Equities

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

The previous Insight showed that businesses remain a weak link for the banking sector, as C&I loan demand has cooled and the corporate sector is the primary source of credit quality concerns following the multi-year credit binge. As such, our preference to play rising interest rates and a modest steepening in the yield curve is through the consumer finance group. Valuations remain dirt cheap, and have not discounted the widening in credit card net interest margins close to historic peaks. That is a far cry from banks, where net interest margins have improved, but only slightly and from still razor thin levels. Importantly, consumers have room to re-leverage after years of de-leveraging, an outcome predicted by the improvement in consumer income expectations. The bottom line is that the consumer finance group provides a cleaner play than banks on the sudden bullish sentiment shift in the overall financial sector. The ticker symbols for the stocks in this index are: BLBG: S5CFINX-AXP, COF, DFS, SYF, NAVI.

The scope of the revaluation in banks stocks on hopes for reduced regulatory constraints and the modest yield curve steepening has surprised us, but it would be dangerous to equate share price strength with the perception that underlying activity has reaccelerated. Indeed, the chart shows that overall bank loan growth is steadily decelerating, led by a cooling in C&I credit creation to its lowest rate since the great recession. While credit growth is far from recessionary levels, it is diverging negatively from what bank stocks might suggest. Importantly, banks have been adding to cost structures in recent months, and our gauge of bank sector productivity (bank loans/bank employment) is receding on a growth rate basis. This suggests that there could be a setback if fourth quarter profits do not validate the share price move. Rather than chase the bank group, our preference to play strength in the financial sector is through the asset manager and consumer finance groups, see the next Insight. The ticker symbols for the stocks in this index are: BLBG: S5BANKX-JPM, WFC, BAC, C, USB, PNC, BBT, STI, MTB, FITB, KEY, CFG, RF, HBAN, CMA, ZION, PBCT.

Highlights This week we elaborate on the issues that we believe will be critical to investors going into 2017: Feature 1. Is China beginning to export inflation? Not yet. As long as the RMB depreciates faster than the rate of domestic inflation, China will be exporting deflation to the rest of the world. 2. Is the selloff in so-called search-for-yield beneficiaries over? Most likely not. There is still meaningful upside in global bond yields as well as downside in prices of bond proxies and search-for-yield beneficiaries. 3. Will China recover or will it have another growth slump in 2017? China's industrial cycle will be topping out in the next couple of months and will relapse thereafter. 4. Will strong U.S./DM growth lift EM economies in 2017? Not really. EM will continue to be driven by its domestic credit cycle and commodities prices. If anything, higher U.S. interest rates and a strong U.S. dollar are bearish for both the EM credit cycle and commodities prices. Overall, we expect EM stocks, currencies, credit markets and domestic bonds to sell off and underperform their U.S./DM peers well into 2017. Is China Beginning To Export Inflation? With various inflation measures in China rising (Chart I-1A and Chart I-1B), the key question is whether China will soon export inflation rather than deflation to the rest of the world. Chart I-1AInflation In RMB Terms, ##br##Deflation In USD Terms Chart I-1BInflation In RMB Terms, ##br##Deflation In USD Terms Investors often confuse domestic inflation in China with China exporting inflation beyond its borders. The missing link is the exchange rate. Because of the yuan's depreciation, China is still exporting deflation, even though its domestic inflation rate is rising. Specifically: Chinese core consumer price inflation, consumer services inflation and ex-factory producer price inflation are all negative in U.S. dollar terms even though they are accelerating in local currency terms (Chart I-1A and Chart I-1B). Importantly, Chinese export prices and U.S. import prices from China are deflating in U.S. dollar terms but rising in RMB terms (Chart I-2). A rise in input costs in China has, so far, not translated into higher U.S. dollar prices of mainland goods shipped overseas. The reason is that the RMB's depreciation has allowed export companies to reduce U.S. dollar prices while receiving more RMBs per a unit. In China, labor compensation and unit labor costs are rising much faster in RMB terms than in U.S. dollar terms due to the currency's depreciation (Chart I-3). Chart I-2Chinese Export Prices ##br##Are Not Rising In USD Terms Chart I-3Chinese Unit Labor Costs ##br##Are Rising In RMB But Not In USD Income per capita (a proxy for employee compensation) is growing at an annual rate of 8% in nominal RMB terms, 6% in real (inflation-adjusted) terms and 2.5% in U.S. dollar terms (Chart I-4). Hence, the RMB's depreciation over the past year has reduced the pace of labor cost increases to Chinese producers in U.S. dollar terms. This has allowed producers to tolerate lower selling prices in U.S. dollars. Finally, there is thus far no evidence worldwide that tradable manufacturing goods (non-commodities) prices are rising. Specifically, Korean and Taiwanese export prices as well as manufactured export goods prices in Mexico have stabilized but are not yet rising (Chart I-5). Chart I-4Income Growth: ##br##Nominal, Real Terms & In USD Chart I-5Global Manufacturing ##br##Goods Prices: No Inflation Yet Bottom Line: Even though domestic price inflation has risen, China's export prices are still falling in U.S. dollar terms. The exchange rate is the key: As and if the RMB depreciates much further - and we expect it to depreciate 12% versus the greenback and to reach USD/CNH 7.8 by the end of 2017 - China will still be exporting deflation to the rest of the world. Is The Selloff In Search-For-Yield Beneficiaries Over? The selloff in so-called search-for-yield beneficiaries - trades that have in recent years benefited from a low interest rate environment globally - will likely persist in the first few months of 2017. Back in July,1 we argued that U.S./DM bond yields were set to rise considerably. Currently, we still expect bond yields to climb further. We believe there is still prevailing investor complacency about U.S./global bond yields as well as bond proxies elsewhere. U.S. bond yields in general, and inflation-adjusted (TIPS) yields in particular, are still very depressed and could rise meaningfully (Chart I-6). There is no reason why 5- and 10-year TIPS yields cannot reach their late 2015 levels - a move of about 30-50 basis points from current levels. At the moment, the market is pricing only 52 basis points in Federal Reserve rate hikes in 2017. This is not enough as animal spirits are rising in America at a time when the labor market is tight, and wages and unit labor costs are accelerating. All of this combined warrants meaningfully higher U.S. bond yields. Critically, in recent years a lot of money has flown into funds that invest in bonds and bond proxies. As U.S. bond yields rise, it is natural to expect some outflows from these funds. Odds are that these outflows could occur in January when many investors review their portfolios. Bond proxies such U.S. dividend aristocrat stocks, U.S. REITs, utilities and telecom share prices have barely corrected. EM local currency bond yield spreads over duration-matched U.S. Treasurys have not widened at all (Chart I-7, top panel). This does not make sense, as EM local bonds have benefited substantially from the so-called global search-for-yield of the past several years, and thereby should suffer meaningfully as U.S. bond yields are rising. Besides, EM currencies have weakened, and their outlook is worrisome.2 In fact, the EM local currency bond index has massively underperformed duration-matched U.S. Treasurys in common currency terms, and will likely continue to do so in the next six months (Chart I-7, bottom panel). Asian corporate spreads in general, and Chinese offshore corporate spreads in particular, have not widened yet (Chart I-8, top panel). More importantly, Chinese offshore corporate spreads over sovereigns have continued to narrow, and now stand at only 65 basis points (Chart I-8, bottom panel). In sum, there has so far been little setback in Asia/China credit markets. Chart I-6U.S. TIPS ##br##Yields Are Too Low Chart I-7EM Local Currency Bond ##br##Yields To Rise Much Further Chart I-8Asian And Chinese ##br##Corporate Spreads Are Too Low It would be strange if after years of blind search-for-yield there is no meaningful retrenchment in search-for-yield beneficiaries as U.S. bond yields shoot up. Finally, the S&P 500 is making new highs, indicating U.S. bond yields have not yet become restrictive. Odds are that U.S. bond yields will continue to rise until they hurt economic growth or the S&P 500. In other words, bond yields will likely overshoot before rolling over. Bottom Line: The path of least resistance for U.S. bond yields remains up. Hence, the current selloff in global bonds, bond proxies and search-for-yield beneficiaries will continue. China: Another Growth Slump In 2017? From our investor meetings on both the east and west coasts of the U.S. over the past month, we got a sense that investor sentiment toward China has improved considerably. While many U.S. investors are not upbeat about China's long-term outlook, the majority have seemingly become complacent on mainland growth for 2017. The common viewpoint is that ahead of Communist party leadership changes at the Party Congress next fall, the authorities will ensure that growth conditions remain very firm. As a result, the reasoning goes that China-related plays will do well in 2017. The missing point, however, is that Chinese