the revival of rig counts; however, we want to point out that different curve shapes at different price levels produce different expected rig-count responses.6 Chart 4Barring a Policy Shock Demand Will Remain Robust bca.ces_wr_2017_02_09_c4 bca.ces_wr_2017_02_09_c4 Global Demand Firing On All Cylinders Robust demand growth - ~ +1.50mm b/d in 2017 and 2018 in our modeling - provides the impetus for the continued draws in storage this year and next (Chart 4). We revised our demand estimates for 2015 - 16 in line with the IEA's just-revised assessment of global consumption published in its January 2017 Oil Market Report.7 The IEA brought 2016 oil demand growth up to 1.50mm b/d, in line with our earlier estimates, but significantly revised 2015 demand growth upward to 2.0mm b/d. The Agency expects higher prices to crimp demand this year, taking it to 1.30mm b/d; our estimate, however, is higher, largely on the back of the first global synchronized growth we've seen since the Global Financial Crisis, which will be supported by accommodative monetary conditions worldwide, all else equal.8 Investment Implications Our analysis suggests there will be no need to extend the OPEC - Russia production accord into 2H17. In addition, it reinforces our view markets will backwardate later this year and stay backwardated in 2018, provided we do not see a BAT-induced rally in the USD, or an overly aggressive Fed normalization trajectory. As we noted in previous research, a BAT would lift the value of the USD, which would lower demand ex U.S. and raise supply at the margin.9 We make the odds of a BAT becoming the law of the land in the U.S. this year 50:50, so this is a non-trivial risk. This would be unambiguously bearish for oil prices. While we do not expect oil to be included among the imported commodities subject to a BAT, we do, nonetheless, expect the imposition of a BAT to lift the USD by 10%. This, coupled with the 5% increase in the greenback we'd already penciled in due to the Fed's monetary-policy normalization, will lift the USD 15% if it goes through. Should this occur, we would be preparing for prices to again fall below $50/bbl and push back to the $40/bbl area, which would cause supply and capex to once again contract significantly. That said, we are reinstating our long front-to-back WTI recommendation (long Dec/17 WTI vs. short Dec/18 WTI), given our updated balances assessment. Our expectation for inventories to continue to draw after the OPEC - Russia production-cutting agreement expires in June supports this recommendation. In addition, if we do see a BAT in the U.S., we believe markets will take the deferred WTI curve significantly lower in expectation of reduced demand and higher marginal supplies that almost surely will ensue in 2018. While the Dec/17 contract also will trade lower, more damage to prices will occur in 2018 contracts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC Cuts Oil Output, But More Work Needed to Fulfill Deal," published by Bloomberg February 2, 2017. Iraq stands out among OPEC producers agreeing to cut, but apparently not following through as diligently as the rest of the Gulf Arab states; we are assuming production of 4.5mm b/d for 1H17, going to 4.6mm b/d in 2H17 for Iraq. 2 Please see BCA Research's Commodity & Energy Strategy "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 3 JODI refers to the Joint Organisations Data Initiative, a supranational producer-consumer oil-market data provider headquartered in Riyadh, Saudi Arabia. 4 "Backwardation" describes a forward price curve in which the price for a commodity for prompt delivery (e.g., tomorrow) exceeds the price of a commodity delivered in the future (e.g., next year). It is the opposite of a contango curve structure. 5 Please see issue of BCA Research's Energy Sector Strategy "Gulf Of Mexico Oil Production Likely To Peak In 2017," dated January 11, 2017, available nrg.bcaresearch.com. 6 In next week's report, we will present scenario analysis of shale-oil production as a function of WTI forward curve shape - i.e., the implications of backwardation for shale rig counts. This will update our assessments of price sensitivities to interest rates and USD movements. 7 Please see the IEA's Oil Market Report of 19 January 2017. 8 We discuss this in last week's Commodity & Energy Strategy feature article entitled "Gold Will Perform...," dated February 2, 2017, available at ces.bcaresearch.com. 9 Please see BCA Research's Commodity & Energy Strategy "Taking A BAT To Commodities," dated January 26, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016

Highlights The evolution of U.S. tax policy - chiefly the border-adjustment tax (BAT) proposed by House Republicans - will preoccupy commodity markets for the balance of the year. Our House view gives 50-50 odds to the passage of a BAT, which, even though these are coin-toss odds, still are significantly higher than the consensus view of 20ish percent. While oil and apparel likely will be exempted from the BAT, steel, bulks, base metals, and ags probably won't be. The BAT's effect on the USD and EM commodity demand could be deflationary longer term. Energy: Overweight. The likelihood of crude oil and refined products being exempted from the BAT exceeds 50%, in our view, which means oil-market fundamentals likely will continue to be dominated by the supply-side adjustments. Base Metals: Neutral. Chinese reflationary policies will dominate pricing short term. Longer term, markets will have to price in the effects of the U.S. BAT. Precious Metals: Neutral. Gold could trade higher in the near term (i.e., until Congress is done with the BAT), as the Fed holds off on any adjustments to policy rates until the Trump administration's fiscal policies come more clearly into view. Passage of a BAT will complicate monetary policy by lifting the broad trade-weighted USD and tightening monetary conditions in the U.S. Ags/Softs: Underweight. Heavy rains in Argentina could support soybeans. We remain underweight. Longer term, the BAT will be an important driver of prices. Feature We give 50-50 odds of BAT legislation passing in the U.S. Congress and being signed into law by President Trump this year. The BAT would tax imports into the U.S. and subsidize U.S. exports. This scheme would replace existing corporate income taxes.1 While apparel and energy products likely would be exempt, we think other commodities - chiefly base metals and ags - would be taxed, and would thus alter global trade flows in these commodities over the short run. Longer term, depending on how onerous the BAT legislation is, we would expect retaliatory taxes ex U.S., which could negate the initial benefits to U.S. commodity exporters. In addition, we would expect a stronger USD following passage of a BAT, which would be bearish for commodities generally. At this point it is impossible to know the tax rate that will be imposed on imports, as U.S. Congressional negotiations have yet to begin. President Trump, however, did tell business leaders he met with earlier this week to prepare for a "very major" border tax and significant deregulation, according to the Financial Times.2 The price effects for commodities subject to it are fairly straightforward: domestic prices will increase by the inverse of (1 - Tax Rate). A 20% tax would increase domestic prices by 25%, which would benefit domestic commodity producers, and disadvantage commodity importers. The BAT would incentivize U.S. exports and narrow the U.S. trade deficit, as a result. This would, in theory, rally the USD as well. If the BAT were set at 20%, the USD would, in theory, appreciate by 25%.3 It is early days on the BAT. Based on our in-house assessment, we think the BAT scheme could rally the USD by as much as 15%. This 15% includes the 5% increase in the USD's trade-weighted value we expect this year, absent any BAT effects. A stronger USD would raise the price of commodities subject to the U.S. BAT outside the U.S. in local-currency terms, thus crimping international demand, but encouraging output ex U.S. to increase as local-currency production costs fall. Both effects are decidedly bearish longer term for commodities subject to the BAT. Servicing of USD-denominated debt would become more expensive for EM borrowers, as the USD appreciated, which also would negatively affect income growth. Oil Markets Handle The BAT While we believe oil and apparel will be exempt from a BAT, if such a tax did gain traction in Congress, West Texas Intermediate (WTI) crude oil futures, the U.S. benchmark, likely would trade at a premium to the global Brent benchmark, reversing years-long discount pricing. Indeed, markets already started pricing this potential outcome toward year-end 2016 (Chart of the Week), taking WTI delivering in Dec/17 from a roughly $2.00/bbl discount to parity with Brent, before retreating a bit in recent sessions. Clearly, markets have been attempting to discount the BAT, as the WTI - Brent differential shows, and this will continue as the debate and negotiations on the measure pick up in the near future. A BAT that included oil would super-charge U.S. exports, which already are growing, and domestic production (Chart 2). Chart of the WeekDeferred WTI Trades Flat To Brent Deferred WTI Trades Flat to Brent Deferred WTI Trades Flat to Brent Chart 2A BAT Applied To Oil ##br##Would Super-Charge U.S. Exports A BAT Applied to Oil Would Super-Charge U.S. Exports A BAT Applied to Oil Would Super-Charge U.S. Exports Bottom Line: We would fade any rally in the WTI - Brent spread toward the end 2017, or in the 2018 and '19 deliveries - selling the spread if it rallies significantly above flat (i.e., $0.00/bbl in the differential), given our expectation oil will be exempt from the BAT scheme. A BAT's USD Impact Will Matter For Commodities Generally Odds favor a USD rally - even if apparel and oil are excluded - given the BAT scheme would shrink the U.S. trade deficit. Our House view is the USD was on course to appreciate 5% this year anyway, on the back of the economy's relative performance and a continuation of the Fed's effort to normalize monetary policy. Even with a BAT becoming law in a somewhat watered down form, as our colleagues at BCA's Global Investment Strategy service anticipate, the USD could rally another 10%, based on our assessment of the impact of the tax scheme. This would encourage higher production ex U.S., where local-currency drilling costs once again would fall (think Russia). And it would seriously dent EM commodity demand, particularly oil and base metals demand, as a stronger USD makes commodities more expensive in local-currency terms ex U.S. (Chart 3). The combination of higher output due to lower costs ex U.S., and lower EM consumption brought about by a stronger USD could unravel the production-cutting accord KSA and Russia agreed last year, as prices weaken once again and producers scramble to make up for lost revenue with higher volumes. Given these effects, there's a good chance the U.S. would see deflationary blowback from this, if oil and base metals prices resume their downtrend (Chart 4). Chart 3A Stronger USD Once Again ##br##Will Weaken Global Oil Prices A Stronger USD Once Again Will Weaken Global Oil Prices A Stronger USD Once Again Will Weaken Global Oil Prices Chart 4Lower Oil Prices Could Drag ##br##Inflation Expectations Lower Lower Oil Prices Could Drag Inflation Expectations Lower Lower Oil Prices Could Drag Inflation Expectations Lower BAT Effects On EM Commodity Demand Oil and base-metals demand are closely aligned with EM income growth. Indeed, the evolution of EM income maps closely to EM oil and base metals demand. This is important for the evolution of the Fed's preferred U.S. inflation gauge, the core PCEPI. Indeed, the co-movement between the core personal consumption expenditures index and EM demand for industrial commodities is extremely high. In earlier research, when we modeled EM oil demand as a function of U.S. financial variables, we found a 1% increase (decrease) in the USD broad trade-weighted index (TWI) is consistent with a 23bp decrease (increase) in consumption. For global base metals, we found a 1% increase (decrease) in the USD TWI corresponds with a 27bp drop (increase) in demand. From this, our general rule of thumb is each 1% increase (decrease) in the USD TWI is roughly corresponds to a 25bp drop (increase) in EM demand for oil and base metals. We also found a 1% decrease in EM oil demand corresponds to nearly a 50bp decrease in the core PCEPI, the Fed's preferred inflation gauge.4 If the USD appreciates by 15% this year following the imposition of a BAT consistent with our in-house view, the effect on commodity demand and EM economic growth prospects would be unambiguously negative. If this was fully passed through to the core PCEPI, the gauge's yoy rate of change could drop more than 1.5%, pushing the yoy change in the Fed's preferred inflation index to just above zero, from its current level of ~ 1.65% yoy