Fiscal

Highlights Theme 1: Secular Stagnation Vs. Trumponomics. A larger deficit will cause Treasury yields to rise in 2017 and, for at least a while, it will appear as though secular stagnation has been conquered. Theme 2: A Cyclical Sweet Spot. Better growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen early in the year and transition to a bear-flattening only when long-dated TIPS breakevens reach the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish. The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty. Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle. Recovery in the energy sector will cause the uptrend in the default rate to reverse in 2017, but poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Theme 6: The Muni Credit Cycle Starts To Turn. The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Theme 7: A Rare Opportunity In Leveraged Loans. The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Feature In this Special Report, the last U.S. Bond Strategy report of the year, we present seven major investment themes that will drive U.S. fixed income market performance in 2017. Our regular publication schedule will resume on January 10 with the publication of our Portfolio Allocation Summary for January 2017. Theme 1: Secular Stagnation Vs. Trumponomics With 2016 almost in the books, it is clear that Treasury returns will likely be close to zero for the year. The total return from the Bloomberg Barclays U.S. Aggregate index will be only marginally better, in the neighborhood of 1% to 2% (see the Appendix at the end of this report for a detailed summary of U.S. fixed income returns in 2016). But these disappointing returns don't tell the whole story. Up until November 8, the Bloomberg Barclays Treasury and Aggregate indexes had returned 4% and 5% year-to-date, respectively (Chart 1). It was only then that the surprise election of Donald Trump caused investors to question many of the assumptions that had driven yields lower during the past several years. As of today, there is not much daylight between the market's expected path of the federal funds rate and the FOMC's own projections (Chart 2). This means that for below-benchmark duration positions to perform well going forward it is no longer sufficient to call for a convergence between the market's rate expectations and the Fed's dots, as we had been doing since July.1 For Treasury yields to rise going forward we must exit the regime of secular stagnation - one that has been characterized by serial downward revisions to the Fed's interest rate forecasts - and enter a new regime where improving global growth and Trumponomics lead to a series of faster-than-expected rate hikes and upward revisions to the Fed's dots. Chart 1Bond Market Returns In 2016 bca.usbs_sr_2016_12_20_c1 bca.usbs_sr_2016_12_20_c1 Chart 2Market Almost In Line With Fed bca.usbs_sr_2016_12_20_c2 bca.usbs_sr_2016_12_20_c2 What Is Secular Stagnation? For the purposes of the bond market we define secular stagnation based on the observation that in each cycle since 1980 it has required lower real interest rates to achieve the Fed's inflation target (Chart 3). The logical conclusion to be drawn is that the equilibrium real interest rate - the one that is consistent with steady inflation - must be in a secular downtrend. A paper published last year by the Bank of England (BoE),2 and discussed in detail by our own Bank Credit Analyst last February,3 identifies the drivers of this long-run decline in the equilibrium real rate and ranks them in order of importance. Chart 3This Is What Secular Stagnation Looks Like bca.usbs_sr_2016_12_20_c3 bca.usbs_sr_2016_12_20_c3 One key finding from the BoE's research is that expectations for lower trend growth account for only 100 bps of the 450 bps decline in global real yields since the mid-1980s. Increases in desired savings and decreases in desired investment for a given level of global growth account for the bulk of the decline (300 bps), while 50 bps of the decline remains unexplained (Table 1). Table 1The Drivers Of Secular Stagnation Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 The most important factors identified in the paper include: Demographics: A lower dependency ratio (the non-working age population relative to the working age population) is associated with an increased desire to save. Inequality: The bulk of income gains during the past 35 years have accrued to the richest tiers of the population, the group that is most inclined to save rather than spend. EM Savings Glut: Since the 1990s many emerging market countries have increased foreign exchange reserves to guard against capital outflows, representing an extra source of demand for safe assets. Falling Capital Goods Prices: The relative price of capital goods has fallen about 30% since the 1980s. This means that less savings are required to undertake the same amount of investment. Less Public Investment: The reluctance of governments to pursue large-scale public investment projects has contributed an additional 20 bps of downside to global real yields. Spread Between Cost of Capital & Risk Free Rate: The expected cost of capital (measured using bank credit spreads, corporate bond spreads and the equity risk premium) has not fallen as much as the risk free rate during the past 30 years. This has made investment less sensitive to changes in the risk-free rate. Is Trumponomics The Solution? Can a Donald Trump presidency actually change any of these long-run factors? It is conceivable that fiscal policies focused on spurring capital investment could enhance the outlook for productivity growth and reverse some of the decline in potential GDP growth expectations. However, lower potential GDP growth expectations have also been driven by slower labor force growth, a trend that fiscal policy is powerless to address. On the plus side, the dependency ratio is likely to bottom in the coming years and the increased infrastructure investment that Trump has promised would certainly put upward pressure on rates. It is also possible that the watering-down of certain regulations might bring the cost of capital more in-line with the risk free rate. However, these potentially positive trends need to be weighed against increasingly isolationist trade and immigration policies that will hamper potential GDP growth, as well as proposed tax cuts that disproportionately target the highest income tiers. The latter will only exacerbate the impact of inequality on real yields. What's The Verdict? With so much uncertainty surrounding fiscal policy it is premature to declare the death of secular stagnation. However, secular stagnation will not be the dominant bond market theme in 2017. Amidst all the uncertainty, one thing that seems likely is that a Trump presidency will result in materially higher deficits next year and consequently more Treasury issuance. Chart 4Big Government Only A##br## Problem For Opposition bca.usbs_sr_2016_12_20_c4 bca.usbs_sr_2016_12_20_c4 With one party now in complete control of the Congress it is certain that government spending will increase next year. As our geopolitical strategists have repeatedly pointed out,4 lawmakers are only opposed to higher spending when they are not in power. Survey results show that this is also true of voters (Chart 4). Further, Moody's has estimated a range of outcomes for the federal deficit in 2017 based on how much of Trump's stated campaign agenda is implemented. These estimates range from 4.1% of GDP at the low end to 6% of GDP at the high end. This compares to 3.8% of GDP that was expected under current law.5 The greater supply of Treasury securities next year will offset some of the increased demand stemming from the excess of desired savings relative to investment. This will cause Treasury yields to move higher in 2017 and, for at least a while, it