policymakers have lately been marginally tightening liquidity/credit conditions amid the lingering credit bubble, and are no longer easing policy. On a rate-of-change basis, this policy stance no longer supports growth acceleration. On the contrary, it warrants a top-out in the nation's industrial cycle in early 2017 and probably a slowdown later in 2017. Chart I-9Interbank Liquidity Tightening In China Not only have Chinese corporate bond yields climbed alongside rising global bond yields, but the People's Bank of China (PBoC) has also tightened liquidity in the interbank market for non-bank financial institutions (Chart I-9). This is intended to limit speculative activities among non-bank financial organizations (shadow banking). This policy move is consistent with PBoC Governor Zhou Xiaochuan's statement this past October at the annual World Bank/IMF meetings in Washington, namely: "With the gradual recovery of the global economy, China will control its credit growth."3 As U.S. and European growth is firming up, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced in late October that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Macro Prudential Assessment ratios, starting from the third quarter.4 The clampdown on WMP accounting will reduce banks' capital adequacy ratios, curbing their ability to originate loans. Finally, property market tightening measures implemented of late are expected to lead to a slowdown in sales and renewed contraction in property starts. This will depress Chinese construction and demand for industrial commodities/materials as well as capital goods. Notably, both credit and fiscal impulses in China have already peaked over (Chart I-10). With no major new fiscal spending initiatives and credit growth gradually moderating, the credit and fiscal impulses will likely diminish. Chart I-11 illustrates that the recovery in industrial electricity consumption (a reliable proxy for industrial activity), industrial profits and manufacturing PMI since early this year has been largely due to combined credit and fiscal impulses. As these impulses wane, the industrial cycle will roll over. Chart I-10China: Credit And Fiscal ##br##Impulses Have Petered Out Chart I-11China: Industrial Sector ##br##Growth To Peter Out In Early 2017 Some clients may wonder why we are placing so much emphasis on the pending rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in early in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend/unwind of excesses. Similarly, moderate tightening in a healthy credit system should not be feared. While base metals prices have surged, tracking improvement in China's industrial sector, there is little evidence that the magnitude of this rally is justified by improvement in underlying demand. Chart I-12 demonstrates that China's imports of base metals have been flat since 2010, with all swings due to inventory cycles. The mainland's iron ore consumption has also been mediocre since late 2014 (Chart I-12, bottom panel). The recent rally in copper and other base metals prices is somewhat, though not entirely, due to financial demand. Chart I-13 reveals that commercial firms (producers) have been selling (shorting) copper while financial investors (non-commercial enterprises) have been buying according to data from Commodity Futures Trading Commission (CFTC). Copper prices are now sitting at their long-term moving average that often marks tops in bear market rallies and bottoms in bull market selloffs (Chart I-13, bottom panel). We expect copper prices to face a major resistance at their current levels, and relapse sooner than later. The U.S. consumes about seven times less copper and other industrial metals compared with China. Therefore, acceleration in U.S. growth and capital spending will be more than offset by a renewed slump in Chinese growth. Several Chinese and China-related financial markets are at a critical juncture (Chart I-14). Their breakdown from current levels will confirm our bias that China's industrial cycle will enter another slump in 2017. Chart I-12China: Net Imports Of Industrial ##br##Metals And Iron Ore Consumption Chart I-13Copper Rally Is Driven ##br##By Financial Demand Chart I-14China Related Plays ##br##Are At A Critical Juncture Bottom Line: China's industrial/capital spending cycle will peter out and will decelerate again in 2017. Will Strong DM Growth Lift EM Economies? Strengthening/robust growth in the U.S. and other developed economies will not be sufficient to lift EM growth. First, in the 1997-98 period, real GDP growth was 4.5% in the U.S. and 3.5% in Europe. In particular, U.S. import volume growth was booming at a double-digit pace (Chart I-15) yet it did not prevent widespread crises throughout the EM during this period. In a nutshell, these 1997-98 crises occurred amid plunging U.S./DM bond yields. Chart I-15The U.S. Growth/Import Boom In 1997-98 Did Not Preclude EM Crises Given the economic boom and falling bond yields in the U.S. and Europe did not prevent the 1997-98 EM financial crises, strong U.S./DM growth now is unlikely to help developing countries much. The importance of U.S. and European economies to EM has declined tremendously since the late 1990s, while the importance of China and intra-EM trade has grown. U.S. import volumes have been weak the past 12 months and will likely recover in 2017, yet this will not be enough to prevent an EM growth slump. The EM crises in 1997-98 were due to poor EM fundamentals and the latter are not much better now. Second, EM growth is primarily driven by the domestic credit cycle and commodities prices. We are bearish on both. Chart I-16 shows EM EPS growth and the aggregate EM credit impulse with projections. Assuming credit growth in each individual EM country converges with its nominal GDP growth in the next 12 months, and in China's case in the next 24 months, the 2017 projected EM credit impulse (equity market cap-weighted) will be negative. Historically, the credit impulse has been a good indicator for EPS (Chart I-16).5 Chart I-16EM EPS Growth To Relapse Again In 2017 In short, EM EPS will improve in the near-term but relapse later in 2017. Share prices are forward looking and their rally early this year is probably already discounting near-term EPS improvement. Thereby, EM share prices are at risk at the moment. Third, real capital spending (inflation-adjusted) in EM ex-China and China is as large as the U.S. and EU (Chart I-17). As the capital spending downturn in China and the rest of EM persists (Chart I-18), this will offset any capex recovery in DM and weigh on commodities, primarily industrial metals, as well as global machinery stocks. Chart I-17Capital Spending By Regions: ##br##EM/China As Large As U.S. And EU Chart I-18EM Ex-China Capex ##br##Has Been Contracting Bottom Line: EM growth will disappoint and EM listed companies' EPS will continue shrinking in 2017, despite the likely profit improvement in the very near term. 2017: The Beginning Of The End Of The EM Bear? Chart I-19 illustrates that this relative equity bear market in EM versus DM is getting late from a duration standpoint. That said, the magnitude of this bear market has been smaller compared with the previous one. Although we do not expect EM stocks to underperform as much as they did in the previous cycle, we still believe there is sizable downside in the months ahead. In short, EM share prices appear very vulnerable technically (Chart I-20), and will likely relapse in absolute terms and also underperform DM markets. Investors should stay short/underweight EM equities versus DM. Chart I-19The EM Bear Market Is Late But Not Over Chart I-20EM Stocks Are Technically Vulnerable For dedicated EM equity investors, our overweights are Korea, Taiwan, China, India, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. EM bank stocks hold the key, and their underperformance versus DM banks has further to run. Maintain the short EM banks / long U.S. banks equity position. EM currencies will depreciate further (odds of new lows are considerable for many of them) and local currency bonds will sell off. In our November 30 Weekly Report,6 we discussed the outlooks for EM local bond markets and exchange rates at great length, and offered asset allocation recommendations across EM local bond markets. EM sovereign and corporate credit spreads will widen versus U.S. corporate spreads. Stay underweight EM credit markets. Within EM sovereign credit, our overweights are Russia, Mexico and Argentina, Hungary, Peru and other defensive credit. In turn, our underweights are South Africa, Turkey, Brazil, Indonesia and Malaysia. As usual, the complete list of our equity, fixed-income and currency recommendations is available at the end of each week's report (please refer to pages 16 and 17). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports, dated July 13 and July 27, 2016; available at ems.bcaresearch.com. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled " Will The Carnage In EM Local Bonds Persist?," dated November 30, 2016; a link is available on page 18. 3 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 5 For more details, please refer to the Emerging Markets Strategy Special Report, titled "Gauging EM/China Credit Impulses," dated August 31, 2016; a link is available on page 18. 6 Please refer to the Emerging Markets Strategy Weekly Report, titled " Will The Carnage In EM Local Bonds Persist?," dated November 30, 2016; a link is available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement this summer, powered by a marked productivity improvement. Indeed, our productivity proxy, defined as sales/employment, is growing rapidly. These trends were supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped. The telecom services sector has scaled back capital spending (third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting a reduction to benchmark weightings. The ticker symbols for the stocks in this index are: BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV.