growth. We will be exploring the implications for this on the Fed's monetary policy in next week's publication, when we cover gold markets. However, it is worthwhile noting here that the BAT's effect on commodity prices and EM income could significantly restrain the Fed in its desire to normalize monetary policy. BAT Would Raise Volatility Following passage of a BAT consistent with our aforementioned expectations, higher commodity-price volatility would ensue: A sharply higher USD would crush EM oil and base metals demand. The import tax side of the scheme would incentivize additional supply (and exports) to come on line in the U.S. - domestic prices would rise faster than costs under the BAT - while, ex U.S., local-currency production costs would fall, leading to increased supplies. The import tax side of the BAT will create an umbrella for domestic oil and metals producers to lift prices to U.S. customers, since their only other choice for charging stocks and ore supplies are imports, which would be taxed under the scheme. In and of itself, this would be inflationary for the domestic U.S. economy. The only party that unambiguously wins in the short run in this scenario would be U.S. shale producers and domestic base-metals producers. In the case of the latter, copper, nickel and aluminum producers already supply more than 60% of domestic requirements, suggesting they have room to expand production at the margin, as tax-induced price hikes outpace cost increases (Charts 5 and 6). Chart 5U.S. Base Metal Production Could Expand Under A BAT Scheme U.S. Nickel and Copper Exports Could Expand Initially Under A BAT Scheme U.S. Nickel and Copper Exports Could Expand Initially Under A BAT Scheme Unstable Equilibrium At the end of the day, the BAT-induced changes in trade flows represent an unstable equilibrium. Second-round effects following the passage of the BAT - i.e., after the initial lift to domestic U.S. prices arising from the imposition of the BAT - are bearish. Chart 6U.S. Nickel And Copper Exports ##br##Could Expand Initially Under A BAT Scheme Taking A BAT To Commodities Taking A BAT To Commodities Recall that in the first round of price adjustment to the BAT, prices theoretically increase by the inverse of (1 - Tax Rate), which most likely will be faster than the increase in domestic production costs. In the second round of price adjustment, production costs catch up to prices, narrowing profit margins and reducing the free cash flow that supports higher production. Domestic demand in the U.S. for refined products - oil and metals - will fall, as prices to consumers rise (e.g., gasoline prices will increase at the margin in line with the BAT tax rate). Meanwhile, ex U.S., as the local-currency costs of production fall, supply is increasing at the margin. And, the stronger USD will raise the local-currency cost of commodities ex U.S., thus reducing demand. The supply- and demand-side effects combine to lower prices, all else equal. In the case of oil, producers ex U.S. - most likely KSA and the Gulf Arab states, and Russia - would once again find themselves in a fight for market share as U.S. production and exports increased. Markets would, once again, have to contend with rising storage levels and lower prices, as supplies increase at the margin and demand falls. This likely happens in 2018, and would return oil prices to our lower trading range of $40 to $65/bbl. In addition, our central tendency for WTI prices would return to $50/bbl from $55/bbl now. Depending on how OPEC and non-OPEC producers respond to rising U.S. production and falling global demand, the downside volatility we saw in 2016 could easily be repeated in 2018 - 2020. In the case of base metals, China still accounts for ~ 50% of total demand. If the USD strengthens significantly, China's demand - along with other EM demand - will fall as local-currency prices rise. Potentially higher U.S. base metal exports on the back of higher domestic prices supporting expanded U.S. supplies will be competing for market share against, e.g., copper volumes from Chile and Peru displaced from the U.S. market. Bottom Line: The BAT scheme could incentivize higher U.S. production and exports, and rally the USD. Together, these effects would pressure commodity prices lower - particularly oil and base metals - as supply increased and demand decreased. This would lower inflation and inflation expectations, complicating the Fed's policymaking later this year. We will develop these themes in subsequent research. Next week, we take up gold markets and how they are likely to respond to the evolution of BAT legislation. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Our colleague Peter Berezin last week published a Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017" in BCA Research's Global Investment Strategy, which examined the BAT in depth, available at gis.bcaresearch.com. 2 Please see "Investors seek clarity from Trump on tax changes and trade restrictions" in the January 24, 2017, issue of the FT. 3 Please see p. 3 of the BCA Research Global Investment Strategy Special Report entitled "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017" cited above, available at gis.bcaresearch.com. 4 Please see pp. 3 and 4 issue of BCA Research's Commodity & Energy Strategy Weekly Report "Commodities Could Be Hit Hard By Fed Rate Hikes" in the September 1, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Taking A BAT To Commodities Taking A BAT To Commodities

Dear Client, I am visiting clients in Saudi Arabia, Abu Dhabi, and India 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, Senior Vice President, BCA's Geopolitical Strategy service. Marko argues that the Middle East has reached a stable equilibrium, as much as is possible, and will not drive the news or markets in 2017. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The Middle East is not a major geopolitical risk in 2017. Saudi-Iranian and Russo-Turkish tensions will de-escalate, for now. The OPEC production cut will go through; oil prices will average $55/bbl in 2017. Geopolitical risk continues to rotate to the Asia Pacific region. Trump, Iranian elections, and Iraqi instability pose risks to the view. Feature The Middle East has dominated the news flow for the past five years, for good reason. The carnage in Syria and Iraq is tragic and reprehensible. However, the investment relevance of the various regional conflicts is dubious. For all the attention paid to the rise of the Islamic State, we would remind clients that the group's conquest of Iraq's second-largest city Mosul in June 2014 did not cause a spike in oil prices but rather marked the end of the bull market (Chart 1)! From an investment perspective, the only dynamic worth watching in the Middle East is the "Great Game" between regional actors, which have been looking to fill the vacuum left by America's dramatic geopolitical deleveraging (Chart 2). The U.S. strategy is permanent and driven by global interests, namely the rise of China and the need to shift resources towards East Asia. Given the incoming Trump administration's laser focus on China, we expect that the U.S. will remain aloof from the Middle East. Chart 1Ironically, Worry About The Fall Of ISIS Ironically, Worry About The Fall Of ISIS Ironically, Worry About The Fall Of ISIS Chart 2While The U.S. Military Deleverages... While The U.S. Military Deleverages... While The U.S. Military Deleverages... Does the recent détente between Russia and Turkey in Syria, and between Iran and Saudi Arabia over OPEC production cuts, signal that the Middle East has finally found geopolitical equilibrium? We tentatively think the answer is yes. This will reduce the importance of the region as the primary source of geopolitical risk premia, which BCA's geopolitical strategists have expected to shift to Asia for some time.1 Saudi-Iranian Tensions Are On Ice Chart 3...The Saudi Arabian Military Leverages Up ...The Saudi Arabian Military Leverages Up ...The Saudi Arabian Military Leverages Up Since the U.S. decision to deleverage from the region in 2011, Saudi Arabia has leveraged up, becoming one of the world's largest arms purchasers and involving itself overtly and covertly in several regional conflicts in the process (Chart 3). Saudi insecurity deepened following President Barack Obama's decision to leave no troops in Iraq. The last U.S. soldier of the main occupation force left Iraq on December 18, 2011. The very next day, on December 19, Iraq's Shia Prime Minister Nuri al-Maliki, a close ally of Iran, issued an order for the arrest of the Sunni Vice-President Tariq al-Hashimi. The move by al-Maliki set off what essentially became a civil war in the country, with the Sunni minority eventually turning to ever-more radicalized militant groups for protection. From the Saudi perspective, Iraq is a vital piece of real estate as it is a natural buffer between itself and its Shia rival Iran. While the Fifth Fleet of the U.S. Navy, based in Bahrain, continues to guard against any Iranian incursion via the Persian Gulf, there is very little space between the Saudi oil fields and Iran if Iraq falls into Iran's orbit. The subsequent five years saw Iran and Saudi Arabia fight several proxy wars in Iraq, Syria, and Yemen. These included direct military action by Iran in Iraq and Syria against Saudi-backed militants and by Saudi Arabia in Yemen against Iranian-backed militants. It also included oil politics, with Saudi Arabia announcing in November 2014 that it was ending years of its price-setting strategy. These strategies ultimately proved to be unsustainable and BCA's Geopolitical Strategy called the peak in Saudi-Iranian tensions in February 2016.2 Why? First, because oil prices collapsed! Geopolitical adventurism is a luxury afforded to those with the means to pursue adventures. The combination of low oil prices, domestic social outlays, and an expensive war in Yemen forced Saudi Arabia to burn through $220 billion of its foreign reserves between July 2014 and December 2016, equivalent to 30% of its central-bank holdings!3 There is a relationship between high oil prices and aggressive foreign policy in oil-producing states (Chart 4). Political science research shows that the relationship is not spurious. As Chart 5 illustrates, petrol states led by revolutionary leaders are much more likely to engage in militarized international disputes.4 This relationship is particularly pronounced when oil sells at above $70 per barrel. At that price, oil producing states become more prone to disputes than non-oil states, regardless of leadership qualities. Chart 4 Chart 5 Second, Saudi Arabia's military campaign in Yemen proved to be a disaster. The kingdom intervened in March 2015 to reinstate the democratically elected President Abdrabbuh Mansour Hadi, who had been removed from power by Iranian-linked Houthi rebels. The real reason for the intervention was for the Saudis to gauge their war-making capabilities, test their recently purchased military equipment, and put a check on Iranian influence in the region. A quick, successful war in Yemen would have been a template for future interventions in Iraq and Syria on behalf of Sunni allies, and would have cemented Saudi Arabia's position as a regional power in the wake of the U.S. withdrawal. As BCA's Geopolitical Strategy warned, however, defeating the experienced Houthis would not be easy and Saudi Arabia would ultimately hesitate to commit to a land war.5 The intervention has resulted in disaster for Saudi Arabia on several levels: Houthis remain in control of the capital Sana'a and largely the same territory that encompassed the former Yemen Arab Republic (North Yemen); The Saudis, desperate for a ground-force presence, have turned a blind eye to Al Qaeda's and ISIS's control of almost a third of the country in the south and coastal regions; Saudi forces have taken considerable losses, including some high-tech and high-priced items; The conflict has exposed severe military deficiencies, from the low level of strategic and tactical planning of senior staff, to the poor communication of units at the middle level, to the pervasive low morale and training of the rank-and-file. The biggest loss for Saudi Arabia has been that of leadership. What began as a pan-Sunni intervention led by Riyadh, with considerable involvement by the UAE and Egypt, has seen the Saudis lose almost all their allies. The UAE removed its troops in mid-2016 (in somewhat of a diplomatic spat with Riyadh) and Egypt has subsequently held military exercises with Russia, a Saudi rival in the region, and decided in December to provide military advisors to the Syrian Arab Army. All the talk about a "Sunni NATO" is over. Saudi Arabia's experience in Yemen, combined with the decline in its currency reserves, forced it to come to terms with reality, and eventually agree to an oil production cut with Russia and Iran. Thus it took Saudi Arabia exactly five years, from the U.S. withdrawal in Iraq in 2011, to realize