will appear as though the forces of secular stagnation have been conquered. Bottom Line: While Trumponomics will rule in 2017, the forces of secular stagnation are simply dormant and are likely to flare-up again in 2018 and beyond. Theme 2: A Cyclical Sweet Spot In the first half of 2017 the combination of improving economic growth and accommodative monetary policy will create a "sweet spot" for risk assets. The positive environment for risk assets will only end when Fed policy becomes overly restrictive. We expect that restrictive Fed policy will not be an issue until near the end of 2017. Above-Trend Growth Chart 5Contributions To GDP Growth Contributions To GDP Growth Contributions To GDP Growth Even prior to the election, U.S. economic growth appeared poised to accelerate in 2017. The main reason being that some of the factors that restrained growth in 2016 are shifting from headwinds to tailwinds (Chart 5). Consumer spending should continue to be a solid contributor to growth next year, just as in 2016. Surveys of consumer sentiment suggest we should even expect a modest acceleration (Chart 5, panel 1). Residential investment actually contributed negatively to real GDP in Q2 and Q3 of 2016 even though leading indicators remained firm. This drag is bound to reverse (Chart 5, panel 2). Government spending contributed almost nothing to growth in 2016 but is poised to accelerate next year based on trends in public sector employment. This does not even take into account the potential for more stimulative fiscal policy in 2017 (Chart 5, panel 3). Inventories were a large negative contributor to growth this year. History suggests that large inventory drawdowns tend to mean-revert fairly quickly (Chart 5, panel 4). Net exports exerted less of a drag on growth in 2016 than 2015 due to moderation in the pace of exchange rate appreciation. With the dollar still in a bull market, net exports will not be a significant driver of growth in 2017 (Chart 5, bottom panel). Nonresidential investment was also a large drag on growth in 2016 and should return to being a small positive contributor next year. First, most of the drag was related to lower capital spending from the energy sector (Chart 6). Now that oil prices have rebounded this drag will abate. Second, surveys of new orders have remained supportive (Chart 7, panel 1) and industrial production growth has rebounded off its lows (Chart 7, panel 2). The rebound in industrial production growth is also likely related to the recovery in energy prices. Chart 6Contribution To Nonresidential Fixed Investment Spending Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 7Will Capex Return In 2017? bca.usbs_sr_2016_12_20_c7 bca.usbs_sr_2016_12_20_c7 The end of the drag from energy alone will be enough to make nonresidential investment a positive contributor to growth next year. The wildcard is that the easier regulatory backdrop under President Trump could unleash the animal spirits of the corporate sector and lead to even larger gains. While this outcome is obviously highly uncertain, there is some evidence that business optimism has already increased. The NFIB small business optimism index shot higher in November (Chart 7, bottom panel) and what's more, the NFIB's Chief Economist Bill Dunkelberg noted that "the November index was basically unchanged from October's reading up to the point of the election and then rose dramatically after the results of the election were known." Accommodative Monetary Policy Even with an improving growth outlook we expect the Fed will be slow to react with a faster pace of rate hikes, opting instead to nurture the recovery in inflation and inflation expectations until they are more firmly anchored around its target. With core PCE inflation still running at 1.7% - below the Fed's 2% target - and the 5-year/5-year TIPS breakeven inflation rate currently at 1.86% - well below the level of 2.4% to 2.5% consistent with the Fed's inflation target - there is no rush for the Fed to send a message that it will move aggressively to snuff out incipient inflationary pressures (Chart 8). Instead, the Fed will continue to send the message that there is no need to be aggressive given the downside risks, and will continue to be sensitive to any negative market response to more restrictive monetary policy. In other words, the "Fed put" is still in place. If risk assets start to sell off due to perceptions of overly restrictive monetary policy, the Fed will be quick to adopt a more dovish posture. The Fed will react in this manner at least until long-dated TIPS breakevens are firmly anchored in the range of 2.4% to 2.5%. It is only at that point that the Fed will be less concerned about negative market reactions to Fed tightening and more concerned with battling inflation. Further, it will take at least until the second half of next year for long-dated TIPS breakevens to return to target. This is because they will be held back by the slow uptrend in actual core inflation. The sensitivity of long-dated TIPS breakevens to core inflation has increased since the financial crisis (Chart 9). We posit that this is due to the zero-lower-bound on the fed funds rate. Prior to the financial crisis, with the fed funds rate well above zero, in the event of a deflationary shock investors would reasonably expect the Fed to offset that shock by easing policy. As such, the deflationary shock had a limited impact on long-dated breakevens. But when the fed funds rate is constrained at the zero-bound, there is reason to question whether the Fed can respond to a deflationary shock as in the past. Given the proximity of the fed funds rate to zero, realized inflation will be a much stronger determinant of long-dated breakevens in the current cycle. Chart 8Inflation Still Needs To Rise bca.usbs_sr_2016_12_20_c8 bca.usbs_sr_2016_12_20_c8 Chart 9Recovery In Breakevens Will Moderate bca.usbs_sr_2016_12_20_c9 bca.usbs_sr_2016_12_20_c9 Inflation Will Move Higher, But Only Slowly Inflation will continue to march higher in 2017, driven by a tight labor market and upward pressure on wage growth. With the unemployment rate already at 4.6% even modest employment gains can lead to exponential increases in wage growth (Chart 10). However, the pass-through from wage growth to overall price inflation is likely to be muted. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017 (Chart 11, panel 1). Core goods inflation (25% of core CPI) will also remain very low. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 11, panel 2), and so will stay depressed as long as the bull market in the dollar remains intact. Chart 10Wage Growth & Unemployment Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 11Core Inflation By Component bca.usbs_sr_2016_12_20_c11 bca.usbs_sr_2016_12_20_c11 Historically, wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 11, bottom panel). This component, which accounts for 25% of core CPI, is where we expect the marginal change in inflation will come from. We expect that the current uptrend in core inflation will remain intact next year, but core PCE will not converge with the Fed's 2% target until late-2017. Investment Implications The combination of better economic growth and accommodative Fed policy is a fertile environment for risk assets, and we expect spread product will perform well in the first half of next year. At the moment, however, we advocate only a neutral allocation to investment grade corporate bonds and an underweight allocation to high-yield based on poor valuation (see Theme 5). Given the positive economic back-drop we will be quick to increase exposure if spreads widen in the near term. Long-dated TIPS breakevens will also continue to widen until they reach the 2.4% to 2.5% range that is consistent with the Fed's inflation target. As such, we remain overweight TIPS relative to nominal