As a long duration sector, technology has struggled since Treasury yields began to surge. This likely marks the onset of a major trend change. Tech pricing power has nosedived and domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. While the tech sector and the U.S. dollar have typically been positively correlated during the initial stages of a currency bull market, history shows that this relationship becomes untenable the longer currency appreciation persists. In the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. Tech sales growth is already sliding rapidly toward negative territory, with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. The bottom line is that there is no rush to lift underweight tech sector allocations.

Highlights Investors' justification for owning stocks has shifted from TINA - There Is No Alternative, to LISA - Let's Invest Somewhere, Anywhere. Long-term earnings expectations have broken out, suggesting that investors have greatly improved confidence about the health and longevity of the business cycle. Economic conditions are improving, but equity prices have overshot. The recent tightening in monetary conditions means that a payback period is ahead. OPEC has put a floor under oil prices; we expect WTI oil prices to average $55/bbl in 2017. Feature Equity market behavior since early November has been both incredible and incredulous. Instead of dropping spectacularly, as most pundits forecast ahead of a Trump win, the S&P 500 has gained 5.2% since November 8. The rally has occurred on the back of a modest improvement in recent economic data, and a lot on the back of hope. As we outlined in our November 21 report,1 there are as many market-negative proposals in Trump's plans as there are equity market-friendly ones. Indeed, it is incredulous that prices have rallied on so little good news. Not only have prices rallied, but there appears to be a fundamental shift in investors' expectations about long-term earnings prospects. Chart 1 shows five-year earnings for S&P 500 companies. Expectations have broken out of the low range that has reigned since the beginning of the Great Recession. It appears that investors' justification for owning stocks has shifted from TINA (There Is No Alternative) to LISA (Let's Invest Somewhere, Anywhere). Chart 1Sudden Optimism In The Long-Term Outlook! From 2010 until last year when the Fed started raising interest rates, "There Is No Alternative," or TINA, was the adage that best described the behavior of investors in a ZIRP/QE world, where cash earned nothing and there was a shortage of risk-free bonds. As central banks across the globe initiated quantitative easing by buying the safest assets and compressing their yields, investors were forced further out on the risk spectrum. This portfolio balance effect from QE first bid up non-Treasury fixed income products and then spilled over to fixed income equity proxies, such as REITs and higher dividend stocks. For instance, the S&P Dividend Aristocrats index, an aggregate of stable dividend-growing stocks, historically only ever outperformed the S&P 500 in recessions, when investors prefer to hide in relatively high-quality companies that consistently grow their dividends (Chart 2). But during this cycle, Dividend Aristocrats have handily outperformed the S&P 500 each year since 2009, as the index was an important TINA beneficiary. Now that the Fed is finally finding its groove in a new rate cycle (please see the section on page 5), cash is no longer earning zero (albeit it is still not particularly appealing), and Treasury yields are finally comfortably off their multi-decade lows. In other words, investors are beginning to once again have alternatives. Does this mean that investors are giving up on TINA? We think so, but what comes next is difficult to gauge. We have long argued that ending the dance with TINA would require one of two scenarios: 1) A drastic economic shock such as a recession that sends investors into cash and other safe havens, or 2) A significant change in the price of bonds that makes dividend yielding equities less attractive. The former is very unlikely given that a non-inflationary backdrop means that the Fed will not need to raise interest rates at a pace that will meaningfully impact growth. The second scenario is now underway, although the sustainability and magnitude of this trend is unclear. As we highlighted last week, bond yields have shot to undervalued territory, based on our indicators and assumptions about growth over the next year. True, it is encouraging that economic indicators have perked up in recent weeks. In particular, it is positive that there has been a noticeable uptick in consumer confidence over the past couple of months, particularly as job security is improving. Chart 3 summarizes a wide range of economic indicators that are showing recent strength: Global LEI, core PCE inflation, and the Global Manufacturing PMI are among those that have increased. Still, as the chart highlights, these improvements remain subdued and in some cases, recent data points have been too choppy to give a reliable signal. The ISM manufacturing survey is a case in point. Meanwhile, the ISM non-manufacturing survey headline index has jumped higher, as did the employment index. However, the forward-looking component, new orders, dropped. Chart 2TINA Pushed Investors##br## Into Yield Chart 3Momentum Strong Enough ##br##To Bid Up Equity Prices? This economic performance is at odds with the investor optimism captured in Chart 1: there is considerable discrepancy between market expectations and economic data. Granted, financial markets tend to be forward-looking, but the current message is that investors have drastically changed their view about the trajectory of growth and earnings. We do expect economic growth to improve in 2017, as consumers begin to spend more of their wage gains than over the past five years. But the headwinds to profit growth, notably a weak pricing backdrop, and a strong currency are still in place. We believe that market moves and investor sentiment has moved too far, too fast. This swing to optimism appears to be ushered in by LISA, Let's Invest Somewhere, Anywhere. With LISA, investors have traded in their forced justifications (i.e. the lack of alternatives) for unfounded ones (drastically improved long-term earnings outlook). In this environment, the likelihood of profit disappointments runs high. For now, LISA's disregard for fundamentals can prop up equity prices, but with monetary conditions tightening via a simultaneous rise in the dollar and bond yields, investor optimism is likely to be curtailed. Indeed, if bond investors begin to forecast the same rosy growth scenario as equity investors, then there is a danger that an overly aggressive re-pricing of the Fed rate path transpires (Chart 4). This after years of bond market expectations remaining lower than the Fed's dot-plot projections. Chart 4Bond Market Risk: From Underpricing To Overpricing The Fed? Fed Preview Bond market expectations for a rate hike on Wednesday are nearing 100%, which is consistent with our expectations. The Fed will raise interest rates and the only uncertainty is the extent of hawkishness in the accompanying FOMC statement and post-meeting press conference. Chart 5Inflation And Stimulus: Canadian Case Study At this point in the economic cycle, the pace of future rate hikes will depend much more on the Fed's outlook for inflation than for the labor market. As we wrote in a Special Report on November 28,2 the labor market is likely now nearing full employment, i.e. is tight enough to create modest upward pressure on wages. In other words, the Fed's objective of full employment has been - or is at least very close to - being met. Nonetheless, we are not worried about an imminent aggressive turn higher in inflation. True, if our economic forecast for next year pans out, then growth will run somewhat hotter than underlying trend growth (estimated by the Fed to be at 1.8%). That said, there are several headwinds that will keep inflation contained: The U.S. continues to import deflation from overseas. About one-third of the core PCE basket is core goods and prices continue to deflate. Recall that in the early 2000s business cycle recovery, even with a falling U.S. dollar, goods prices could not escape deflation. Retail prices, which represent about 30% of the total core PCE index, continue to deflate at a faster rate than at any point in the past fifteen years. Bond market inflation expectations have surged on the expected inflationary impact of Trump's political agenda. We concede that aggressive fiscal spending and larger budget deficits have the potential to spur inflation, but this is not yet a foregone conclusion. Investors looking for a roadmap for the impact of fiscal spending may turn to Canada. The Trudeau government was elected in October 2015 on a platform of fiscal spending and middle-income