the limits of its regional power. Bob Ryan, Senior Vice President of BCA's Commodity & Energy Strategy, correctly forecast the OPEC cut and expects the deal to be successfully implemented in 2017.6 One reason Bob is confident is that both Saudi Arabia and Russia are looking to privatize their energy sector significantly by 2018. Russia has sold 19.5% of Rosneft and the Saudis want to conduct an IPO of 5% of their state-owned oil company Aramco. It makes no sense to do this IPO in an environment of low oil prices. Furthermore, sovereign debt issuance to cover budget deficits will become cheaper when oil prices are higher. Geopolitics are aligning with Bob's view as well. Saudi Arabia's attempt to counter Iranian influence in the region has failed both militarily and via oil politics. Riyadh is focusing inwards, on its "Vision 2030" reforms, which will entail considerable domestic upheaval as a result of its comprehensive effort to remove the ultra-conservative religious establishment from power.7 This is now coming to light, with Deputy Crown Prince Mohammed bin Salman recently announcing harsh punitive measures for any cleric who incites or resorts to violence against the reform agenda. Bottom Line: Saudi Arabia's bid for regional hegemony is over, at least for now. The country is focusing inwards, on long-term political and social reforms and economic diversification. Its efforts to bring Iran to heel with low oil prices and with direct military confrontation in Yemen have failed. The oil production-cut deal between Saudi Arabia, Iran, and Russia should hold as a result of the de-escalation of Saudi-Iranian tensions and the socio-economic priorities of all three states. BCA's Commodity & Energy Strategy service is overweight energy relative to other commodities as a result.8 Is The Russia-Turkey Détente Sustainable? Turkey and Russia have concluded a political and military détente in Syria with surprising speed. This has made one of our major geopolitical risks for 2017 - a Turkish-Russian confrontation over Syria - already obsolete. Much as with Saudi Arabia, Turkey has had a bite of regional hegemony, did not like the bitter taste, and has decided to make a deal with its rivals instead. For Turkey, the real concern over the past five years has been American inaction in Syria. President Recep Tayyip Erdogan has spent a lot of political capital opposing Syrian President Bashar al-Assad. He had hoped that a successful revolution would create a new client state for Turkey, yielding Turkey overland access to Persian Gulf energy sources. Erdogan was therefore beyond dismayed when President Barack Obama failed to intervene in Syria in 2013 following Assad's use of chemical weapons. The chronology of what happened next is important: Russia intervened two years later, in September 2015, to stem the progress of anti-Assad rebels and save the regime from collapse. Two months later, a Russian Sukhoi Su-24 was shot down by Turkish F-16s in the Turkey-Syria border area. Turkey and Russia broke relations for a while, but tensions did not escalate. Ankara faced a coup attempt in mid-July 2016, which the ruling party linked to the U.S.-based Islamist preacher Fethullah Gülen. The Obama administration refused to extradite Gülen without concrete evidence of his involvement. By late July, Turkish officials were calling Russia a "friendly neighbor" and a "strategic partner." In early August, Erdogan met Russian President Vladimir Putin in St. Petersburg, after issuing a letter with an apology to the family of the shot-down pilot. Then, on August 24, Turkey invaded Syria. The military intervention, dubbed "Operation Euphrates Shield," was officially launched to fight the Islamic State, a common pretext these past three years. Erdogan officially stated that he also aimed to fight Assad's regime, but this appeared to put Ankara and Moscow back on collision course, and statements from the Turkish side have since been "corrected." The real reason for the intervention was not to fight ISIS or Assad, but rather to curb the gains made by the various Kurdish militias on the ground in Iraq and Syria. In particular, Ankara intervened to prevent the Kurdish People's Protection Units (YPG) - the armed wing of the Syrian Democratic Union Party, which is affiliated with the Turkey-based Kurdistan Workers' Party - from linking up with its now vast territory held in the north of Syria (Map 1). Chart The territory, which our map shows has expanded considerably as the YPG has claimed mostly Islamic State-held areas, is split between Rojava, the main territory east of the Euphrates river, and the Afrin enclave near the Mediterranean Sea. For Turkey, the proximity of such a vast Kurdish-held territory so close to its own Kurdish southeastern region presents a national-security nightmare. The operation's strategic goal was to capture Al-Bab, the stronghold of the Islamic State in northern Syria and a strategic point between the two YPG-held swaths of territory. However, it has taught the Turks that they have no experience fighting a prolonged battle, especially against local insurgents and militants who know the region. Since the first attack on Al-Bab's western part, the Turkish army has suffered three defeats and retreated to initial positions. With Turkey stuck in Al-Bab, the Russian air force has now begun to bomb Islamic State positions to help their tentative new ally. This level of operational coordination is notable and important. It suggests that Turkey, a NATO member state, is now reliant on Russian air strikes for ground support rather than on American sorties flying out of NATO's air base in Incirlik, Turkey. Turkey even claims that U.S. presence in Incirlik is obsolete if it receives no help from the U.S. Air Force around Al-Bab. How sustainable is the Turkey-Russia détente? We suspect it will be quite sustainable, at least in the short term. Ankara has moved away from demands for Assad to step down, with the Deputy Prime Minister, Numan Kurtulmus, recently stating that Turkey would not "impose any decision" on the Syrian people regarding future leadership. The assassination of the Russian ambassador in Turkey also failed to derail Russo-Turkish cooperation. Beyond the short term, however, the question remains what Turkey intends to do about Kurdish gains, which are considerable in both Syria and Iraq. The town of Manbij, for instance, is strategically located west of the Euphrates and was supposed to be ceded to Turkey by the Kurds. The situation could grow even more complicated for Turkey as the Kurdistan Regional Government (KRG) in Iraq may proclaim independence after the Islamic State stronghold of Mosul is liberated in early 2017.9 The YPG in Syria could then ask to join their fellow Kurds in Iraq in forming a unitary state. Although unlikely, this scenario is probably on Turkey's mind, as it would mean that the Kurds inside Turkey may intensify their anti-government insurgency. Note, however, that this scenario does not bother Russia. As far as Moscow is concerned, it has succeeded in keeping Assad in power, its Syrian naval base in Tartus is secure, and it has proven its ability to project power outside of its immediate sphere of influence (Ukraine, Crimea, Georgia, and the Caucasus), thus advertising its "Great Power" status. Bottom Line: For the time being, the Russian-Turkish détente will hold. The real risk is not a Turkish-Russian confrontation, but rather a wider Turkish engagement in both Syria and Iraq against the Kurds sometime in the future. We suspect that the Turkish military experience in Syria may make the Turks think twice about engaging in a large-scale war against the Kurds across three states. But given the erratic policymaking out of Ankara in recent years, it is difficult to say this with any confidence. The geopolitical risk of Turkish imperial overreach will continue to weigh on Turkish assets in 2017. Risks To The Sanguine View There are many reasons why investors should stay up at night in 2017, but the Middle East is not one of them. The process of U.S. deleveraging from the region has been painful and costly (from a human perspective especially), but it has ultimately forced regional powers to figure out how to carve out the leftover space between them. There are a few questions left to answer, starting with the Kurdish question. But, for the most part, we do not expect to see the major players - Iran, Saudi Arabia, Turkey, Russia, Egypt, or Israel - come to blows with each other. There are three major risks to this sanguine view. The U.S. Is Back! The current semi-stable equilibrium will definitely be thrown off track if the Trump administration decides to sink its teeth fully into the Middle East. We expect President-elect Donald Trump to authorize greater military action against the Islamic State, including more intense air strikes. However, this is not a qualitative reversal of Obama's deleveraging policy. A real reversal would be if Trump decided to follow the advice of Iran hawks in his government - of whom there are several - and increase tensions with Tehran. This is unlikely, given Trump's focus on China and his willingness to improve ties with Russia, a nominal ally of Iran. In fact, there has been almost no talk of Iran from either President-elect Trump or any of his advisors since the election. Furthermore, while U.S. oil imports from OPEC are no longer declining, they are still massively down since their peak in the mid-2000s (Chart 6). It is unlikely that Trump will commit resources to a region of diminishing importance to U.S. interests. Change Of Guard In Tehran. While the risk of Washington saber-rattling with Iran is overstated, what happens if the moderate President Hassan Rouhani is defeated in the upcoming May election? Hardliners are arguing that the nuclear deal with the West has done nothing for the economy, the main pillar of Rouhani's 2013 platform. This is not true. Headline inflation ticked up in late 2016, but remains well off the 40% levels in 2013, while GDP growth has been in the black throughout Rouhani's term, and net exports have bottomed (Chart 7). However, the flow of FDI into the country has been tepid, probably due to ongoing uncertainty with the government transition in the U.S. Both European and Asian businesses are waiting to see if the incoming Trump administration wants to revive sanctions. Meanwhile, skirmishes between U.S. and Iranian vessels - purportedly controlled by the hardline Islamic Revolutionary Guard Corps - have increased in the Persian Gulf. Perhaps the hardliners in Tehran are hoping that they can bait the hardliners in D.C. into a pre-election confrontation that sinks Rouhani. Iraqi Instability. Although the Iraqi government is set to take over Mosul from the Islamic State some time in Q1 2017, the fact remains that the country is bitterly divided between Sunnis and Shia amidst sluggish oil revenues. While the production cut deal will raise revenues marginally, revenues will still be well below their highs (Chart 8). Defeating the Islamic State militarily is one thing, but the real challenge is for Baghdad to reintegrate the Sunni population, which largely lives in territory devoid of oil production. A renewal of civil strife and terrorism targeting Iraqi civilians, which could happen as the Islamic State militants blend back into the wider population, may be a risk in 2017. Chart 6U.S. Imports From OPEC Remain Low U.S. Imports From OPEC Remain Low U.S. Imports From OPEC Remain Low Chart 7Iranian Economy Improves Under Reformist Rule Iranian Economy Improves Under Reformist Rule Iranian Economy Improves Under Reformist Rule Chart 8Iraqi Oil Revenues Still Down From Highs Iraqi Oil Revenues Still Down From Highs Iraqi Oil Revenues Still Down From Highs A word on Israel may also be in order. Israel has not played a major geopolitical role in the region for the past five years and we suspect it will not in the next five. It is secure from its neighbours, who cannot match it in terms of military capability, and remains preoccupied with domestic politics and internal security. Meanwhile, the days when the region unified against Israel are over. Sectarian and ethnic conflicts have gutted Israel's traditional enemies. And former foes, particularly Egypt and Saudi Arabia, are now close allies. The one geopolitical threat that remains is Iran. However, that threat remains dormant as long as Israel maintains nuclear supremacy over Iran and as long as the U.S. remains a security guarantor for Israel. We do not see either changing any time soon. Investment Implications The main investment implication of our thesis that the Middle East has found a new equilibrium is that the region will not dominate the news flow in 2017. Short of a major Turkish blunder in Syria and Iraq, we see the current status quo largely frozen in place. Saudi Arabia appears to have conceded, for now at least, its inferior place in the geopolitical pecking order. Investors have plenty of things to worry