Treasury yields, even though the uptrend in breakevens is likely to moderate in the months ahead. We will likely downgrade TIPS in 2017, once long-dated breakevens reach our target in the second half of the year. The cyclical sweet spot of better growth and an easy Fed also means that the Treasury curve is likely to bear-steepen in the New Year. Historically, excluding periods when the Fed is cutting rates, the 2/10 Treasury curve tends to steepen when TIPS breakevens rise and flatten when they fall (Chart 12). Further, after last week's Fed meeting the 5-year bullet now looks very cheap on the curve (Chart 13). Chart 12Wider Breakevens Correlated With A Steeper Yield Curve Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 13The 5-year Bullet Is Cheap On The Curve bca.usbs_sr_2016_12_20_c13 bca.usbs_sr_2016_12_20_c13 We expect Treasury curve steepening to persist next year until TIPS breakevens normalize near our target. At that point the bear-steepening curve environment will shift to a bear-flattening one. Investors should buy the 5-year bullet and sell a duration-matched 2/10 barbell to profit from curve steepening in the first half of next year and to take advantage of the cheapness of the 5-year bullet. Bottom Line: The combination of better economic growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen and TIPS breakevens will continue to rise. Curve bear-steepening will transition to bear-flattening once long-dated TIPS breakevens level-off in the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish Alongside secular stagnation, the most important theme driving U.S. bond markets during the past several years has been the divergence in growth between the U.S. and the rest of the world. We have repeatedly pointed out that these global growth divergences have led to upward pressure on the dollar, and that a strong dollar necessarily limits the amount of monetary tightening that can be achieved through higher interest rates. The strong dollar thus serves as a cap on long-dated Treasury yields. This theme will remain very much intact for most of 2017, but will probably be less potent than in prior years. Our Global LEI diffusion index - a measure of global growth divergences - has moved firmly into positive territory. This makes it unlikely that we will see another dollar appreciation of the scale witnessed in 2014/15 (Chart 14). The fact that the U.S. is still leading the way in terms of growth means the bull market in the dollar will stay in place, but the appreciation will be less potent going forward. Still, from the perspective of Treasury yields, it will be important to monitor the trade-off between accelerating global growth on the one hand and a stronger dollar on the other. One tool we have devised to help guide us in this respect is our 2-factor Global PMI model (Chart 15). This is a model of the 10-year Treasury yield based on global PMI and bullish sentiment toward the U.S. dollar. A stronger global PMI puts upward pressure on the 10-year Treasury yield while, for a given level of global growth, an increase in bullish sentiment toward the dollar pressures the 10-year yield lower. Chart 14Global Growth Divergences ##br##Less Pronounced bca.usbs_sr_2016_12_20_c14 bca.usbs_sr_2016_12_20_c14 Chart 152-Factor Global ##br##PMI Model bca.usbs_sr_2016_12_20_c15 bca.usbs_sr_2016_12_20_c15 At present, this model tells us that fair value for the 10-year Treasury yield is 2.26%, well below current levels. This is one reason we tactically shifted to a benchmark duration stance on December 6 even though we expect yields to rise next year. Going forward we will continue to use this model to assess whether increasing global growth or a stronger dollar is dominating in terms of the impact on Treasury yields. Chart 16A Bond Bearish Surprise? bca.usbs_sr_2016_12_20_c16 bca.usbs_sr_2016_12_20_c16 Through the mechanism described above, the rest of the world will continue to be a bond-bullish force with respect to U.S. Treasury yields for most of 2017. However, near the end of 2017 it is possible that either the Eurozone or Japan could start to exert upward pressure on U.S. Treasury yields. This could occur if it seems likely that either economic bloc is poised to reach its inflation target and the market starts to discount an end to their extremely accommodative monetary policies. We have highlighted the risks of such events in prior reports, in the context of our Tantrum Theory of Global Bond Yields.6 The unemployment rate in the Eurozone is declining rapidly, but has historically needed to break below 9% before core inflation starts to rise (Chart 16, panels 1 & 2). If the current pace of above-trend growth in Europe is sustained throughout 2017 then higher inflation and the end of the European Central Bank's (ECB) asset purchases could become a risk to global bond markets late next year. However, even minor setbacks in growth would be enough to push this risk out to 2018. In Japan, although inflation is still well below the Bank of Japan's (BoJ) target, yen weakness suggests it should begin to rise (Chart 16, bottom panel). While the BoJ has promised to wait until inflation is above target before abandoning its yield curve peg, it is possible that near the end of next year, if inflation is much higher, the market will start to discount the eventual end of the BoJ's policy and cause global bonds to sell off. For now we would characterize these bond-bearish surprises from the BoJ and/or ECB as tail risks for the global bond market that could flare in late 2017. Bottom Line: The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty With fiscal policy having the potential to drastically alter the economic landscape and yet with so much still unknown about what will occur, lingering policy uncertainty will undoubtedly be a major theme for fixed income markets in 2017. Historically, the Global Economic Policy Uncertainty index created by Baker, Bloom and Davis7 has been a reliable gauge of these risks and has also tracked asset prices surprisingly well (Chart 17). Recently, the uncertainty index has spiked and asset prices have not responded in kind. This is likely a signal that the spike in uncertainty will quickly reverse, but it could be a signal that asset prices are overly complacent. At the very least the spike in uncertainty highlights the fact that bond markets have been very quick to discount the potentially positive impacts of a Trump presidency, but are at risk if these policies are not delivered. This lack of a "policy risk premium" in fixed income markets is driven home by the reading from our 3-factor Global PMI model (Chart 18). This model adds the Global Economic Policy Uncertainty index to the 2-factor Global PMI model mentioned in the previous section, increasing the explanatory power of the model in the process. At present, the 3-factor model gives a fair value reading of 1.82% for the 10-year Treasury yield. Chart 17Economic Policy Uncertainty & Bond Markets Economic Policy Uncertainty & Bond Markets Economic Policy Uncertainty & Bond Markets Chart 183-Factor Global PMI Model bca.usbs_sr_2016_12_20_c18 bca.usbs_sr_2016_12_20_c18 While the most recent spike in policy uncertainty may reverse before asset prices respond, the volatile nature of the incoming administration means that more frequent spikes of the uncertainty index are likely in 2017. At some point asset prices will probably react. There is another political risk in 2017 that carries extra importance for bond markets. In 2017 President Trump will appoint two new Fed Governors. Also, there is a good chance that Janet Yellen and Stanley Fischer will not be re-appointed as Chair and Vice-Chair respectively when their terms expire in early 2018. Given the pedigrees of Trump's economic advisors, we would expect the newly appointed Governors in 2017 to have hawkish