family tax cuts. According to the Bank of Canada this week, "the effects of federal infrastructure spending are not yet evident in the GDP data... business investment and non-energy goods exports continue to disappoint". Fourteen months after the election, inflation is still at 2% (Chart 5). A final point is that multiple statistical models refute the notion that a sustainable breach of the 2% inflation target is imminent. Last month, the Cleveland Fed published a report that showed that 5 out of 6 of the top Fed inflation models assign a less than 50% probability to inflation's being 2% or higher over the next three years!3 Our takeaway from their research is a reminder that even once the output gap closes, it can take a long time for inflation pressures to build and for inflation expectations to move higher. The bottom line is that it is too early to expect a shift in the message from the Fed. After the December rate hike, the Fed will maintain its policy of responding to incoming data. We expect minimal revisions to the Fed's economic and inflation forecasts and therefore to their expected rate path. An Update On Oil Two weeks ago, OPEC members agreed to cut 1.2 million barrels of its daily oil output, starting in January. After the initial knee-jerk reaction to a potentially tighter oil market next year (oil prices jumped 10%), prices have started to reverse. Doubts about OPEC's ability to stick to the quota are beginning to set in. According to a Reuters poll,4 most analysts expect cheating, and have doubts about whether quota cuts will be enough to rebalance markets. Our commodity strategists believe that OPEC will by and large respect the new quotas, primarily because both Russia and Saudi Arabia need higher prices. Both countries have consumed considerable foreign reserves to fund government expenditures following the price collapse. BCA estimates that Saudi Arabia will have burned through $220 billion in reserves between July 2014, just prior to its decision to launch OPEC's market-share war, and December 2016, equivalent to 30% of foreign reserves. Russia will have drawn down its official reserves by $77 billion over the same period, or 16% of its total holdings. Our commodity team expects to see evidence of the cuts begin to show up in February-March, in the form of falling commercial inventory levels. Even if actual cuts only amount to 60-70% of the volumes agreed at OPEC's November 30 meeting, OECD storage levels - combined commercial inventories of both crude oil and refined products - could fall by 10%, i.e. to about 2.75 billion barrels by the end of 2017Q3. This would put stocks roughly at their five-year average levels, the stated goal of OPEC, and its reason for negotiating the production cut (Chart 6). Chart 6Oil Inventories Normalizing Chart 7OPEC Putting A Floor At /bbl For WTI In sum, we believe that the OPEC agreement will at the very least put a floor under oil prices at around $45/bbl for WTI (Chart 7). We expect prices to average at $55/bbl in 2017. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com David Boucher, Editor/Strategist U.S. Investment Strategy davidb@bcaresearch.com 1 Please see U.S. Investment Strategy Weekly Report "Q&A: The Top Ten," dated November 21, 2016, available at usis.bcaresearch.com. 2 Please see U.S. Investment Strategy Special Report "U.S. Wage Growth: Paid In Full?," dated November 28, 2016, available at usis.bcaresearch.com. 3 "The Likelihood of 2 Percent Inflation in the Next Three Years," Federal Reserve Bank Of Cleveland, November 29, 2016. 4 Please see "OPEC expected to deliver only half of target production cut: Kemp," published online by reuters.com on December 6, 2016. OPEC has invited Russia, Colombia, Congo, Egypt, Kazakhstan, Mexico, Oman, Trinidad and Tobago, Turkmenistan, Uzbekistan, Bolivia, Azerbaijan, Bahrain and Brunei to meet in Vienna Dec. 10, according to Reuters.

Highlights Portfolio Strategy If the Fed is about to begin interest rate re-normalization in earnest, then investors should heed the message from historic sector performance during tightening cycles. The tech sector remains vulnerable to tighter monetary conditions. Downshift communications equipment to neutral and stay clear of software. The OPEC supply agreement reinforces our current energy sector bias, overweight oil services and underweight refiners. Recent Changes S&P Communications Equipment - Reduce to neutral. Table 1 Feature Chart 1Why Is Equity Vol So Low? The equity market has been in a remarkably low volatility uptrend in recent weeks, powered by hopes that political regime shifts will invigorate growth. Signs of economic life have also played a role. The risk is that investors have pulled forward profit growth expectations on the basis of anticipated fiscal stimulus that may disappoint. In the meantime, the tighter domestic monetary conditions get, the less likely equity resilience can persist, especially in the face of rising instability in other financial markets. Volatility has jumped across asset classes, with the bond market leading the charge. The MOVE index of Treasury bond volatility has spiked. Typically, the MOVE leads the VIX index of implied equity market volatility (Chart 1, second panel). Currency and commodity price volatility has also picked up. It would be dangerous to assume that the equity market can remain so sedate. If the economy is about to grow in line with analysts double-digit profit growth expectations and/or what the surge in some cyclical sectors would suggest, then a re-pricing of Fed interest rate hike expectations is likely to persist. Against this backdrop, it is instructive to revisit historic sector performance during past Fed tightening cycles. If one views the next interest rate hike as the start of a sustained trend based on the steep trajectory of expected profit growth embedded in valuations and forecasts, then it is useful to use that as a starting point rather than last year's token 'one and done' interest rate hike. Charts 2 and 3 show the one-year and two-year average sector relative returns after Fed tightening cycles have commenced. A clear pattern is evident: defensive sectors have been the best performers by a wide margin, followed by financials, while cyclical sectors have underperformed over both time horizons. To be sure, every cycle is different, but this is a useful frame of reference for investors that have ramped up growth and cyclical sector earnings expectations in recent months. There has already been considerable tightening based on the Shadow Fed Funds Rate, a bond market-derived fed funds rate not bound by zero percent (Chart 4, shown inverted, top panel). The latter foreshadows a much tougher slog for the broad market. The point is that tighter monetary conditions can overwhelm valuation multiples and growth expectations. Chart 212-Month Performance After Fed Hikes Chart 324-Month Performance After Fed Hikes Chart 4A Blow-Off Top? The violent sub-surface equity rotation has presented a number of rebalancing opportunities. The defensive health care and consumer staples sectors have been shunned in recent weeks, with capital rotating into financials and industrials. As discussed previously, the industrials and materials sectors cannot rise in tandem for long with the U.S. dollar. These sectors should be used as a source of funds to take advantage of value creation in consumer discretionary, staples and health care where value has reappeared. Chart 5It's Not A ''Growth'' Trade Indeed, the abrupt jump in the cyclical vs. defensive share price ratio appears to have been driven solely by external forces, i.e. the sell-off in the bond market, rather than a shift in underlying operating profit drivers. For instance, emerging market (EM) equities and the cyclical vs. defensive share price ratio have tended to move hand-in-hand (Chart 5). The former are pro-cyclical, and outperform when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the U.S. cyclical vs. defensive share price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debt liabilities, and the lack of EM equity participation reinforces that the recent rise in industrials is not a one way bet. As a result, our preferred cyclical sector exposure lies in the consumer discretionary sector, and not in capital spending-geared deep cyclical sectors. A market weight in financials, utilities and energy is warranted, as discussed below, while the tech sector is vulnerable. A Roundtrip For The Tech Sector? After a semiconductor M&A-driven spurt of strength, the S&P technology sector has stumbled. As a long duration sector, technology has borne a disproportionate share of the backlash from a higher discount rate, similar to the taper-tantrum period in 2013. Then, bond yields soared as the Fed floated trial balloons about tapering QE. Tech stocks did not trough until yields peaked (Chart 6). In addition, a recovery in tech new orders confirmed that the sales outlook had