about in 2017, such as general de-globalization, a potential Sino-American trade war, geopolitical tensions in East Asia, and elections in four of the five largest euro-area economies. Our geopolitical team's long-standing thesis that geopolitical risk is rotating out of the Middle East and into East Asia is therefore fully playing out.10 Chart 9KSA-Russia Production ##br##Pact Aims at Lowering Inventories KSA-Russia Production Pact Aims at Lowering Inventories KSA-Russia Production Pact Aims at Lowering Inventories In the near term, the geopolitical equilibrium should allow Saudi Arabia, Iran, and Russia to maintain their six-month agreement to cut production by up to 1.8 million b/d. The stated volumes to be cut are comprised of 1.2 million b/d from OPEC, 300,000 b/d from Russia, and another 300,000 b/d from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels, which our commodity strategists believe will happen by the end of 2017 (Chart 9). Bob Ryan, of the Commodity & Energy Strategy, forecasts U.S. benchmark WTI crude prices to average $55/bbl in 2017. The incoming Trump administration will focus its Middle East policy on cooperating with regional actors against the Islamic State. Investors should expect to see more American "muscle" dedicated to the fight, perhaps at the risk of causing civilian casualties (which the Obama White House was careful to avoid). The downside of this strategy is that as the Islamic State loses its territory and ceases to be a caliphate, it will revert to being a more conventional terrorist organization. Its foreign fighters may return home to Europe, Russia, and elsewhere, while home-grown militants will seek to sow further Sunni-Shia discord, especially in Iraq. Unfortunately, this trend will keep our thesis of "A Bull Market For Terror" intact, which lends support to U.S. defense stocks.11 Marko Papic, Senior Vice President marko@bcaresearch.com Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk 1 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 2 Please see "Middle East: Saudi-Iran Tensions Have Peaked," in BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 3 According to the estimates of BCA's Commodity & Energy Strategy, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com. 4 Please see Cullen S. Hendrix, "Oil Prices and Interstate Conflict Behavior," Peterson Institute for International Economics, dated July 2014, available at iie.com. According to Hendrix, revolutionary leaders are "leaders who come to power by force and attempt to transform preexisting political and economic relationships, both domestically and abroad." The definition is broad and includes leaders who used force in order to gain prominence. 5 Please see BCA Geopolitical Strategy Client Note, "Does Yemen Matter?" dated March 26, 2015, available at gps.bcaresearch.com. 6 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," December 8, 2016, available at ces.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "Saudi Arabia's Choice: Modernity Or Bust," dated May 11, 2016, available at gps.bcaresearch.com. See also Emerging Market Equity Sector Strategy, "MENA: Rise Early, Work Hard, Strike Oil," dated October 4, 2016, available at emes.bcaresearch.com. 8 Please see BCA Commodity & Energy Strategy, "Tactical Focus Again Required In 2017," dated January 5, 2017, available at ces.bcaresearch.com. 9 Please see P. Ronzheimer, C. Weinmann, and K. Mössbauer, "Kurden Brauchen Mehr Deutsche Abwehrraketen," Bild, dated October 28, 2016, available at http://www.bild.de/politik/ausland/mossul/kurden-brauchen-dringend-milan-systeme-48495330.bild.html. 10 Please see BCA Geopolitical Strategy Monthly Report, "The Great Risk Rotation," dated December 11, 2013, available at gps.bcaresearch.com. 11 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "A Bull Market For Terror," dated August 5, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights China's monetary and fiscal policy in 2017 will likely remain accommodative, in order to achieve the goal of an average 6.5% GDP growth over the next five years. China's policies related to its property market will be much more restrictive than the previous two years. Chinese metal demand will grow at a slower pace than last year, as reflationary policies are throttled back. Feature Base metals and bulk markets had a fantastic year in 2016, a complete reversal of their miserable performance in 2015 (Chart 1, panels 1 and 2). Last year, the LMEX base metal index, steel prices and iron ore prices were up 30%, 75%, and 91%, respectively (using average prices in January and December). In comparison, during the same period of 2015, the LMEX index, steel and iron ore were down 22%, 30%, and 41%, respectively. Massive supply reductions, and recovering demand caused by China's reflationary fiscal and monetary policies, were the driving forces behind these sharp rallies in bulks and base metals prices last year. Both the official manufacturing PMI and Keqiang index, which are broadly used as key measures of Chinese economic conditions, reached a three-year high in late 2016 (Chart 1, panels 3 and 4). Clearly, metal prices had already discounted a positive outlook vis-a-vis Chinese economic growth, which was boosted by a series of reflationary policy initiatives in the past two years. The question now is: will reflationary monetary and fiscal policies continue into 2017? If so, on how large a scale will it be? What factors could limit or even prevent reflationary policies in China? A look back China's reflationary policies actually started in late 2014, when the property market and overall economy showed signs of weakness. The country accelerated its reflationary policies throughout 2015 and maintained a moderate reflationary stance in 2016, in order to spur domestic economic growth. Monetary policy: China cut its central-bank directed policy rate five times in 2015 from 5.6% to 4.35%, the lowest level since the data started in 1980 (Chart 2, panel 1). The People's Bank of China (PBoC), the country's central bank, also lowered the reserve requirement ratio at banks - the amount of reserves banks must keep on hand - four times in 2015 and once in 2016 from 18% to 15%, the lowest level since May 2010 (Chart 2, panel 2). Chart 1China Reflationary Policy Drove ##br##Metal Price Rallies In 2016 China Reflationary Policy Drove Metal Price Rallies In 2016 China Reflationary Policy Drove Metal Price Rallies In 2016 Chart 2Both Monetary and Fiscal Policies ##br##Were Reflationary Last Year Both Monetary and Fiscal Policies Were Reflationary Last Year Both Monetary and Fiscal Policies Were Reflationary Last Year Fiscal policy: China halved its 10% sales tax on passenger cars with engines up to 1.6 liters in October 2015, which boosted auto sales and production significantly last year (Chart 2, panel 3). The country also maintained its high-growth infrastructure investment last year (Chart 2, panel 4). Real estate-related policy: China loosened its housing-related policies extensively since September 2014, by among other things, reducing down-payment requirements for first-time home buyers, and reducing down payments needed to finance second homes. The goal of the policies was to reduce elevated housing inventories. Indeed, those policies, along with the combination of falling mortgage rates, revived the Chinese property market in 2016, and sparked a massive rally in steel-making commodities - metallurgical coal and iron ore - and in base metals. For the first 11 months of last year, the average selling prices of 70 cities and the total floor-space-sold area rose 13.6% and 24.3% yoy, respectively, which considerably improved from the 2015 same period's 6% and 7.4% yoy growth. The floor-space-started area had an even more significant improvement - a growth of 7.6% for the first 11 months of last year versus a deep contraction of 14.7% yoy for the same period of 2015 (Chart 3). What now? This year, we continue to expect accommodative monetary and fiscal policy in China. "Stability" was the key word during the three-day Central Economic Work Conference (December 14-16, 2016), an annual meeting that set out economic targets and policy priorities for next year. "Stability" means the country's leaders will try to implement policies designed to keep the country's GDP growth around 6.5% this year, the average GDP growth target for the five years between 2016 and 2020, under China's five-year plan. China's economic growth is on a downtrend, coming in at 6.9% in 2015, and a predicted 6.7% in 2016 (for the first three quarters of 2016, China's GDP growth was all 6.7%) (Chart 4, panel 1). Chart 3Property Market Policy: ##br##Greatly Loosened In 2015 And 2016 Property Market Policy: Greatly Loosened In 2015 And 2016 Property Market Policy: Greatly Loosened In 2015 And 2016 Chart 4We Expect Chinese Monetary And Fiscal Policies ##br##To Stay Accommodative This Year We Expect Chinese Monetary and Fiscal Policies To Stay Accommodative This Year We Expect Chinese Monetary and Fiscal Policies To Stay Accommodative This Year The market's expectation for China's 2017 GDP growth currently is 6.5%. Even though President Xi has stated he is open to growth in China falling below 6.5%, too far below this level - for example, below 6% - could cause widespread disappointment in the country and trigger the "instability" leaders are trying to avoid. Hence, monetary accommodation likely will persist in 2017. As both headline inflation and core inflation in China still are not elevated, we do not expect any rate hikes or increases in the reserve requirement ratio to be announced by the PBoC this year (Chart 4, panel 2). In addition, the RMB depreciated considerably last year, which helps the country's exports and, to some extent, stimulates domestic economic growth (Chart 4, panel 3). In mid-December last year, Chinese policymakers raised the tax on small-engine autos slightly - from 5% last year to 7.5% this year - but this is still below its normal 10% level. This also indicates the country wants to maintain a moderate, but not too expansionary, level of fiscal stimulus In 2017. In 2016, most of Chinese automobile production growth came from small-engine passenger cars, which clearly benefited from this policy (Chart 4, panel 4). This year, we still expect positive growth in Chinese vehicle production but at a much slower rate than last year. Curbing Property Market Exuberance Regarding the Chinese property market, our take-away from the Central Economic Work Conference was that "curbing the speculative home purchases, containing asset bubbles and financial risks" will be among the country's top 2017 priorities. In comparison, back in 2016, reducing housing inventories was the focus. Indeed, with property sales recovering, inventory has fallen from its 2015 peak. Inventories still are elevated, but most of the overhang is in third- and fourth-tier cities, with some of it in even smaller cities (Chart 4, panel 5). A continuation of stricter housing policies deployed since last September to cool the over-heated domestic property market is expected. For example, Beijing raised the down payment for first-time homebuyers from 30% to 35%. Down payments for second homes rose from 30% to a minimum of 50%. For a second home larger than 140 square meters, the down payment is now 70%. So far, more than 20 cities have declared similarly strict policies to control speculative buying in property markets. Currently, a record high 20% of people surveyed plan to buy a new house in the next three months, which indicates further cooling measures are needed for the property market (Chart 5, panel 1). In the meantime, new mortgage loans as a share of home sales in value also reached a record high of 49%, and real estate-related loans as a share of total new bank loans now stand at a 6-year high, signaling financial risk in these markets is rising (Chart 5, panels 2 and 3). All of these factors signal that the Chinese authorities will maintain their restrictive property market policies in 2017. This will be negative for the country's bulk and base metals demand, as the property market accounts for some 35% of demand for these commodities. In conclusion, China's monetary and fiscal policies are likely to stay accommodative in 2017, while the country's housing market is facing restrictive policies. Shifting Economic Drivers For Bulk and Base Metal Demand We would like to remind our clients that China's economic structure is shifting: Services (also known as the "tertiary sector") account for a rising share of GDP, and are not big users of bulks or metals, while manufacturing (i.e., the "secondary sector) demand for these commodities is slowing. Services now account for 51.4% of GDP, while manufacturing now accounts for 39.8% (Chart 6). The GDP weight of services is up from 42% ten years ago, while the GDP weight of manufacturing is down 8 percentage points over the same period. Chart 5Property Market Policy Will Remain ##br##Restrictive in 2017 