policy leanings. While this will not significantly alter Fed decision making in 2017, since the core members of the Committee will still be in place, there is a risk that the market will anticipate that one of the newly appointed Governors will be Janet Yellen's eventual replacement. If that Governor is hawkish, then there is a risk that the market will start to discount a much more hawkish Fed reaction function as early as next year. This could potentially speed up the transition from a bear-steepening curve environment to a bear-flattening environment, putting spread product at risk earlier than we currently anticipate. The MBS market would also be at risk in this scenario, since any incoming hawkish Fed Governor would be very likely to favor an unwind of the Fed's balance sheet at a much quicker pace than is currently anticipated. We already recommend an underweight allocation to MBS due to low spread levels and a continued recovery in the housing market that will keep net issuance trending higher. A change of leadership at the Fed represents an additional tail risk. Although we think it is premature to say for certain that Chair Yellen and Vice-Chair Fischer won't be re-appointed in 2018, the key risk for next year is that the market anticipates that they will be replaced. Bottom Line: Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle The uptrend in the trailing 12-month speculative grade default rate will reverse in 2017, falling from its current 5.6% back closer to 4%. But this will only be a temporary reprieve and the uptrend will resume in 2018 and beyond. Increases in job cut announcements, contractions in corporate profits and tightening C&I lending standards all tend to coincide with a rising default rate (Chart 19). All three of these factors signaled rising defaults last year, but have since rolled over. We have often drawn a comparison between the current default cycle and the default cycles of the mid-1980s and mid-1990s, and this comparison is still apt. Chart 19The Current Default Cycle Is A Hybrid Of the Mid-1980s and Late-1990s bca.usbs_sr_2016_12_20_c19 bca.usbs_sr_2016_12_20_c19 Distress in the energy sector caused a contraction in corporate profits and rising defaults in 1986. But then a sharp easing of Fed policy and a recovery in oil prices caused the uptrend in defaults to reverse. Corporate profit contraction, increasing job cut announcements and tighter lending standards also caused the default rate to trend higher in 1998. This time, however, Fed policy remained restrictive (Chart 19, bottom panel) and banks had no incentive to ease lending standards amidst a back-drop of rising corporate leverage. The default rate continued to trend higher in the late 1990s, and did not peak until the next recession. While the energy price shock and subsequent recovery make the current cycle similar to the 1980s episode, the fact that the Fed is more inclined to hike than cut rates brings to mind the late 1990s. This leads us to believe that the recovery in energy prices will cause the default rate to fall next year. This, along with better economic growth and a relatively accommodative Fed, will keep downward pressure on credit spreads throughout most of 2017. However at some point, likely after TIPS breakevens have recovered to pre-crisis levels, the Fed's tone will turn decidedly more hawkish. This will lead to renewed tightening in lending standards, a resumption of the uptrend in defaults and wider corporate spreads. Despite our optimism about the macro outlook for 2017 we cannot forget that corporate balance sheet health continues to deteriorate (Chart 20). Our Corporate Health Monitor has been in 'deteriorating health' territory since 2013, and although corporate spreads have tightened since February they have yet to regain their 2014 lows. Additionally, net leverage for the nonfinancial corporate sector - defined as outstanding debt less cash on hand as a percent of EBITDA - is still trending higher (Chart 20, bottom panel). The only other period since 1973 when corporate spreads narrowed as net leverage increased was following the oil price crash and default spike of 1986. In that period spreads remained under downward pressure for approximately two years but never regained their prior lows. Spreads also benefitted from Fed rate cuts and a weakening dollar during that timeframe. In our view, the best way to play the corporate bond market in the current cycle is to maintain a cautious long-term bias but to look for attractive opportunities to initiate overweight positions. At the moment, we are actively looking to upgrade our allocation to corporate bonds but need a more attractive entry point first. At 405 bps, the average spread on the Bloomberg Barclays High-Yield index is only 65 bps above the average level observed in the 2004 to 2006 period when our Corporate Health Monitor was deep in 'improving health' territory. Not surprisingly, the spread appears even lower after adjusting for expected default losses (Chart 21). Chart 20Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage Chart 21Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation The default-adjusted high-yield spread is our preferred valuation measure for high-yield and investment grade corporate bonds alike. As is shown in Charts 22 and 23, the current default-adjusted spread of 162 bps is consistent with negative excess returns for both investment grade and high-yield bonds, on average, over a 12-month investment horizon. Chart 2212-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 2312-Month Excess Investment Grade Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 However, this average negative excess return is heavily influenced by a few periods when excess returns were deeply negative. A more detailed examination, shown in Tables 2 & 3, reveals that when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns for high-yield have been positive 65% of the time. Investment grade excess returns have been positive only 35% of the time with spreads at current levels, but have been positive 55% of the time when the default-adjusted spread is between 100 bps and 150 bps. Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Table 312-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Given our optimistic assessment of the macro back-drop, we conclude that excess returns for both investment grade and high-yield corporate bonds are likely to be positive, but very low, during the next 12 months. But we will continue to look for opportunities to upgrade our allocation to spread product from more attractive levels. Bottom Line: The improving macro back-drop means that the default rate will move lower in 2017. However, the poor state of corporate balance sheets means that the default rate will likely resume its uptrend in 2018, once Fed policy turns decidedly more hawkish. Theme 6: The Muni Credit Cycle Starts To Turn Back in October, we published a Special Report 8 wherein we observed that Municipal / Treasury (M/T) yield ratios tend to fluctuate in long-run cycles determined by ratings downgrades and net borrowing at the state & local government level. That is, there exists a municipal bond credit cycle much in the same way that there exists a corporate credit cycle. Additionally, we introduced a Municipal Health Monitor - a composite indicator of the health of state & local government finances - to help us assess the stage of the municipal credit cycle and observed that it has tended to follow our Corporate Health Monitor with a lag of approximately two years (Chart 24). Chart 24The Municipal Credit Cycle Lags The Corporate Cycle bca.usbs_sr_2016_12_20_c24 bca.usbs_sr_2016_12_20_c24 This analysis leads us to believe that our Municipal Health Monitor will move into 'deteriorating health' territory at some point during 2017 and that municipal bond