brightened. Now, the capital spending outlook remains shaky, and tech new order growth is nil (Chart 6). Meanwhile, tech pricing power has nosedived (Chart 6). Domestic deflationary pressures are likely to intensify as the U.S. dollar appreciates, particularly against the manufacturing and tech-sensitive emerging Asian currencies. Tech sales growth is already sliding rapidly toward negative territory (Chart 7), with no reprieve in sight based on the contraction in emerging market exports, as well as U.S. consumer and capital goods import prices. Chart 6Tech Doesn't Like Rising Bond Yields Chart 7No Sales Growth True, tech stocks have a solid relative performance track record when the U.S. dollar initially embarks on a long-term bull market (Chart 8). Why? Because tech business models incorporate deflationary conditions, investors have been comfortable bidding up valuations in excess of the negative sales impact from a stronger U.S. dollar. Nevertheless, history shows that this relationship becomes untenable the longer currency appreciation persists. Chart 8 shows that in the final phase of the past two U.S. dollar bull markets, tech stocks have abruptly reversed course, rapidly ceding the previously accrued gains. Apart from a loss of competitiveness from currency strength, the new anti-globalization trend is bad for tech as it has the highest foreign sales exposure. The bottom line is that there is no rush to lift underweight tech sector allocations. In fact, we are further tweaking weightings to reduce exposure. For instance, software companies are worth another look through a bearish lens. Software sales growth is at risk from pricing power slippage amidst cooling final demand (Chart 9). Chart 8Beware Phase II Of Dollar Bull Markets Chart 9Sell Software... The financial sector is an influential technology sector end market. On the margin, financial companies are likely to reduce capital spending on the back of deteriorating credit quality. Chart 9 demonstrates that when financial sector corporate bond ratings start to trend negatively, it is a sign that software investment will stumble. A similar message is emanating from the decline in overall CEO confidence (Chart 10), which mirrors the relentless narrowing in the gap between the return on and cost of capital (Chart 8, bottom panel). Even C&I bank loans, previously an economic bright spot, are signaling that corporate sector demand for external funds and working capital are softening, consistent with slower capital spending. Against a backdrop of fading software M&A activity, we are skeptical that the S&P software index can maintain its premium valuation (Chart 11). Chart 10... Before Sales Erode Chart 11Not Worth A Premium Elsewhere, the communications equipment industry will have trouble sustaining this summer's outperformance. Communications equipment stocks broke out of a long-term downward sloping trend-line on the back of productivity improvement. Chart 12 shows that after a period of intense cost cutting, wage inflation was negative. Our productivity proxy, defined as sales/employment, is growing rapidly. These trends are supportive of profit margins, and at least a modest valuation re-rating from washed out levels. Nevertheless, our confidence that a major bullish trend change has occurred after years of underperformance has been shaken. The budding reacceleration in top-line growth has hit a snag. New orders for communications equipment have rolled over relative to inventories. Investment in communications equipment has dipped (Chart 13). The telecom services sector has scaled back capital spending (Chart 13, third panel), suggesting that final demand will continue to soften. It will be difficult for companies to maintain high productivity if revenue growth stagnates. Chart 12Productivity Strength... Chart 13... May Be Pressured Consequently, the most likely scenario is that relative performance is entering a base-building phase rather than a new bull market, warranting benchmark weightings. Bottom Line: Reduce the S&P communications equipment index (BLBG: S5COMM - CSCO, MSI, HRS, JNPR, FFIV) to neutral, in a move to further reduce underweight tech sector exposure. Stay underweight software (BLBG: S5SOFT - MSFT, ORCL, ADBE, CRM, INTU, ATVI, EA, ADSK, SYMC, RHT, CTXS, CA). Energy Strategy Post-OPEC Production Cut Chart 14Energy Stocks Need Rising Oil Prices The energy sector continues to mark time relative to the broad market, but that has masked furious sub-surface movement. We have maintained a benchmark exposure to the broad sector since the spring, but shifted our sub-industry exposure in October to favor oil field services over producers, while underemphasizing refiners. OPEC's recent agreement to trim flatters this positioning. Whether OPEC's announcement actually feeds through into meaningfully lower production next year and higher oil prices remains to be seen, but at a minimum, supply discipline should put a floor under prices. Rather than expecting the overall energy sector to break out of its lateral move relative to the broad market, we continue to recommend a targeted approach. The energy sector requires sustained higher commodity prices to outperform, and our concern is that a trading range is more likely (Chart 14). OPEC producers suffered considerable pain over the last two years as they overproduced in order to starve marginal producers of the capital needed for reinvestment. U.S. shale producers slashed capital expenditures by 65% from 2014 to 2016, and the International Oil Companies (IOCs) cut capital expenditures by 40% over the same period. Chart 15 shows that only OPEC has been expanding production. That has set the stage for limited global production growth, allowing for demand growth to eat into overstocked crude inventories in the coming years. OPEC's decision to trim output should mitigate downside commodity price risks, providing debt and equity markets with confidence to increase capital availability to the sector. With a lower cost and easier access to capital, producers, especially shale, will be able to accelerate drilling programs. The rig count has already troughed. The growth in OECD oil inventories has crested, which is consistent with a gradual rise in the number of active drilling rigs. As oversupply is absorbed, investment in oil field services will accelerate, unlocking relative value in the energy services space (Chart 16). Chart 15OPEC Cuts Would Help... Chart 16... Erode Excess Oil Supply This overweight position is still high risk, because it will take time to absorb the excesses from the previous drilling cycle. There is still considerable overcapacity in the oil field services industry, as measured by our idle rig proxy. Pricing power does not typically return until the latter rises above 1 (Chart 17). Companies will be eager to put crews to work and better cover overhead, and may accept suboptimal pricing, at least initially. Meanwhile, if EM currencies continue to weaken, confidence in EM oil demand growth may be shaken, eroding valuations. Still, we are willing to accept these risks, but will keep this overweight position on a tight leash and will take profits if OPEC does not follow through with plans to limit production. On the flipside, refiners will not receive any relief in feedstock prices, which should ensure that the gap between Brent and WTI prices remains non-existent (Chart 18). That is a strain on refining margins. Our model warns that there is little profit upside ahead. That is confirmed by both domestic and global trends. Chart 17Risks To A Sustained Rally Chart 18Sell Refiners Chart 19Global Capacity Growth Refiners have continued to produce flat out, even as domestic crude production has dropped (Chart 18). As a result, inventories of gasoline and distillates have surged, despite solid consumption growth. In fact, refined product output is about to eclipse the rate of consumption growth, which implies persistently swelling inventories. There is no export outlet to relieve excess supply. U.S. exports are becoming much less competitive on the back of U.S. dollar strength and the elimination of the gap between WTI and Brent input costs (Chart 19). Moreover, rising capacity abroad has trigged an acceleration of refined product exports in a number of low cost producer countries, including India, China and Saudi Arabia (Chart 19). Increased global refining capacity is a structural trend, and will keep valuation multiples lower than otherwise would be the case. The relative price/sales ratio is testing cyclical peaks, warning that downside risks remain acute. Bottom Line: Maintain a neutral overall sector weighting, with outsized exposure to the oil & gas field services industry (BLBG: S5ENRE - SLB, HAL, BHI, NOV, HP, FTI, RIG), and undersized allocations to the refining group (BLBG: S5OILR - PSX, VLO, MPC, TSO). Current Recommendations Current Trades Size And Style Views Favor small over large caps and growth over value.