Property Market Policy Will Remain Restrictive in 2017 Property Market Policy Will Remain Restrictive in 2017 Chart 6China's Economic Structure Shift Is ##br##Negative To Metals Demand China's Economic Structure Shift Is Negative To Metals Demand China's Economic Structure Shift Is Negative To Metals Demand This shift is negative for metal demand growth, as the related manufacturing activity growth slows faster than the overall GDP growth. Overall, we believe Chinese bulk and base metal demand growth in 2017 will slow as a result of less expansionary policies than prevailed last year, and a more restrictive domestic housing market. Next week The Chinese Central Economic Work Conference also emphasized that 2017 will be a year to deepen supply-side structural reforms, which we will discuss in our next week's pub. We also will address the impact of Chinese environmental policy on Chinese metal output. Ellen JingYuan He, Editor/Strategist ellenj@bcaresearch.com ENERGY Chart 7Evidence Of Production Cuts Will Lift Oil Prices Evidence Of Production Cuts Will Lift Oil Prices Evidence Of Production Cuts Will Lift Oil Prices Oil Production Expected To Fall Reports of production cuts and reduced volumes being made available to U.S. and Asian refiners have been trickling out since the start of the year, lending underlying support to prices globally (Chart 7). The Kingdom of Saudi Arabia (KSA) is reducing exports of heavy-sour crudes favored by U.S. Gulf refiners, and boosting light-sweet sales, which will compete with North Sea volumes and U.S. shale production. This should tighten the spread between the light-sweet benchmarks Brent and WTI vs. Dubai (medium/heavy-sour). Reduced volumes being shipped by KSA to Asian refiners - particularly to Chinese refiners - will support Brent prices. We continue to expect the production cuts negotiated under the leadership of KSA and Russia to become apparent next month, and for inventories to draw in response. Continued high output by Iraq likely will be reduced in the near future. U.S. shale-oil output most likely will increase in 2H17 by ~ 200k to 300k b/d on average, given higher prices supporting drilling economics. Our expectation for global demand growth remains ~ 1.4mm b/d this year, roughly in line with 2016 growth. Given these underlying fundamentals, we expect inventories will begin showing sharp draws, causing backwardation in crude-oil markets to re-emerge in 2H17. As such, we are re-establishing our Dec/17 vs. Dec/18 WTI front-to-back spread - i.e., buying Dec/17 WTI and selling Dec/18 WTI against it. This spread was in contango going to press, making it particularly compelling. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets China Commodity Focus: How China's Monetary And Fiscal Policy Will Affect Metal Markets

Highlights Portfolio Strategy A battle between tighter monetary conditions and the anticipation of fiscal largesse will be a dominant market theme this year. Our high-conviction equity allocation calls do not require making a major directional global economic bet, or second guessing the Fed's desire to continue tightening. The bulk of our calls could currently be considered contrarian, based on recent market momentum and sub-surface relative valuation swings. Recent Changes S&P Insurance Index - Downgrade to high-conviction underweight. Nasdaq Biotech Index - Downgrade to high-conviction underweight. Feature Stocks have already paid for a significant acceleration in earnings and economic growth this year and beyond. Fourth quarter earnings season will be the first real test of investor expectations since the post-election market surge. While recent data have been encouraging, forward corporate profit guidance is unlikely to be robust in the face of the U.S. dollar juggernaut. Currently, the hope is that fiscal stimulus will offset tighter monetary settings, ultimately delivering a higher plane of economic activity. The major risks are that the economy loses momentum before fiscal spending cranks up, and/or that profits diverge from a more resilient economic performance than liquidity conditions forecast. Indeed, fiscal stimulus isn't slated to accelerate until next year (Chart 1), while the impact of anti-growth market moves is far more imminent. Our Reflation Gauge has plunged, heralding economic disappointment (Chart 1). With the economy near full employment, Fed hawkishness could persist even in the face of any initial evidence of economic cooling. Under these conditions, the gap between nominal GDP and 10-year Treasury yields could turn negative in the first half of the year (Chart 2), which would be a major warning sign for stocks. Chart 1Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Fiscal Stimulus Is Still A Long Way Off Chart 2Warning Signal Warning Signal Warning Signal As a result, while the market has recently been focused almost solely on return, our emphasis at this juncture is on minimizing risk. That is consistent with the historic market performance during Fed tightening cycles. Going back to the early-1970s and using the last seven Fed interest rate hiking periods, it is evident that non-cyclical sector relative performance benefits immensely on both a 12 and 24 month horizon from the onset of Fed tightening (Charts 3 and 4). Cyclical sectors typically lag the broad market, while financials generally market perform1. Chart 312-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Chart 424-Month Performance After Fed Hikes 2017 High-Conviction Calls 2017 High-Conviction Calls Some of the other major macro forces that are likely to influence the broad market and sectoral trends are: Ongoing strength in the U.S. dollar and its drag on top-line growth: loose fiscal policy and tight monetary policy is a classic recipe for currency strength. Tack on high and rising interest rate differentials due to policy divergences with the rest of the world (Chart 5), and exchange rate strength is likely to persist in the absence of a major domestic economic downturn. A tough-talking Fed. Wage growth is accelerating and broadening out, and will sharpen the Fed's focus on inflation expectations. With dollar strength constraining revenue growth potential, strong wage gains are profit margin sapping (Chart 2). A divergence between economic growth and profit performance, i.e. stronger growth is unlikely to feed into equal growth in corporate sector earnings given the squeeze on profit margins from a recovery in labor's ability to garner a larger share of aggregate income. Disappointment and/or uncertainty as to the timing and rollout of the much anticipated fiscal spending programs and unfunded tax cuts. Favoring domestic vs. global exposure will remain a key theme. Emerging markets (EM) have not validated the sharp jump in the global vs. domestic stocks, nor cyclical vs. defensives (Chart 6). Chart 5Greenback Is A Drag##br## On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Greenback Is A Drag On S&P 500 Top Line Growth Chart 6Mind##br## The Gap Mind The Gap Mind The Gap EM stocks are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. The surging U.S. dollar is a growth impediment for many developing countries with large foreign liabilities to service. The U.S. PMI is gaining vs. the Chinese and euro area PMI (Chart 7, second panel), heralding a rebound in cyclical share price momentum. World export growth remains anemic and will remain so based on EM currency trends (Chart 7). When compared with the reacceleration in U.S. retail sales, the outlook for domestically-sourced profits is even brighter. The other key sectoral theme is to favor areas geared to the consumer rather than the corporate sector. Consumer income statements and balance sheets are far healthier than those of the corporate sector (Chart 8). As a result, they are in a more propitious position to spend and expand. Chart 7Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Domestics Will Rise To The Occasion Chart 8Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector Consumers Trump The Corporate Sector We expect all of these forces to truncate rally attempts in 2017. The market is already stretching far enough technically to flag risk of a potentially sizeable correction in the first quarter, i.e. greater than 10%, particularly given the significant tightening in monetary conditions and overheating bullish sentiment that have developed. In other words, it is not an environment to chase the post-election winners, nor turn bearish on the losers that have been eschewed. Against this backdrop, we are introducing our top ten high-conviction calls for 2017. As always, these calls are fundamentally-based and we expect them to have longevity and/or meaningful relative return potential, rather than just reflect recent momentum trends. We recognize the difficulty of trading in and out of positions on a short-term basis. Energy Services - Overweight Chart 9Playable Rally Playable Rally Playable Rally The energy sector scores well in relative performance terms when the Fed is hiking interest rates2, supporting a high-conviction overweight in the energy services group. OPEC's agreement to curtail production should hasten supply/demand rebalancing that was already slated to occur via non-OPEC production declines through 2017. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies reduced capital expenditures by 40% over the same period. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to restore capital availability to the sector. With easier access to capital, producers, especially shale, will be able to accelerate drilling programs in a stable commodity price environment. The three factors traditionally required to sustain a playable rally are now in place. The rig count has troughed. The growth in OECD oil inventories has crested. The latter is consistent with a gradual rise in the number of active drilling rigs. Finally, global oil production growth is falling steadily. Pricing power is likely to be slow to recover this cycle given the scope of previous capacity excesses, but even a move to neutral would remove a major drag and reduce the associated share price risk premium (Chart 9). Consumer Staples - Overweight 2016 delivered a number of company specific body blows to the consumer staples sector, most notably concerns about the pharmacy benefit manger pricing model, which undermined the retail drug store group. Thereafter, the sector was shunned on a macro level following the election, as it was used as a source of capital to fund aggressive purchases in more cyclical sectors. This has set the stage for a contrarian buying opportunity in a high quality, defensive sector with one of the best track records during Fed tightening cycles3. The sector is now closing in on an undervalued extreme, in relative terms, having already reached such a reading in technical terms (Chart 10). Our Cyclical Macro Indicator is climbing, supported by the persistent rise in consumers' preference for saving. The latter heralds an increase in outlays at non-cyclical retailers relative to sales at more discretionary stores. Importantly, consumer staples exports have reaccelerated, despite the strong U.S. dollar, pointing to a further acceleration in sector sales growth, and by extension, free cash flow. The strong U.S. dollar is a major boon, from an historical perspective, given that it typically creates increased global economic and market volatility. The latter is starting to pick up (Chart 10). A strong currency, particularly bilaterally against China, also implies a reduction in the cost of imported goods sold, and heralds a relative performance rebound (Chart 11). Chart 10Contrarian Buy Contrarian Buy Contrarian Buy Chart 11China To The Rescue? China To The Rescue? China To The Rescue? Home Improvement Retail - Overweight Enticing long-term housing prospects argue for looking through the recent rise in mortgage rates. Household formation is reaccelerating, as full employment is boosting consumer confidence, and clocking at a higher speed than housing starts. The implication is that pent-up housing demand will be unleashed. In fact, consumers have only recently started re-levering, with banks more than willing to facilitate renewed appetite for mortgage debt. Remodeling activity is booming and anecdotes of house flipping activity picking up steam are corroborating that the housing market is vibrant. Now that house prices have recently overtaken the 2006 all-time highs, the incentive to upgrade and remodel should accelerate. While the recent backup in bond yields has been a setback for housing affordability, the U.S. consumer is not priced out of the housing market. Yields are rising in tandem with job security and wages. Mortgage payments remain below the long-term average as a share of income and effective mortgage rates remain near generationally low levels. Building supply store construction growth has plumbed to the lowest level since the history of the data. Historically, capacity restraint has represented a boost