downgrades could start to outpace upgrades late next year. As such, we adopt a cautious stance with respect to the municipal bond market, not least of which because of the potentially negative impact on the market from a Donald Trump presidency. Lower tax rates next year will certainly undermine the tax advantage of municipal debt, while the potential for increased infrastructure spending could lead to a sizeable increase in municipal bond supply. Historically, most public investment has been financed at the state & local government level, and while Trump's current infrastructure plan relies entirely on incentives for private sector investment, these details could change before any plan is implemented. By far the largest risk to the municipal bond market would be if the municipal tax exemption is done away with entirely in the context of broader tax reform, but this now appears unlikely. Even in the absence of a federal government initiative we would not rule out increased state & local government investment next year. State & local government finances have made substantial progress since the crisis and many states are now in a position where they may start to loosen the purse strings (Chart 25). This poses an upside risk to muni supply in 2017. Of course, we have already seen large fund outflows in response to Trump's election victory. ICI data show that net outflows from municipal bond funds have totaled $14.86 billion since the end of October, and while M/T yield ratios have risen, they remain near the middle of their post-crisis trading ranges (Chart 26). Chart 25Healthy Enough To Invest bca.usbs_sr_2016_12_20_c25 bca.usbs_sr_2016_12_20_c25 Chart 26Municipal / Treasury Yield Ratios bca.usbs_sr_2016_12_20_c26 bca.usbs_sr_2016_12_20_c26 We will continue to look for opportunities to upgrade municipal bonds when the reading from our tactical Muni model turns more positive (Chart 27). This model- based on policy uncertainty, issuance, fund flows and ratings migration - shows that M/T yield ratios are not yet attractive. This is true even if we assume that last month's spike in policy uncertainty is completely reversed. This model has a strong track record of predicting Muni excess returns since 2010 (Table 4). Chart 27Tactical Muni Model Tactical Muni Model Tactical Muni Model Table 4Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Bottom Line: The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Remain underweight for now, but look for near-term tactical buying opportunities in municipal bonds. Theme 7: A Rare Opportunity In Leveraged Loans Chart 28Leveraged Loans Will Outperform In 2017 Leveraged Loans Will Outperform In 2017 Leveraged Loans Will Outperform In 2017 Our final theme for 2017 relates to the potential for floating rate leveraged loans to outperform fixed rate high-yield bonds. Historically, these periods of outperformance have been few and far between. There have only been two periods since 1991 when loans have outperformed bonds for any length of time (Chart 28). However, we believe that the conditions are in place for loans to outperform fixed-rate junk in 2017. There are two factors that can potentially cause leveraged loans to outperform fixed-rate junk. The first is rising LIBOR, which causes loan coupon payments to reset higher. While there is some concern that LIBOR floors prevent loans from benefitting from higher LIBOR, most loans have LIBOR floors of 75 bps or 100 bps. With 3-month LIBOR already at 99 bps, LIBOR floors will not be a constraint for much longer. The second factor that could cause loans to outperform bonds is an elevated default rate. Since loans are higher-up in the capital structure than bonds, they benefit from higher recovery rates. This matters more in terms of relative performance when the default rate is high. It is highly unusual for elevated defaults and rising LIBOR to coincide. This is because the Fed is typically cutting rates when the default rate is rising. However, next year, much like in the late 1990s, both conditions are likely to be in place. Bottom Line: The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com 2 Lukasz Rachel & Thomas D. Smith, "Secular Drivers of the Global Real Interest Rate (Staff Working Paper No. 571)", Bank of England, December 2015. 3 Please see Bank Credit Analyst Special Report, "Secular Stagnation And The Medium-Term Outlook For Bonds", dated February 25, 2016, available at bca.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 Mark Zandi, Chris Lafakis, Dan White and Adam Ozimek, "The Macroeconomic Consequences of Mr. Trump's Economic Policies", Moody's Analytics, June 2016. 6 Please U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 7 For further details on the construction of this index please see www.policyuncertainty.com 8 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Appendix: U.S. Bond Market 2016 Risk/Return Summary Chart A-1U.S. Bond Returns In Historical Context U.S. Bond Returns In Historical Context U.S. Bond Returns In Historical Context Chart A-22016 Total Returns Versus Volatility Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-32016 Vol-Adjusted Total Returns Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-42016 Excess Returns Versus Volatility Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-52016 Vol-Adjusted Excess Returns Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-62016 Corporate Sector Excess Returns Versus Duration-Times-Spread Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-7The Performance Of Our Corporate Sector Model In 2016 Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017

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

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

Highlights Dear Client, This week's BCA's Commodity & Energy Strategy features our 2017 Outlook for the Gold market. We will address the other precious metals markets early in the New Year. We model gold as a currency. While fundamental data - supply, demand and inventories - are important, they do not drive gold prices. Gold has been our window on market expectations for Fed policy, given it is highly sensitive to the central bank's preferred inflation gauge - the Personal Consumption Expenditure (PCE) core index (ex food and energy prices) - and the evolution of key variables driven by Fed actions: the broad trade-weighted dollar (USD, in our usage), and 5- and 10-year real rates. Gold prices also are highly sensitive to broad macroeconomic variables - e.g., U.S. real wages and EM income growth. In addition to behaving like a currency, gold has continuing appeal to investors as a safe haven, particularly in turbulent markets and especially outside a deflationary context. Our research confirms gold provides an excellent portfolio hedge against inflation - particularly vs. core PCE inflation. Before getting to our gold outlook, a housekeeping note: We are closing our long Dec/17 WTI futures vs. short Dec/18 WTI futures basis Tuesday's mark-to-market value of $0.89/bbl for an indicated profit 493.3% (vs. the $0.15/bbl level at which we opened the position). We put the position on as the market was correcting from its earlier rally, just before the Saudi oil minister made his "whatever it takes" remarks in Vienna on Saturday. We also are closing our long 2017Q1 natural gas position as of Tuesday's mark-to-market close for an indicated profit of 16.3%. We remain bullish the backwardation trade and will look for opportunities to re-set the position on sell-offs in the front of the curve. We also remain bullish U.S. natural gas near-term, we expect U.S. production growth to resume next year. We trust you will find this week's report useful going into the New Year. Kindest regards, Robert P. Ryan, Managing Editor Feature Precious Metals: What Is Gold Pricing To? After falling some 16% from its recent