Highlights Investors are understating the risks that the Trump administration will enact protectionist trade policies. Contrary to popular belief, the economic costs to the U.S. of a protracted "trade war" would be low. The geopolitical impact, however, would be much more sizeable, as would the impact on S&P 500 profits. The near-term risks to global equities are on the downside, although firmer growth in developed economies should provide support to stocks over a 12-month horizon. Global bond yields will be higher this time next year, as will the dollar. The yen is especially vulnerable. We are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. Feature They come over here, they sell their cars, their VCRs. They knock the hell out of our companies. - Donald Trump in an interview with Oprah Winfrey discussing trade with Japan, 1988 Making Tariffs Great Again Donald Trump has flip-flopped on many issues. On trade, however, he has been perfectly consistent. As the quote above demonstrates, Trump has been advocating mercantilist policies ever since he entered the public spotlight in the 1980s. Even in the unlikely event that he wanted to pivot on this issue, he would be hard-pressed to do so. The Republican establishment and most Democrats will hate him no matter what he does. If Trump backpedals from his hardline stance on trade and immigration, he will lose a large chunk of his white, working-class base (Chart 1). One might argue that Trump would have no choice but to adopt a more conciliatory tone if the imposition of protectionist trade policies were to push the U.S. into a recession. However, contrary to widespread opinion, it is far from obvious that this would happen. While rising protectionism would have a major negative effect on many other economies, the impact on the U.S. would be modest, even if other countries were to match higher U.S. tariffs with retaliatory measures. Keep in mind that the U.S. is a relatively closed economy, with exports totaling only 12% of GDP. Exports to China and Mexico amount to 0.9% and 1.4% of GDP, respectively. And much of these exports are intermediate goods that are processed and reshipped back to the U.S. or some other third market. It would not make sense for China or Mexico to put up import barriers on these intermediate goods because this would just reduce domestic employment, without giving domestic firms much of a leg up. One should also remember that an appreciation of the dollar reduces U.S. export competitiveness in much the same way as higher tariffs placed by foreign governments on U.S.-made goods. The real trade-weighted dollar has appreciated by 20% since mid-2014 (Chart 2). While this obviously has been unpleasant for U.S. exporters, it has not pushed the economy into recession. Neither will retaliatory foreign tariffs. Chart 1Trump's Supporters Are Not ##br##Free Trade Enthusiasts Chart 2The Dollar Has Been ##br##Appreciating Since Mid-2014 Why The Consensus On Trade Is Misleading The view expressed above is far outside the consensus and clashes strongly with the large number of studies arguing that the implementation of Trump's trade agenda would have grave consequences for the U.S. economy. Let me first enumerate the ways these studies fall short on strictly economic grounds, and then discuss why they may still ring true if one takes a broader perspective. As far as the pure economics are concerned, these studies all suffer from some combination of the following deficiencies: They assume that foreign producers can fully or almost fully pass on the cost of U.S. tariffs to their customers. In reality, the evidence suggests that foreign producers will absorb about half of the increase in tariffs through lower profit margins. In other words, the imposition of a 20% tariff would only raise U.S. import prices by around 10%. Granted, retaliatory tariffs would squeeze the profit margins of U.S. exporters. However, this effect would be mitigated by the fact that the U.S. runs large bilateral trade deficits with China and Mexico (Chart 3), as well as the fact that foreign producers have less pricing power in the relatively large U.S. market than American producers have abroad. On net, this implies that higher trade barriers could actually make the U.S. better off by shifting the terms of trade in its favor. Chart 3The U.S. Runs Large Bilateral Trade Deficits With China And Mexico These studies treat tariffs like regular old taxes. To the extent that tariffs are taxes whose burden is partly borne by domestic consumers, their imposition has a dampening effect on activity. However, to model the impact of higher tariffs simply as a tightening of fiscal policy implicitly assumes that any tariff revenue will be used to pay down debt, rather than being used to finance tax cuts and spending increases. Given that Trump is touting a program of fiscal stimulus, that is not a sensible assumption. Moreover, unlike, say, a sales tax hike, higher tariffs divert demand towards domestically-produced goods. This tends to boost employment. These studies overstate the adverse effect of tariffs on domestic investment. More than half of global trade consists of capital equipment and intermediate goods (Chart 4). To the extent that higher tariffs raise the cost of production, this can lower investment. Moreover, trade barriers tend to increase economic inefficiencies. This can lead to slower productivity growth, causing firms to reduce capital spending. In practice, however, neither effect is particularly significant. As we discussed two weeks ago, the negative impact of trade barriers on productivity growth is generally overstated, especially for large economies like the United States.1 Chart 5 shows that productivity growth was actually faster in the three decades following the Second World War than in the hyper-globalization era that began in the early 1980s. Chart 4Intermediate And Capital Goods ##br##Make Up Over Half Of Global Trade Chart 5Rising Trade Has Not ##br##Boosted Productivity Growth While the price of capital goods does influence investment spending, for the most part, firms tend to base their investment decisions on the expected demand for their products. Since the U.S. runs a trade deficit, an equal percentage-point decline in both exports and imports would increase final demand through the familiar Y=C+I+G+X-M identity. This should lead to higher investment. Moreover, even if higher trade barriers leave final demand unaffected, there are reasons to think that investment would still rise. Think about a closed economy where most households decide all of a sudden that they prefer strawberry ice cream over vanilla ice cream. Let us assume, just for the sake of argument, that shifting production from vanilla to strawberry ice cream is very difficult and requires a lot of new investment. What do you expect would happen to overall investment in this economy? The answer is that it would likely rise, as companies scramble to build out new strawberry ice cream-making capacity. Now extend the analogy to trade. If the U.S. slaps tariffs on manufacturing imports, this will lead to a wave of new domestic investment in industries that benefit from tariff protection. This is bad news for companies that must incur the cost of relocating production back onshore, but it is good news for American workers who can now find gainful employment. The Bigger Picture Our guess is that in purely economic terms, the U.S. would not suffer much if the Trump administration were to forge ahead with its protectionist trade agenda, and could actually benefit if America's trading partners felt restrained in how they could retaliate. Yet, focusing only on the economics misses the bigger picture. Trade agreements are also about politics - they help form the geopolitical glue that holds the global community together. As we noted two weeks ago, the real reason the 1930 Smoot-Hawley Tariff Act was so disastrous was not because it contributed to the Great Depression, but because it led to a breakdown of international relations among democratic governments at a time when fascism was on the rise.2 Donald Trump's threat to pull out of trade deals and unilaterally impose tariffs on countries that he feels are engaging in unfair trade practices is likely to accelerate the shift to a multipolar geopolitical order where competing countries strive to carve out their own spheres of influence. As Chart 6 shows, such geopolitical orders have often contributed to the breakdown of globalization, and at times, have even led to military conflict. Chart 6AIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand Chart 6BIncreasing Multipolarity And De-Globalization Tend To Go Hand-In-Hand The fact that rising protectionism could benefit the U.S. at the expense of other countries is bound to stoke anger abroad. China, the focus of much of Trump's rhetoric, is especially vulnerable. Trump has threatened to declare the country a "currency manipulator," even though it meets only one of the three criteria for such a designation as set out by the Treasury Department.3 Other countries should not breathe a sigh of relief, however. There is a certain logic about protectionism that makes it difficult to hike tariffs on just one or two countries. For example, if the U.S. raises tariffs on China, some of the existing demand for Chinese goods will be diverted to countries such as Korea or Vietnam, rather than back to the U.S. This creates an incentive to raise tariffs on those countries as well. It is easy to see how the whole global trading system can break down under such circumstances. Investment Conclusions Donald Trump's threat of across-the-border