to home improvement retail (HIR) profit margins and has been inversely correlated with industry sales growth. Stable housing data and improving operating industry metrics entice us to put the compellingly valued S&P HIR on our high-conviction buy list for 2017 (Chart 12). Chart 12Benefiting From Enticing##br## Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Benefiting From Enticing Long-Term Housing Prospects Chart 13Healthy Consumer Is A Boon##br## To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Healthy Consumer Is A Boon To Consumer Finance Stocks Consumer Finance - Overweight We are focusing our early-cyclical exposure on overweighting the still bruised S&P consumer finance index. This group is levered to the rising interest rate environment and debt-financed consumer spending. The selloff in the 10-year Treasury bond has been closely correlated with relative performance gains and the current message is to expect additional firming in the latter (Chart 13, top panel). Importantly, higher interest rates have boosted credit card interest rate spreads (the industry's equivalent net interest margin metric), underscoring that the next leg up in relative share prices will be earnings led (Chart 13, bottom panel). On the consumer front, consumer finances are healthy, the job market is vibrant and consumer income expectations are on the rise. In addition, house prices have vaulted to fresh all-time highs and are still expanding on a y/y basis. The positive wealth effect provides motivation for consumers to run down savings rates (Chart 13, second & third panels). Health Care Equipment - Overweight Health care equipment (HCE) stocks have been de-rated alongside the broad health care index, trading at a mere market multiple and below the historical mean, representing a buy opportunity. Revenue growth has been climbing at a double digit clip (Chart 14, third panel) and the surging industry shipments-to-inventories ratio is signaling that still depressed relative sales growth expectations will surprise to the upside (Chart 14, top panel). Synchronized global growth is also encouraging for U.S. medical equipment exports, despite the U.S. dollar's recent appreciation. The ageing population in the developed markets along with pent up demand for health care services in the emerging markets where a number of countries are developing public safety nets, bode well for HCE long-term demand prospects. The bottom panel of Chart 14 shows that the global PMI has been an excellent leading indicator of HCE exports and the current message is positive. The recent contraction in valuation multiples suggests that sales are expected to disappoint in the coming year, an outlook that appears overly cautious, especially within the context of the nascent improvement in industry return on equity (Chart 14, second panel). Chart 14HCE Stocks Are Cheap Given##br## Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook HCE Stocks Are Cheap Given Improving Final Demand Outlook Chart 15More Than##br## Meets The Eye More Than Meets The Eye More Than Meets The Eye REITs - Overweight REITs have traded as if the back up in global bond yields will persist indefinitely, and that the level of interest rates is the only factor that drives relative performance. Improving cash flows and cheap valuations suggest that REITs can decouple from bond yields. Our REIT Demand Indicator (RDI) has climbed into positive territory, signaling higher rental inflation. The latter is already outpacing overall CPI by a wide margin. The RDI is also positively correlated with commercial property prices, implying more new highs ahead. That will support higher net asset values. While increased supply is a potential sore spot, particularly in the residential space, multifamily housing starts have rolled over relative to the total, suggesting that new apartment builds are diminishing. As discussed in previous research reports, contrary to popular perception, relative performance is also depressed from a structural perspective. REIT relative performance is trading well below its long-term trend, a starting point which has historically overwhelmed any negative pressure from a Fed tightening cycle (Chart 15). Tech Hardware Storage & Peripherals - Underweight The S&P technology hardware storage & peripherals (THSP) sector is a disinflationary play (10-year treasury yield change shown inverted, second panel, Chart 16) and benefits when prices are deflating, not when there are whiffs of inflation4. The tech sector has the highest foreign sales/EPS exposure among the top 11 sectors, and the persistent rise in the greenback is weighing on export prospects for the THSP sub-index (Chart 16, third panel), and by extension top and bottom line growth. Computer and electronic products new order growth has fallen sharply recently, warning that THSP sales growth will remain downbeat. Industry investment is also probing multi-year lows (not shown). Asian inventory destocking is ongoing, which will pressure selling prices, but the end of this liquidation phase would be a signal that the worst will soon be over. Technical conditions are bearish. A pennant formation signals that a breakdown looms. Chart 16Tech Stocks Hate Reflation Tech Stocks Hate Reflation Tech Stocks Hate Reflation Chart 17Shy Away, Don't Be Brave Shy Away, Don’t Be Brave Shy Away, Don’t Be Brave Biotech - Underweight The Nasdaq biotech index is following the BCA Mania Index, which includes previous burst bubbles in a broad array of asset classes. The top panel of Chart 17 shows that if history at least rhymes, biotech bubble deflation is slated to continue. Only 45 stocks in the NASDAQ biotech index have positive 12-month forward earnings estimates, comprising 27% of the 164 companies in the index according to Bloomberg. There is still a lot of air to be taken out of the biotech bubble. Historically, interest rates and relative performance have been inversely correlated. The back up in bond yields and Fed tightening represent a draining in liquidity conditions which bodes ill for higher beta and more speculative investments. The biotech derating has been earnings driven and a sustained multiple compression period looms, especially given the sector's poor sales prospects (Chart 17, bottom panel) Worrisomely, not only have biotech stocks fallen despite Trump's win, but recent speculative zeal (buoyant equity sentiment and resurging margin debt, not shown) has also failed to reinvigorate biotech equities. The NASDAQ biotech index is a sell (ETF ticker: IBB:US). Industrials - Underweight The industrials sector was added to our high-conviction underweight list late last year so the turn in calendar does not require a change in outlook. The sector has discounted massive domestic fiscal stimulus and disregarded the competitive drag on earnings from the U.S. dollar, trading as if a profit boom is imminent. Recent traction in surveys of industrial activity is a plus, but is more a reflection of an improvement in corporate sentiment and is unlikely to translate into imminent industrials sector profit improvement. The U.S. dollar surge is a direct threat to any benefit from an increase in domestic infrastructure or private sector investment spending. Commodity prices and EM drag when the dollar is strong. Chronic surplus EM industrial capacity remains a source of deflationary pressure for their currencies, economies and U.S. industrial companies. U.S. dollar strength warns of renewed pricing power pressure (Chart 18). Non-tech industrial capacity is growing faster than output, and capital goods imports prices are contracting (Chart 18). Tack on the relentless surge in the U.S. dollar, and a new deflationary wave appears inevitable. Relative forward earnings momentum is already negative, and is likely to remain so given the barriers to a top-line recovery, and a soaring domestic wage bill. The sector is not priced for lackluster earnings. Chart 18Fade The Bounce Fade The Bounce Fade The Bounce Chart 19Advance Is Precarious Advance Is Precarious Advance Is Precarious Insurance - Underweight Insurance stocks have benefited from the upward shift in the yield curve and the re-pricing of the overall financials sector, but the advance is precarious. Previously robust insurance pricing power has cracked. The CPI for household insurance is barely growing. The latter is typically correlated with auto premiums, underscoring that they may also slip (Chart 19). While higher interest rates are positive for investment portfolio income, they also imply mark-to-market losses on bond portfolios and incent insurers to underwrite at a faster pace with more lenient standards, which is often a precursor to increased competition and less pricing power. Insurance companies have added massively to cost structures in recent years (Chart 19), while the rest of the financials sector was shedding labor costs. Relative valuations have enjoyed a step-function upshift, but the path of least resistance will be lower for as long as relative consumer spending on insurance products retreats on the back of pricing pressure (Chart 19). 2016 Review... Last year's high-conviction calls were hot out of the gate, and generally had very strong gains until the late-summer/early-fall, but were hijacked by the post-election surge in a few sectors. As a result of the end of year fireworks, our high conviction calls trailed the market by just under 2% for the year ending 2016. Had we had the foresight to predict a Trump win and a massive market rally, we could have closed our positions in early November for comfortably positive gains. In total, our average booked gains in the year were 3% in excess of the broad market since the positions were initiated. We are also closing our pair trades, and will re-introduce a number of new trades in the near future. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy & U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see the U.S. Equity Strategy Special Report titled: "Sector Performance And Fed Tightening Cycles: An Historical Roadmap", available at uses.bcaresearch.com. 2 Ibid 3 Ibid 4 Please see the U.S. Equity Strategy Special Report titled: "Equity Sector Winners And Losers When Inflation Climbs", available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Highlights The tactical environment is dynamic, chaotic and unpredictable. ...Chaos also brings opportunity. We must recognize and exploit opportunities when chance presents them. Look for recurring patterns to exploit.1 Feature Highlights Strategically, major commodity markets are balanced with the exception of ags, where we remain underweight on the back of record grain harvests and high stock-to-use ratios. Otherwise, broad exposure to the asset class is warranted. However, within the larger investment context, we believe tactical positioning once again will produce higher returns than strategic index exposure to commodities. Chart of the WeekTactical Positioning ##br##Rewarded In Oil Markets Tactical Positioning Rewarded In Oil Markets Tactical Positioning Rewarded In Oil Markets Supply-driven price volatility and erratic monetary policy presented commodity markets strategic and tactical opportunities in 2016, particularly in oil, where our recommendations returned an average of 95% (Chart of the Week). We remain overweight oil, expecting continued opportunities from volatile markets. Going forward, the contribution of demand-side risk to price volatility will increase. This will be evident in iron ore, steel and base metals, where the opacity of China's fiscal and monetary policy - especially re heavily indebted state-owned enterprises (SOEs) and the banks that support them - in the lead-up to the Communist Party's Congress abounds. Continued adjustments by the U.S. Fed to random-walking data will again contribute to volatility, particularly in oil and gold markets. A stronger dollar resulting from continued Fed tightening will hit U.S. ag exports, and benefit competitors such as Argentina and the EU. However, uncertainty re the Trump administration's fiscal and trade policies could keep the Fed looser for longer, particularly if border-adjusted taxation favoring exports over imports is realized. Geopolitics - particularly vis-à-vis U.S. and China trade and military policy - will become more important if America tilts toward dirigisme, i.e., actively managing its economy by adjusting taxation and policy to support favored industries. Governments typically allocate resources inefficiently, which distorts fundamentals. If border-adjusted taxation becomes law in the U.S. we will look to get long volatility across commodity markets: Such legislation likely would rally the USD, which would lower global demand for commodities generally and lift supply by lowering local costs. This would run smack into higher U.S. inflation arising from the increasing cost of imported goods. This is a recipe for heightened uncertainty and price volatility. Russia lurks in the background: U.S. sanctions in the