high of $1,374/oz, gold appears to have found support just above $1,150/oz as the year winds down. Part of this sell-off no doubt was induced by investors liquidating ETFs and futures ahead of yesterday's FOMC meeting, where the Fed, as expected, raised its overnight rate 25 basis points (Chart 1). Even before the Fed's rate hike yesterday, which markets were pricing in with near 100% certainty (Chart 1, bottom panel), monetary conditions had been tightening going into the FOMC meeting; The broad trade-weighted USD was up some 7% since the bottoming for the year in May, while the St. Louis Fed's 5-year 5-year forward inflation expectation rate was up almost 70 basis points (at 2.09%) since bottoming in June. The other part of gold's price evolution reflects uncertainty surrounding U.S. fiscal and monetary policy, particularly as markets grope for insight on the fiscal policies that will be pursued by the incoming Trump administration. In addition to their direct implications for U.S. economic growth, these policy decisions will profoundly influence EM growth, which is the critical variable for commodity prices generally. Unsurprisingly, the combination of increasing financial stress brought about by contracting monetary conditions, and policy uncertainty emanating from the U.S. has lifted gold volatility (Chart 2). Chart 1Gold Corrects bca.ces_wr_2016_12_15_c1 bca.ces_wr_2016_12_15_c1 Chart 2Increasing Financial Stress ##br##Pulls Gold Volatility Higher Increasing Financial Stress Pulls Gold Volatility Higher Increasing Financial Stress Pulls Gold Volatility Higher The tightening of financial conditions likely will, over the short-term, induce a slowing in economic growth at the margin going into 2017Q1, which will, all else equal, cause the USD to weaken, according to our colleagues at BCA's Foreign Exchange Strategy service.1 In addition, it likely will cause U.S. interest rates to retreat, consistent with our House view. Short-term, both of these effects should be bullish gold, which is why we're recommending investors go tactically long if prices retrace to $1,150/oz (see below). Forming A Strategic View On Gold Becomes More Difficult The proximate cause of the heightened risk in financial markets that is showing up in gold volatility is the uncertainty surrounding U.S. monetary and fiscal policy next year in the U.S., and an increasingly fragmented commercial and political backdrop globally. Forming a longer term view on gold is difficult, given the huge amount of incomplete economic information available to markets, much of which will only become clear over the next quarter or two. There are, of course, a host of geopolitical risks - i.e., the types of risk investors typically use gold to hedge against - but we will leave those assessments to our colleagues at BCA's Geopolitical Strategy service.2 The incoming U.S. presidential administration has promised greater fiscal stimulus, which is bullish for growth, and, at the same time, has signaled its hostility to the Fed. On the back of higher growth expectations - overlaid against a labor market in the U.S. that is close to full employment - inflation expectations are rising. This is coloring interest-rate expectations - particularly the path for real rates - and contributing to the strengthening of the USD. Among risk factors, these three - higher inflation, a stronger USD and rising real rates - rank at the top of most investors' hierarchies, regardless of how they allocate. Realistically, it will take time for the incoming Trump administration to draft the legislation that deploys fiscal stimulus - at least six months. It will then take even more time to see this legislation have effect. Given this reality, we agree with the assessment of our colleagues on the FX and bond desks that key U.S. monetary variables - chiefly the USD and real rates - have moved too far too fast, and likely will correct. The increased inflation expectations we've seen in the forward markets, however, probably are warranted. Going Tactically Long, Expecting Higher Inflation Chart 3Fiscal Stimulus Will Lift Real Wages,##br## Then Core PCE bca.ces_wr_2016_12_15_c3 bca.ces_wr_2016_12_15_c3 Given this expectation, we believe the correction in gold was warranted. We will get tactically long spot gold at tonight's close, with a stop loss of 5%. This will position us for what we believe will be a strategic opportunity to be long gold once U.S. fiscal policy comes into focus. With the U.S. at or close to full employment, we expect the fiscal stimulus introduced next year - tax cuts, deregulation, increased defense spending, and more money for infrastructure - to provide a significant boost to the economy beginning in 2017H2. This will, we believe, result in stronger wage growth, which will lead to higher inflation. All else equal, this will lift core PCE (Chart 3): Our modeling indicates a 1% increase in real U.S. nonfarm wages translates into a 0.62% increase in core PCE.3 As good as this sounds, we have to account for the Fed's likely response. Presently, we expect two rate hikes next year. Depending on how strong growth comes in, we might even get a third hike in the Fed funds rate next year, as Fed Chair Yellen suggested at her press conference yesterday. If, as we expect, the USD corrects over the short term, this would imply another rally in the dollar next year, as markets once again price in a tighter U.S. monetary policy against a backdrop of global monetary accommodation. The big unknown is how far out ahead of the expected inflation increase the Fed will get vis-à-vis its interest-rate policy. If Janet Yellen and her colleagues decide to allow the economy to run hot, and keep monetary policy "behind the curve" - i.e., slowly raise real rates while the economy is expanding and inflation is increasing - that will be bullish for gold. If, on the other hand, the Fed wants to get out "ahead of the curve" - i.e., raise rates in anticipation of higher inflation before it actually materializes - that would be bearish. We believe the Fed will err on the side of allowing the economy to run hot and will keep monetary policy "behind the curve" next year, and most likely in 2018. So, in addition to core PCE picking up, we would expect the USD to rise, but not by as much as it would if the Fed were more aggressive in its policy stance. Most important for commodity markets, we believe real rates will not surge ahead with the Fed continuing to maintain a relatively accommodative policy. This is a bullish backdrop for gold. But it's not enough to compel us to get long strategically. Why We Won't Go All-In On Gold Chart 4A Relatively Accommodative ##br##Fed Will Be Bullish For Gold bca.ces_wr_2016_12_15_c4 bca.ces_wr_2016_12_15_c4 We believe the Fed will err on the side of continued relative accommodation for two reasons: The U.S. central bank will be restrained by the continued massive accommodation of other systemically important central banks - i.e., it cannot unilaterally tighten policy too aggressively in a world where accommodation reigns: It would send the USD through the roof and kill off whatever expansion the U.S. could muster under the Trump administration's fiscal policy. The Fed's core PCE inflation target is symmetric, with an indicated target level of 2% p.a. change. For the past 20 years, the average p.a. change in core PCE has been 1.7%. The Fed can allow inflation to overshoot for years before the symmetry of its target is violated: Among other things, this would allow the Fed to further distance itself from the zero lower bound on interest rates, which appears to be a goal of many of the central bankers. Our modeling suggests that if the Fed remains behind the curve as inflation is increasing gold prices could appreciate substantially after the expected U.S. fiscal stimulus kicks in. A 1% increase in core