tariffs of 35% on Mexican goods and 45% on Chinese goods will likely turn out to be a negotiating ploy. That said, some increase in trade barriers seems inevitable. These need not even be explicit barriers. Trump's success in browbeating Carrier into keeping its plant open in Indiana is an example of things to come. Corporate America does a lot of business with the government, and the subtle threat of cancelled government contracts will make any CEO take notice. Good news for Main Street perhaps, but definitely bad news for Wall Street. For now, investors are focusing on the positive elements of Trump's agenda. That may change soon. Yes, increased infrastructure spending and corporate tax cuts are both bullish for stocks. However, effective U.S. corporate tax rates are already quite low thanks to numerous loopholes. Thus, any cuts to statutory rates may not boost S&P 500 profits by as much as investors are hoping (Chart 7). And while more infrastructure investment is welcome, there simply are not enough "shovel ready" projects around. Chart 7U.S. Effective Corporate Tax Rate Is Already Quite Low Moreover, Trump's plan to finance infrastructure spending through private-public partnerships greatly narrows the universe of possible projects. The U.S. Society Of Civil Engineers estimates that most of the "infrastructure gap" consists of deferred maintenance (i.e., potholes to fix, bridges to repair).4 It is difficult to get investors interested in such work, which is why it is typically financed directly through government budgets. Meanwhile, financial conditions have tightened via a stronger dollar and higher bond yields (Chart 8). Historically, such a tightening has been bearish for stocks (Table 1). We are tactically cautious on a three-month horizon, and are positioned for this by being short the NASDAQ 100 futures. Our guess is that global equities will correct by about 5%-to-10% from current levels, setting the stage for positive returns down the road. U.S. high-yield spreads, which are near post-crisis lows, are also likely to widen (Chart 9). Chart 8U.S. Financial Conditions Have Eased Chart 9U.S. High-Yield Spreads Likely To Widen Table 1Stocks Tend To Suffer When Bond Yields Spike A correction in risk assets could temporarily knock down Treasury yields. Nevertheless, the long-term path for global bond yields is to the upside. The three key features of Trump's platform - fiscal stimulus, tighter immigration controls, and trade protectionism - are all inflationary. Only JGB yields are likely to stay put for the foreseeable future due to the BOJ's well-timed decision to peg the 10-year yield at zero. As bond yields elsewhere rise, the yen will come under further downward pressure. We see USD/JPY reaching 125 in 12 months' time. Chart 10Global Growth Is Accelerating A weaker yen should boost Japanese stocks, at least in local-currency terms. European equities will also benefit from a somewhat cheaper euro and firming global growth (Chart 10). Steeper yield curves are helping to boost European bank shares, despite ongoing concerns about the health of the Italian financial sector. As we have discussed in the past, systemic risks around the Italian banks are overstated.5 With that in mind, we are closing our long Spanish/short Italian 10-year bond trade for a gain of 6.2%. The recent rally in commodity markets and the uptick in global activity indicators are welcome developments for emerging markets. Still, it will be hard for EM equities to muster a sustainable rally as long as the dollar remains in an uptrend and protectionist sentiment is on the rise. For now, a modest underweight in EM stocks is warranted. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1,2 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 3 The U.S. Treasury is allowed to define a country as a currency manipulator if: i) it runs a large trade surplus with the U.S.; ii) it has an excessively large current account surplus with the rest of the world; and iii) it is engaging in direct foreign exchange intervention in order to weaken its currency. While the first criterion arguably holds, the other two do not, given that China's overall current account surplus currently stands at 2.4% of GDP and recent currency intervention has been designed to prevent the yuan from depreciating more than it would have otherwise. 4 Please see "Failure to Act: Closing the Infrastructure Investment Gap for America's Economic Future," American Society of Civil Engineers (2016). 5 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights The brief history of our model portfolios is a tale of two regions: our global portfolios are beating their benchmarks by an aggregate 350 basis points ("bps"), while our U.S. portfolios lag by 55 bps. Defensive sector tilts weighed on all four portfolios, but market-cap tilts gave the U.S. portfolios a big boost, and currency-hedged country and fixed-income positions turbocharged global portfolio performance. We expect to see bond yields, the dollar and DM equity prices higher at year-end 2017 and our portfolio positioning will continue to reflect these broad themes. True inflection points are few and far between, but the U.S. will at least experience a sugar rush, and we are adding some credit risk while walking back some of our defensive equity positioning to prepare for it. Table 1Summary Portfolio Performance Feature This report presents the first review of our model portfolios, which have now been live for seven weeks. Going forward, we will review them in our first publication of every month. The reviews will have two components: an ex-post examination of portfolio performance and an ex-ante discussion of our outlook. Both components are meant to foster transparency, with the ex-post component opening a window on our ongoing efforts to improve our process, and the ex-ante component shining a light on how our views are evolving in real time. Results To Date Our model portfolios have outperformed, on balance, over their first two months, but the aggregate results cover over a fault line between U.S. and global portfolio performance. The U.S. Long-Only portfolio is just even with its benchmark and the Long/Short lags by 55 bps, (Table 1). The disparity highlights the way dollar moves can create international opportunities. Being on the right side of the greenback helped us generate alpha despite dreadful sector positioning. Portfolio Performance Attribution We track portfolio attribution on up to six applicable dimensions. For all the portfolios, we consider Asset Allocation, Equity Sector Allocation and Fixed Income Category Allocation. If the Equity portion of the portfolios has any mid- or small-cap exposures, we track Market Cap Allocation; if it has multi-country exposures, we track Country Allocation; and if it has short positions, we track Long/Short Allocation based on the contribution from its long/short pairs. Since all of the portfolios were initially set to match our benchmark asset allocations (60% Equity/37.5% Fixed Income/2.5% Cash), we have no Asset Allocation attribution to report in this update (Table 2). Table 2Applicable Attribution Sources U.S. Long-Only Our U.S. Long-Only portfolio (Table 3) outperformed its benchmark by 1 basis point through November 30.1 Market cap allocation paved the way to the outperformance, as small- and mid-cap stocks zoomed higher following the election (Table 4). Our fixed-income category allocations helped, as well, with the outperformance of our income hybrids bucket and our sizable underweight in lagging investment-grade corporates more than making up for our zero weight in outperforming high yield (Table 5, bottom panel). The gains were consumed by equity sector underperformance, which labored mightily under an inopportune defensive bias (Table 5, top panel). Table 3U.S. Long-Only Model Portfolio: Absolute Performance By Position Table 4U.S. Relative Performance Contribution From Market-Cap PositioningTable 5U.S. Relative Performance Contribution From Sector Positioning U.S. Long/Short Our U.S. Long/Short portfolio (Table 6) underperformed its benchmark by 55 basis points through November 30.2 Larger defensive sector tilts weighed on the long/short portfolio relative to its long-only counterpart, compounded by short positions in cyclical sectors (Table 7, bottom panel). Our fixed-income pairs fared better: while the HYG short/LQD long detracted from performance, the IEF short/TIP long was able to offset it (Table 7, top panel). The former, an anti-credit risk (and duration-extending) play, was poorly positioned on both counts, but the latter was well positioned to reap the benefit of the pickup in inflation expectations. Table 6U.S. Long/Short Model Portfolio: Absolute Performance By Position Table 7U.S. Relative Performance Contribution From Long/Short Pairs Global Long-Only Our Global Long-Only portfolio (Table 8) outperformed its benchmark by 188 basis points through November 30.3 Successful country positioning contributed to the sizable outperformance, as the (currency-hedged) Japan overweight was a rousing success (Table 9). Fixed-income category allocations were also big winners, driven by the currency-hedged non-U.S. aggregate exposure (BNDX) and the U.S. aggregate (AGG) and corporate holdings (LQD), which more than offset the drag from the unhedged international sovereign exposure (BWX) (Table 10, bottom panel). Only equity sector allocations weighed on the portfolio, as both Staples and Health Care were drubbed by the benchmark index (Table 10, top panel). Table 8Global Long-Only Model Portfolio: Absolute Performance By Position Table 9Global Relative Performance Contribution From