wake of alleged interference in American presidential elections, and Russia's response, will keep oil markets on edge. 2017 Weightings Energy: Overweight. The OPEC-Russia co-operation pact to limit production could evolve into a durable modus operandi for managing oil supply. Markets will judge the pact effective if tanker chartering out of the Persian Gulf falls, and global inventories draw by mid- to end-February. Base Metals: Neutral. Bulks and base metals prices will remain rangebound, until greater clarity on China's fiscal and monetary policy emerges. Fiscal stimulus in the U.S. will have a marginal effect on demand toward year-end. Precious Metals: Neutral. Gold will remain sensitive to shifts in U.S. fiscal and monetary policy expectations. The possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. Should it pass, the Fed could be forced to keep interest rates lower for longer to offset the massive tightening in financial conditions such a tax would impose. Ags/Softs: Underweight. We see limited downside for grains, despite record harvests. We favor wheat and rice over corn and beans. A stronger USD will be bearish for grain exports. Feature Commodities as an asset class remain attractive. However, constantly changing information flows affecting these markets compel us once again to favor tactical positioning over a broad strategic exposure to the asset class. Fundamentals - supply, demand, inventories - and financial variables remain in a state of flux. In the oil market, the durability of the OPEC-Russia co-operation pact to reduce oil production will be tested, following a year-end surge in global production. Markets will closely follow shipping activity - particularly out of the Persian Gulf - and global oil inventory levels for signs the production cuts engineered late last year by OPEC, led by the Kingdom of Saudi Arabia (KSA), and non-OPEC producers, led by Russia, are taking hold. Uncertainty regarding the incoming Trump administration's tax and trade policies - and responses from states targeted by such policies (e.g., China and Mexico) - will keep decisions affecting supply and demand fluid. The incoming Trump administration's trade policies could alter global oil flows: e.g., a re-working of NAFTA that reduces U.S. refined-product exports to Latin America would result in lower demand for crude at American refineries, and present an opening to Chinese refiners. In addition, as mentioned above, legislation authorizing border-adjusted taxes favoring exports and penalizing imports likely will be taken up this year in the U.S. Congress. If we did see tax policy favouring U.S. exports over imports, we believe it would prompt a USD rally via reducing America's current account deficit. This would, all else equal, send commodity prices sharply lower, as EM commodity demand will contract, owing to higher USD prices for commodities, and production ex U.S. will increase, due to lower local costs. That said, border-adjusted taxation in the U.S. also would increase the price of imports, and lift realized and expected inflation. How this plays out is highly uncertain at present. A border-adjusted tax bill likely will be taken up in the current session. If it passes, it would have major implications for pricing relationships globally - chiefly WTI vs. Brent, and Brent vs. Dubai crudes, along with product differentials that drive shipping economics. If such a bill looks like it will pass, we expect a sharp increase in commodity-price volatility globally. If the odds do favor such a tax regime shift, we would look to get long WTI and short Brent further out the curve, expecting higher U.S. exports and lower imports. In addition, we would look to get long gold volatility - buying puts and calls - as policy uncertainty effects resolve themselves. Heightened Uncertainty Means Tactical Positioning Once Again Trumps Passive Commodities Allocation The primacy of tactical positioning was demonstrated in 2016 in the oil market, when strategic positions quickly became tactical, either because they were stopped out or reached their P&L targets quicker than expected. Supply destruction dominated price formation last year, following OPEC's decision to abandon its strategy to support prices via production management in November 2014. This destruction occurred mostly in non-Gulf OPEC, which was down 7.0% yoy in 2016 (Chart 2), and non-OPEC producers, particularly the U.S. shale-oil fields, where yoy production was down 12.0% by year-end 2016 (Chart 3). Chart 2Low Prices Crushed Non-Gulf Production... Low Prices Crushed Non-Gulf Production ... Low Prices Crushed Non-Gulf Production ... Chart 3...And U.S. Production ... and U.S. Production ... and U.S. Production Even in states where production increased - chiefly KSA and Russia (Chart 4) - domestic finances crumbled, leaving them in dire straits. By our estimates, between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, KSA had burned through $220 billion of it foreign reserves, equivalent to 30% of its central-bank holdings. Russia had drawn down its official reserves by $77 billion over the same period, or 16% of its holdings; its burn rate was reduced by allowing its currency to depreciate, which lowered the local cost of producing oil and boosted profitability of exports priced in USD. This was the background that forced OPEC, led by KSA, and non-OPEC, led by Russia, to negotiate the year-end pact that resulted in an agreement to cut production by up to 1.8 mm b/d. The stated volumes to be cut are comprised of 1.2 mm from OPEC, 300k b/d from Russia, and another 300 from other non-OPEC producers. The goal of this agreement is to reduce global oil inventories to more normal levels (Chart 5). Chart 4KSA, Russia Production Ramp ##br##Exacerbated Price Weakness KSA, Russia Production Ramp Exacerbated Price Weakness KSA, Russia Production Ramp Exacerbated Price Weakness Chart 5KSA-Russia Production Pact Aimed ##br##At Lowering Inventories KSA-Russia Production Pact Aimed at Lowering Inventories KSA-Russia Production Pact Aimed at Lowering Inventories Throughout 2016, as the supply-destruction drama was unfolding, numerous opportunities opened up to investors to fade market overshoots, brought about by over-reactions to fast-moving news flows. Unrestrained output by OPEC and non-OPEC producers strained oil-storage facilities early in the year, taking markets to the brink of breaking down entirely. Unexpected shifts in U.S. monetary policy - driven by random-walking data - also contributed to oil price volatility and opened numerous trading opportunities. Markets essentially ignored the cumulating right-tail price risks last year, following the supply destruction wrought by OPEC's declaration of a market-share war, and Russian overtures to OPEC seeking a production-allocation dialogue, which were very much in evidence in January 2016. The continual OPEC-Russia dialogue, which appeared to be bearing fruit in Doha before it was scuppered by KSA at the last minute in April, was the underlying geopolitical driver last year, and kept the odds of a production deal elevated. Based on our modeling, the supply surge following OPEC's decision made getting long contingent upside price exposure extremely compelling, particularly as it imperiled the finances of all oil producers - rich and poor, but mostly the poorer states like Venezuela and Nigeria. Our reasoning was lower prices would accelerate rebalancing of global markets and raise the odds of a major supply disruption at one of these failing states.2 Our modeling consistently indicated global oil markets would rebalance in 2016H2.3 Ultimately, this is how things played out, aided in no small measure by mid-year wildfires in Canada, which temporarily removed move than 1mm b/d from global markets, and sabotage of pipelines and loading facilities in Nigeria. Even with that, markets remained under pressure as Canadian barrels returned, and foreign reserves in KSA and Russia were rapidly depleted. These fundamentals, along with constantly changing Fed guidance, provided numerous opportunities to exploit recurring patterns thrown up by chance, as is evident in the returns on recommendations we made - averaging 95.1% last year - that naturally followed from our analysis (Table 1). Our favored exposure was getting long contingent exposure (i.e., options), using deferred call spreads in WTI and Brent, given our assessment the odds of higher prices exceeded the market's. Later in the year, following the OPEC-Russia pact, we got long a front-to-back crude oil spread (Dec/17 WTI vs. Dec/18 WTI) expecting the goal of the deal - reducing global inventories - stood a good chance of being realized. We got lucky putting the trade on as the market was correcting, but just ahead of the statement by KSA's oil minister that the Kingdom would do "whatever it takes" to make the deal work. This transformed a strategic position - one we expected to hold for months - into a one-week exposure that returned 493% (Table 1). Table 1Energy Trades Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 In order to obtain a more detailed assessment of our energy portfolio's performance, we built an information ratio (IR) to evaluate how our energy recommendations performed compared to a selected benchmark, the S&P GS Commodity Index (GSCI). Essentially, our IR is used to assess whether an active portfolio has outperformed the selected benchmark in a consistent manner during the period of analysis, given the risk it incurred. To that end, our ratio looks at the average excess return of the active portfolio against the benchmark. This average excess return is then divided by its standard deviation (also referred to as the tracking error volatility) in order to get a risk-adjusted metric to evaluate whether the risk we took were compensated by the returns we generated. Our IR thus is calculated as: Formula Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: high returns in the portfolio, low returns in the benchmark, or low tracking error volatility. Hence, this measure helps analyzing the notion of risk-reward tradeoff; it tells us whether or not the risk assumed in our trades was compensated by larger returns. In our case, to get the risk-adjusted returns of the energy portfolio, we selected the GSCI as a benchmark, as it is heavily skewed towards Energy commodities (around 60% of its composition). We believe this is a plausible benchmark alternative to our energy trade recommendations for an investor, whose choice is passive index exposure with a significant energy weighting. Our portfolio's average return in 2016 was 95%, while the GSCI return was 11%. The tracking error volatility was 56%.4 Using these inputs, we calculated the IR of our recommendations was 1.47. This is an excellent risk-adjusted return, and indicates the high volatility of our returns was more than compensated for by consistent positive excess returns our recommendations generated relative to passive GSCI exposure, which also can be used as a benchmark for energy-heavy commodity index exposure (i.e., "commodity beta"). Remain Overweight Oil We expect the combination of production cuts and natural declines will remove enough production from the market this year to restore global oil stocks to five-year average levels toward the end of 2017Q2 or early Q3 (Chart 5), even with cheating by OPEC and non-OPEC producers capable of increasing production. As a result, in 2017, we expect the OPEC-Russia deal to result in inventory draws of ~ 10% by 2017Q3. On the demand side, we continue to expect global growth of ~ 1.3 to 1.5mm b/d. Given these expectations, we expect U.S. benchmark WTI crude prices to average $55/bbl, up $5 from our 2016 forecast, on the back of the end-year OPEC-Russia pact. We are moving the bottom of the range in which we expect WTI prices to trade most of the time to $45/bbl and keeping the upside at $65/bbl. Markets already are pricing in a normalization of global inventories by year end (Chart 6 and Chart 7). We will look for opportunities to re-establish our long front-to-back positions, expecting the backwardation further out the curve will steepen. Chart 6Backwardation Steepening Near Term... Backwardation Steepening Near Term ... Backwardation Steepening Near Term ... Chart 7...And Further Out the Curve ... And Further Out the Curve ... And Further Out the Curve Further out the curve - i.e., mid-2018 and beyond - our conviction is lower: The massive capex cuts seen in the industry for projects expected between 2015 - 2020 will place an enormous burden on shale producers and conventional oil producers, chiefly Gulf Arab producers and Russia. It will be difficult to offset natural decline-curve losses - which will increase as U.S. shales account for a larger share of global supply - and meet increasing demand. As we've often noted, any indication U.S. shales or conventional supplies (Gulf states and Russian production) will not be able to move quickly enough to meet growing demand and replace