PCE translates into an increase in gold prices exceeding 4%. A 1% decrease in real rates implies a 6% increase in gold prices. And a 1% decrease in the USD translates to close to a 3% increase in gold prices (Chart 4).4 We're comfortable with a short-term gold position, but we are not ready to go all-in on gold as a strategic allocation at present because we do not know what to expect from the incoming Trump administration in terms of fiscal policy initiatives. Nor do we know whether the president-elect will assume office openly hostile to the sitting Fed Chair, Dr. Yellen. Trump has indicated dissatisfaction with her leadership of the Fed, and has indicated he will not reappoint her when her term is up, given the accommodation the Fed pursued while she was in charge. If the relationship becomes acrimonious while she continues to run the Fed, the independence of the Fed may come under question, and the coherence of policy might be placed in doubt. An openly hostile relationship between the U.S. chief executive and the head of the country's independent central bank will make it difficult to form macro expectations, particularly around gold prices. Perhaps such uncertainty would improve gold's appeal as a safe-haven, which would keep the metal bid in the event of such an outcome. Of course, the next logical question would be, who would Trump appoint to replace Yellen? If his beef with the central bank was that policy was too accommodative, does that mean he's likely to appoint a more hawkish Chair when Yellen's term is up? If so, this would be decidedly bearish gold and commodities in general. Hence the inability to take a clear position strategically. EM Growth Will React To U.S. Policy, And Affect Gold What happens in Washington doesn't stay in Washington. Fed policy is extremely important for EM growth, which has been picking up recently (Chart 5). The global driver of increasing commodity demand - and U.S. core PCE - has been EM income growth (Chart 6), which we proxy using non-OECD oil consumption and world base metals demand, given 50% of base metals demand comes from China.5 Chart 5EM Growth At Risk ##br##If Fed Gets Aggressive bca.ces_wr_2016_12_15_c5 bca.ces_wr_2016_12_15_c5 Chart 6EM Oil and Base Metals Demand##br## Highly Correlated With U.S. Core PCE bca.ces_wr_2016_12_15_c6 bca.ces_wr_2016_12_15_c6 Too aggressive a policy stance by the Fed - e.g., getting too far out "ahead of the curve" - would suffocate EM income growth by encouraging capital flight and increasing the burden of USD-denominated debt in those countries. Bottom Line: We are recommending a tactically long gold position, given our expectation the USD and interest rates will correct after moving too far too fast in anticipation of stronger U.S. economic growth following the election of Donald Trump as the 45th president of the United States. Although we do expect significant stimulus from the incoming administration's to-be-announced fiscal policies will stoke inflation going forward - especially with the U.S. economy at or close to full employment - we are uncomfortable going strategically long gold until we gain greater clarity on these policies. In addition, we await a clear signal on the sort of relationship the executive office will have with the Fed. Robert P. Ryan, Senior Vice President rryan@bcaresearch.com 1 Please see BCA Research's Foreign Exchange Strategy "Cyclical And Tactical Divergences," dated December 9, 2016, available at fes.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook "Strategy Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Real nonfarm hourly compensation follows the same long-term trend as core PCE - i.e., these variables are cointegrated. The adjusted-R2 for the cointegrating regression is 0.99. 4 This is a long-term estimate (2000 to present). The adjusted-R2 for the cointegrating regression using these inputs is 0.95. Of course, if the Fed gets out "ahead of the curve" these effects will work in the opposite direction: Increasing real rates, falling core PCE and a stronger USD will militate against any price appreciation. 5 We have noted in previous research that oil and base metals demand frequently are used to approximate EM income growth, given the income elasticity of demand for these commodities approaches 1.0. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). The evolution of these real EM demand variables shares a common trend with U.S. money supply (M2), real rates in the U.S., and the trade-weighted USD. In addition, these real variables also are highly correlated with EM exchange rates, as is to be expected. Please see issue of BCA Research's Commodity & Energy Strategy "Memo TO Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Feature At no time in recent history have China's foreign reserves been under such tight scrutiny by global investors as they are now. The country's multi-trillion-dollar official reserve assets, long viewed by both Chinese officials and the global investment community as an unproductive use of resources, have suddenly became a lifeline for China's exchange rate stability. The latest numbers released last week show China's official reserves currently stand at US$3.05 trillion, a massive drawdown from the US$3.99 trillion all-time peak reached in 2014. Over the years, we have been running a series of Special Reports tracking the composition of China's foreign asset holdings.1 This year's update has become all the more relevant. The monthly headline figures on China's official reserves have been eagerly anticipated for clues of domestic capital outflows and the RMB outlook. Meanwhile, as the largest foreign holder of American government paper, changes in China's official reserves are also being scrutinized to assess any impact on U.S. interest rates. Moreover, Chinese outward direct investment (ODI), which had already accelerated strongly in the past few years, has skyrocketed this year - partially driven by expectations of further RMB depreciation. The Chinese authorities have recently tightened scrutiny on large overseas investments by domestic firms, which will likely lead to a notable slowdown in Chinese ODI in the near term.2 This week we take a closer look at the U.S. Treasury International Capital (TIC) system data and various other sources to check the evolution of China's official reserves and foreign assets. There are some important caveats. First, Chinese holdings of U.S. assets reported by the TIC are not entirely held by the People's Bank of China in its official reserves. Some assets, particularly corporate bonds and equities, may be held by Chinese institutional investors. Meanwhile, it is well known that in recent years China has been using offshore custodians in some European countries, the usual suspects being Belgium, Luxembourg and the U.K., which disguises the true situation of the country's official reserve holdings. Finally, China's large conglomerates owned by the central government also hold vast amounts of foreign assets, or "shadow reserves" that could be utilized to support the RMB if needed. Recently these state-owned giants were reportedly required by the government to repatriate some of their foreign cash sitting idle overseas to counter capital outflows. All of this suggests the resources available to the government are larger than the official reserve figures. With these caveats, this week's update reveals some important developments in the past year: Chinese foreign reserves have dropped by around US$400 billion since the end of 2015 to US$3.05 trillion, a level last seen in 2005 when the RMB was de-pegged from the dollar followed by a multi-year ascendance (Chart 1). China still holds the largest amount of foreign reserves in the world, but its global share has dropped to about 40%, down from a peak of over 50% in 2014. TIC data show Chinese holdings of