Country PositioningTable 10Global Relative Performance Contribution From Sector Positioning Global Long/Short Our Global Long/Short portfolio (Table 11) outperformed its benchmark by 166 basis points through November 30.4 Just like its U.S. counterpart, the global Long/Short portfolio was weighed down by its wrong-footed long defensives/short cyclicals pairs (Table 12). Country long/short pairs paid off nicely, however, especially in November, as emerging markets with sizable current account deficits, like Turkey and Brazil, underperformed their less dollar-vulnerable peers. Our fixed-income long/short pairs also outperformed, albeit by a smaller margin. Table 11Global Long/Short Model Portfolio: Absolute Performance By Position Table 12Global Relative Performance Contribution From Long/Short Pairs How Our Views Fared Rates, Inflation And Credit Markets rewarded two of the four components of our fixed-income view. U.S. inflation expectations surged (Chart 1) and developed-world sovereigns proved to be an especially poor value, as the aggregate G7 economies' 10-year bond yield spiked faster than at any point since the taper tantrum in 2013 (Chart 2). These views, expressed as portfolio tilts - underweight fixed income, own TIPS and hold duration at or below benchmark duration - worked well when translated to portfolio positions, as noted above. Chart 1Inflation Expectations Spiked... Chart 2...And So Did Nominal Yields The bear-flattening call turned out to be a dud, as the Treasury yield curve steepened despite the looming Fed tightening cycle. Overwhelmed by our anti-duration call, though, it had no meaningful portfolio impact. Our credit-bearish call was a central fixed-income pillar in all four of our portfolios, and it did constrain performance as high yield outperformed at home and abroad. Yields may well be due to pull back following their November surge, but we see them ending 2017 higher, making credit's positive carry an attractive buffer against rising rates. Economic Growth And Corporate Earnings Our concerns that the equity rally has become uncomfortably stretched, and that U.S. corporate margins face downward pressure, did not amount to anything over the last two months. Since we maintained benchmark equity weightings across all of our portfolios, however, our too-early views did not affect performance. We expressed our defensives-over-cyclicals view in every portfolio's sector allocations to the detriment of performance across the board. Thanks to currency-hedged Japanese equities' surge, the global portfolios benefitted slightly from our view that European and Japanese multinationals would find the going easier than their U.S. counterparts, and we remain optimistic about the potential for a relative European profit inflection. New And Revised Views Rates, Inflation And Credit There are still too many unknowns about the details of policy proposals to assess whether or not the U.S. is on the cusp of sustained growth acceleration, but the incoming administration, supported by a compliant Congress, can unquestionably bestow a sugar rush. The credit upshot is that it will be harder to default if both growth and inflation get a fillip in 2017. The curve is likely to steepen on the grounds that our bond strategists expect the Fed to allow inflation expectations to gather momentum before it signals an increased pace of hikes and a higher terminal rate. The bond vigilantes could add to the upward pressure on long rates if they ever stir from their long hibernation. It would be entirely reasonable for yields to retrace at least a portion of their sudden and sizable move, and our U.S. Bond Strategy service has moved to benchmark duration to position for near-term consolidation. It still sees long rates higher a year from now, though, and we are not going to wait to add some carry to the portfolio. We are replacing our U.S. REIT exposure with business development company exposure via the BIZD ETF, which will add some beta along with credit exposure. We are going to add bank loans in the form of the BKLN ETF, providing some rate protection (bank loans carry floating rates) and allowing us to dip our toe into the most senior tranche of the high-yield space. BKLN will push our Treasuries exposure to below benchmark,5 but we will maintain Treasury duration near benchmark in line with our bond strategists' tactical guidance. We will look to exit our TLT position on a 10-year rally back to the 2-2.2% range. Chart 3Pigs Get Slaughtered Cyclicals Versus Defensives The uncertainty around the impact of the incoming administration's proposed policies keeps us from fully reversing course on our cyclicals/defensives positioning. But our conviction about higher rates increases our remorse at overstaying our welcome in Staples and Telcos (Chart 3). As an analogue to positioning for near-term economic acceleration by taking on some credit risk, we're shifting capital away from rate-driven Staples and Telecom to Discretionaries and Energy. Our exit from Swiss equities in the global portfolios furthers our move to more neutral intra-equity settings. We are adding Energy exposure to all of the portfolios to reflect our strategists' bullish take on crude oil. The recently agreed OPEC-Russia production cuts will fuel inventory drawdowns that will keep crude prices from falling below $50. Our Energy Sector Strategy service argues that U.S. shale producers will reap the greatest benefits, as $50+ crude will allow them to accelerate oilfield reinvestment and grow production in 2017. We are therefore adding FRAK, an ETF dominated by U.S. shale oil and natural gas producers, to our U.S. portfolios.6 Other Portfolio Changes Aside from dialing back our defensive equity positioning and embracing some credit risk, our biggest change has been to pull in our horns on the sector tilts across all of our portfolios. We are chastened by being off-sides with our sector calls and are pulling back until we have a better sense of direction. We are waiting in all portfolios for an opportune time to shorten duration. We expect to maintain our sizable income hybrids sleeve as the nascent bond bear market grinds along. Table 13 shows our revised U.S. Long-Only portfolio. As mentioned above, it no longer shuns cyclical sector or credit exposures and will continue to evolve with the anticipated direction of the economy. We have chosen not to rebalance our mid- and small-cap exposures and we would be happy to increase them if they retrace some of their relative gains in the near term. The U.S. Long/Short portfolio (Table 14) is effectively an amplified version of the Long-Only portfolio but its sector tilts are being trimmed considerably as well. Table 13Revised U.S. Long-Only Model Portfolio Table 14Revised U.S. Long/Short Model Portfolio The changes to our Global Long-Only portfolio mute its defensive bias and attempt to simplify it by removing standalone currency-hedging positions (Table 15). We substitute HEWU, the currency-hedged version of EWU, for our existing EWU/FXB pair, giving up some liquidity to save on ETF and borrow fees. We clean up the other currency short by exiting our Swiss equity position, which is no longer needed now that we are dialing back the portfolio's defensive cast. We exit BWX and reallocate its proceeds to BNDX and AGG to simplify the portfolio and remove incremental sovereign and currency exposure. We replace LQD with JNK to introduce a modest high-yield exposure to the portfolio. Table 15Revised Global Long-Only Model Portfolio Like its U.S. counterpart, our Global Long/Short portfolio is significantly dialing back its sector tilts (Table 16). The Staples, Telco and Utilities overweights are being eliminated, along with the Financials short. The Health Care overweight and the corresponding Industrials and Tech shorts have been reduced. As in the Long-Only portfolio, we are exiting Switzerland and redeploying the proceeds in Energy, Discretionaries and a slightly reduced U.S. underweight. We are replacing the incremental exposure to U.S. Investment Grade (LQD) with High Yield (JNK), reflecting our U.S. rates and credit view. With the addition of JNK, we are taking the opportunity to do a little housecleaning by replacing the U.S. leg of our EM junk spread-widening pair, formerly HYG, with JNK, which better aligns with our portfolio benchmark and is 10 bps cheaper per annum. Table 16Revised Global Long/Short Model Portfolio Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 Through December 5th, the U.S. Long-Only portfolio is in line with its benchmark. 2 Through December 5th, the U.S. Long/Short portfolio has underperformed by 65 basis points. 3 Through December 5th, the Global Long-Only portfolio has outperformed by 184 basis points. 4 Through December 5th, the Global Long/Short portfolio has outperformed by 160 basis points. 5 In our October 12th Special Report introducing the model portfolios, we referred to outdated Aggregate/High Yield proportions in our U.S. and global fixed income benchmarks. Based on the outstanding value of the bonds in the indexes, the correct U.S. breakdown is 90/10 AGG/HY and the correct global breakdown is 93/7 AGG/HY, not 95/5 as originally stated. Our performance attribution calculations reflect the correct benchmarks. 6 For more information on the shale producers and the effects of the OPEC cuts, please see the following Energy Sector Strategy reports, available at nrg.bcaresearch.com: Constructive On U.S. Shale Producers And Select Service Companies, published July 6, 2016; The OPEC Debate, published November 23, 2016; and Recommendation Additions & Changes Following OPEC's Cut, published December 7, 2016.