natural declines could spike prices further out the curve. We expect U.S. oil exports to increase this year, which means the international benchmark, Brent crude oil, will increasingly price to move WTI into global markets. We expect U.S. WTI exports to increase from an average ~ 500k b/d, which should keep the price differential roughly around +$1.50/bbl differential (Brent over) for 2017. If we see border-adjusted taxation laws take effect, we would look to get long WTI vs. short Brent, and long U.S. products (e.g., U.S. Gulf gasoline and distillate exposure) vs. short Brent exposure. Remain Neutral Bulks, Base Metals Over in the bulks and base metals markets, a full-fledged iron-ore market-share war at the beginning of last year threatened to take prices to $30/ton. Then, seemingly out of the blue, an unexpected pivot by Chinese policymakers toward stimulating the "old economy" caught many bulks and base-metals traders and analysts - ourselves included - flat-footed. Powerful rallies in iron ore, steel and base metals early in the year on Chinese exchanges were dismissed as irrational exuberance on the part of retail investors. But, at the end of the day, these market participants were responsible for well-informed price signals that fully reflected low inventories and surging demand.5 The -0.5% average return in our bulks and base metals recommendations last year attests to how difficult we found these markets to read and anticipate (Table 2). Table 2Base Metals Trades Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 As always, the evolution of China's economy will, as always, be critical to these markets, given that country's outsized role in iron ore, steel and base metals. We are broadly neutral the complex, and, with the exception of the nickel market, see supply and demand relatively balanced to slightly oversupplied globally and in China. Production globally and in China is growing yoy, while consumption shows signs of slowing. (Chart 8 and Chart 9). Chart 8World Base Metals Consumption Slowing,##br## Relative to Production... World Base Metals Consumption Slowing, Relative to Production ... World Base Metals Consumption Slowing, Relative to Production ... Chart 9...As Is ##br##China's ... As Is China's ... As Is China's Uncertainty re the direction of China's fiscal and monetary policy - chiefly, whether policymakers will, once again, resort to stimulating the "old economy" - will keep us broadly neutral bulks and base metals until we get further clarity on the direction of policy. We expect the monetary and fiscal stimulus that massively boosted China's housing market this year will wind down, bringing an end to the run-up in iron ore, steel and base metals prices. Odds favor "reflationary" policies to continue going into the Communist Party Congress next fall, but we do not expect anything along the lines of the surge in policy stimulus seen earlier this year: Unwinding and controlling property-market excesses and high debt levels will limit policymakers' desire to turbo-charge the housing market again, limiting the boost such policies provide. The fate of border-adjusted taxation in the U.S. Congress is critically important to bulk and base-metals markets, since it would encourage exports and discourage imports (along with raising their prices). Tax policy favouring U.S. exports over imports likely would prompt a USD rally, which would send commodity prices generally sharply lower. It would boost U.S. steel production and base metals exports, while raising the cost of imports. A border-adjusted tax bill likely will be taken up in the current session of Congress. We are downgrading our tactically bullish view on iron ore to neutral. Strategically, we retain a bearish bias, as rising iron ore supply may overwhelm the market again in 2017H2. We remain tactically neutral and strategically bearish steel. Low steel inventories and production disruptions caused by China's recently launched environmental inspection program likely will continue to support steel prices in the near term. However, persistently high steel output and falling demand from the Chinese property sector will eventually knock down prices in 2017H2. Manufacturing will play a larger role in copper markets, and will drive the demand side this year. However, if we see a stronger USD - either as a result of Fed policy or U.S. fiscal policy - price appreciation will be limited. We remain neutral copper, expecting a concerted effort to slow the housing boom in China. Reflationary policies will still support real demand for copper, but will reduce demand from new construction. The supply deficit in nickel will widen on the back of rising stainless steel demand and falling nickel ore supply in 2017, which will support prices. We expect nickel will outperform zinc over a one-year time horizon. For zinc, we remain tactically neutral and strategically bearish. We expect zinc supply to rise considerably in response to current high prices. Aluminum supply - for the moment - will lag demand globally, which keeps us tactically bullish and strategically neutral. Supply shortages will likely persist ex-China over the next three to six months. Stay Neutral Precious Metals Precious metals, gold in particular, staged an impressive rally on the back of unexpected easing by the U.S. Fed in response to weaker-than-expected sub-1% GDP growth in 1Q16 GDP. Markets had been pricing in as many as four interest-rate hikes earlier in the year into short-term expectations, which were quickly dashed. Markets lowered their expectations for multiple rate hikes last year, which weakened the USD and U.S. real rates, setting the stage for the gold rally. Nonetheless, gold proved a difficult commodity to trade last year, as our results indicate - the average return on our precious metals recommendations amounted to a paltry -0.65% (Table 3). For the near term - i.e., until greater clarity on Fed policy and the incoming Trump administration's fiscal policy direction becomes clear - we remain neutral precious metals, and will avoid taking any further exposure other than perhaps getting long gold volatility - i.e., buying puts and calls in the gold market - if the odds of border-adjusted taxation legislation passing increase. Such legislation likely would rally the USD, which would lower global demand and increase supply ex U.S. at the margin for commodities generally, oil and base metals in particular. This would be deflationary, given the high correlations between oil and base metals consumption and U.S. inflation (Chart 10).6 However, such a taxation scheme also would raise U.S. inflation by increasing the cost of imported goods, sending the U.S. core PCE, the Fed's preferred inflation gauge, higher. The global disinflationary impulse from a stronger USD would run headlong into higher U.S. inflation, which would be a recipe for heightened uncertainty and price volatility. Table 3Precious Metals Trades ##br##Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 Chart 10Risk of Deflation Will Rise If Border-Adjusted ##br##Taxes Prove Deflationary Risk of Deflation Will Rise If Border-Adjusted Taxes Prove Deflationary Risk of Deflation Will Rise If Border-Adjusted Taxes Prove Deflationary This will complicate U.S. monetary policy. We believe the Fed also will be waiting on such direction, and that interest-rate policy will, therefore, remain pretty much be on hold, keeping precious metals - gold, in particular - rangebound. For the moment, the possibility of border-adjusted taxes in the U.S. will hang like the proverbial Sword of Damocles over the gold market. We are taking profits on the tactical long gold position we opened December 15, 2016, as of today's close. Remain Underweight AGS Lastly, Ag markets provided us no joy, as the El Nino wreaked havoc on our recommendations. Our average -1.0% return for the year amply demonstrates the difficulty of trading markets so heavily influenced by weather (Table 4). Going into 2017, we believe there is a limited downside for grains. The downtrend since August 2012 like forms a bottom this year, if, as we are modeling, we see a return to normal weather conditions. That said, the principal upside risk remains unfavorable weather in major grain-producing countries, which could send badly battered grain prices surging as they did in 2016H1. Among grains, we favor wheat and rice over corn and soybeans. Global soybean acreage is likely to expand as the crop provides higher returns than other grains. South American corn output will continue rising on favorable policies and weak currencies, adding further pressure to already-high U.S. corn inventories, in particular, and global inventories globally (Chart 11). Table 4AGS Trades Closed In 2016 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017 Chart 11Global Grain Inventories Remain High Global Grain Inventories Remain High Global Grain Inventories Remain High Softs - cotton and sugar - likely will underperform grains in 2017, reversing their outperformance this year. We are tactically bearish cotton, as U.S. cotton acreage is likely to increase next spring. Strategically, we are neutral cotton. For the global sugar market, barring extremely unfavorable weather, we are tactically and strategically bearish. This year's extreme rally in prices may result in a small supply surplus in 2017. Our Ag strategies will continue to focus on relative-value investments. Robert P. Ryan, Senior Vice President Commodities & Energy Strategy rryan@bcaresearch.com Hugo Belanger, Research Assistant hugob@bcaresearch.com 1 Please see "Tactics Cliff Notes; A Synopsis of MCDP 1-3 Tactics," published by the United States Marine Corps, Marine Corps Warfighting Lab, Marine Corps Combat Development Command, Quantico, Virginia. 10 May 1998 (pp. 2, 3. sf). 2 In our January 7, 2016, publication we noted investors were ignoring growing upside price risk and suggested they get long a Dec/16 $50/$55 WTI call spread to gain exposure to higher volatility. We also recommended remaining long Dec/16 and Dec/17 WTI vs. Brent following passage of legislation to allow U.S. crude exports. We ultimately took profits on these recommendations of 172% on the call spread in June, and 97% on the Dec/16 WTI vs. Brent spread in June, and 88% on the Dec/17 WTI vs. Brent spread in July, respectively (Table 1). Please see "Oil Market Ignores Right-Tail Saudi Risks" in the January 7, 2016, issue of BCA Research's Commodity & Energy Strategy, which is available at ces.bcaresearch.com. 3 In our January 21, 2016, Commodity & Energy Strategy article entitled "Global Oil Sell-off Will Accelerate Rebalancing," we noted, "We expect oil markets to rebalance by late 2016Q3 or early Q4. We remain long Dec/16 $50 calls vs. $55 calls, in anticipation of rebalancing and as a hedge against geopolitical risk." 4 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 203 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking error volatility. 5 Please see "Dead-Cat Bounces Notwithstanding, Iron Ore Will Trade Lower" in the January 21, 2016 issue of BCA Research's Commodity & Energy Strategy, and "Fade The Copper Rally" in the February 25, 2016 issue. Both are available at ces.bcaresearch.com. 6 In earlier research, we've shown U.S. core PCE inflation is highly correlated with EM oil and base metals demand. Please see "2017 Commodity Outlook: Precious Metals" published December 15, 2016. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Tactical Focus Again Required In 2017 Tactical Focus Again Required In 2017

Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed bca.ems_wr_2016_12_21_s1_c3 bca.ems_wr_2016_12_21_s1_c3 Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices bca.ems_wr_2016_12_21_s1_c4a bca.ems_wr_2016_12_21_s1_c4a Chart I-4BGold Led Oil Prices Gold Led Oil Prices Gold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6a bca.ems_wr_2016_12_21_s1_c6a Chart I-6BGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6b bca.ems_wr_2016_12_21_s1_c6b In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies bca.ems_wr_2016_12_21_s1_c7 bca.ems_wr_2016_12_21_s1_c7 The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement bca.ems_wr_2016_12_21_s1_c9 bca.ems_wr_2016_12_21_s1_c9 The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Brazil's Economy: No Improvement At All Brazil's Economy: No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Rand, AUD And Precious Metals Rand, AUD And Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Very Weak Employment Outlook Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Indian PMIs Are Sinking Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Indian Capex Is Anemic Indian Capex Is Anemic Chart II-4Banks Prefer Consumers bca.ems_wr_2016_12_21_s2_c4 bca.ems_wr_2016_12_21_s2_c4 We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations

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

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

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