U.S. assets declined by a mere US$100 billion in the past year, leading to a sharp increase in U.S. assets as a share of the country's total foreign reserves (Table 1). This could be attributable to mark-to-market "paper losses" of Chinese holdings in non-dollar denominated foreign assets, due to the broad strength of the greenback. It is also possible that China may have intentionally increased its allocations to U.S. assets due to heightened risks in other countries, particularly in Europe. Chinese holdings of Japanese government bonds also increased significantly this past year. Table 1Chinese Foreign Exchange Reserves Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chinese holdings of U.S. Treasurys have dropped by about US$100 billion in recent months, but holdings of some other countries suspected as China's overseas custodians have continued to rise (Chart 2). This could mean that Chinese holdings of U.S. assets could be larger than reflected in the TIC data. Chinese outward direct investments have continued to power ahead. Previously Chinese investments were heavily concentrated in commodities sectors and resource-rich countries. This year the U.S. has turned out to be the clear winner in attracting Chinese capital. Moreover, recent investment deals have been concentrated in consumer related sectors such as tourism, entertainment and technology industries. Chart 1Chinese Foreign Reserves##br## Have Continued To Decline bca.cis_sr_2016_12_15_c1 bca.cis_sr_2016_12_15_c1 Chart 2U.S. Treasurys: How Much ##br##Does China Really Hold? bca.cis_sr_2016_12_15_c2 bca.cis_sr_2016_12_15_c2 Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets", dated September 30, 2015, available at cis.bcaresearch.com Please see China Investment Strategy Weekly Report, “How Will China Manage The Impossible Trinity”, dated December 8, 2015, available at cis.bcaresearch.com China's official data shows that the country's total holdings of international assets have stayed flat at around US$6.2 trillion since 2014, including foreign exchange reserves, direct investment, overseas lending and holdings of bonds and equities. Official reserves have declined in recent years, but other holdings have jumped sharply. Reserves assets still account for over half of total foreign assets, but their share has continued to drop. In contrast, outward direct investment and overseas loans have gained significantly both in value terms and as a share of the country's total foreign assets. Chart 3 bca.cis_sr_2016_12_15_c3 bca.cis_sr_2016_12_15_c3 Chart 4 bca.cis_sr_2016_12_15_c4 bca.cis_sr_2016_12_15_c4 Despite the sharp decline, international investment positions by Chinese nationals, public and private combined, are still much more heavily concentrated in official reserve assets compared with other major economies. In other major creditor countries, outward direct investments and portfolio investments account for much larger shares than reserve assets. Official reserves in the U.S. are negligible. Chinese official reserves give the PBoC resources to maintain exchange rate stability, but they also lower the expected returns of the country's foreign assets. Encouraging domestic entities to acquire overseas assets directly has been a long-run policy. More recently, however, the authorities have been alarmed by the pace of Chinese nationals' overseas investment and have been taking restrictive measures. Chart 5 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Our calculations shows that Chinese total holdings of U.S. assets reached US$1.74 trillion at the end of September 2016, including Treasurys, government agency bonds, corporate bonds, stocks and non-Treasury short-term custody liabilities of U.S. banks to Chinese official institutions, based on the TIC data (Table 1, on page 2). Treasurys still account for the majority of the country's total holdings of U.S. assets, while bonds and stocks are relatively insignificant. China's holdings of U.S. assets as a share of total reserves declined between the global financial crisis and 2014, since when the trend has reversed. The share of U.S. asset holdings currently accounts for 55% of Chinese official reserves, compared with a peak of over 70% in the early 2000s and a trough of 46% in 2014. This could also be attributable to the sharp appreciation of the U.S. dollar against other majors. The U.S. dollar carries a 42% weight in the SDR (Special Drawing Rights of the International Monetary Fund), and it accounts for about 60% of total foreign reserves managed by global central banks. These could be two relevant benchmarks to gauge China's desired level of holdings of U.S. dollar-denominated assets in its official reserves. Chart 6 bca.cis_sr_2016_12_15_c6 bca.cis_sr_2016_12_15_c6 Chart 7 bca.cis_sr_2016_12_15_c7 bca.cis_sr_2016_12_15_c7 In terms of duration, the major part of Chinese holdings of U.S. assets is long-term (with maturity more than one year), mainly in the form of government and agency bonds, corporate bonds and stocks. Chinese holdings of short-term U.S. assets were minimal in recent years but picked up notably in the past few months, while longer term assets declined. During the global financial crisis in 2008/09, China massively increased its holdings of short-term U.S. assets, amid a global drive of "flight to liquidity" at the height of the crisis. Chart 8 bca.cis_sr_2016_12_15_c8 bca.cis_sr_2016_12_15_c8 Chart 9 bca.cis_sr_2016_12_15_c9 bca.cis_sr_2016_12_15_c9 In terms of risk classification, the majority of Chinese holdings of U.S. assets are risk-free assets, including Treasurys and government agency bonds. China's holdings of these assets have plateaued in recent years. As a share of China's total reserves, U.S. risk-free assets currently account for about 45%, down from about 65% in 2003. Meanwhile, its accumulation of U.S. risky assets, including stocks and corporate bonds, has increased sharply in the past year. Chart 10 bca.cis_sr_2016_12_15_c10 bca.cis_sr_2016_12_15_c10 Chart 11 bca.cis_sr_2016_12_15_c11 bca.cis_sr_2016_12_15_c11 China currently holds US$1.16 trillion of Treasurys, which account for over 80% of total Chinese holdings of U.S. risk-free assets, or 37% of total Chinese foreign reserves. Notably, Treasurys as a share of Chinese foreign reserves have been relatively stable, ranging between 30% and 40% over the past decade. This may be the comfort zone for the Chinese authorities' asset allocation to the U.S. government paper. China's holdings of U.S. government agency bonds have picked up in the past year, but are still significantly lower than at its peak prior to the U.S. subprime debacle. Its share in Chinese foreign reserves has declined to 8% from a peak of close to 30% in 2008. Chart 12 bca.cis_sr_2016_12_15_c12 bca.cis_sr_2016_12_15_c12 Chart 13 bca.cis_sr_2016_12_15_c13 bca.cis_sr_2016_12_15_c13 Almost the entire Chinese holding of Treasurys is parked in long-term paper (with duration of more than one year). China's possession of short-term Treasurys has been negligible in recent years, but picked up notably of late. It is possible that the Chinese central bank may be increasing cash holdings to deal with capital outflows. Chart 14 bca.cis_sr_2016_12_15_c14 bca.cis_sr_2016_12_15_c14 Chart 15 bca.cis_sr_2016_12_15_c15 bca.cis_sr_2016_12_15_c15 Chinese holdings of risky U.S. assets - corporate bonds and equities - account for over 10% of China's total foreign reserves, up sharply since 2008 after China established its sovereign wealth fund. China's holdings of risky assets are predominately equities, currently standing at about USD 325 billion, little changed in recent years. Its possessions of corporate bonds are very low. Chart 16 bca.cis_sr_2016_12_15_c16 bca.cis_sr_2016_12_15_c16 Chart 17 bca.cis_sr_2016_12_15_c17 bca.cis_sr_2016_12_15_c17 China remains the largest foreign creditor to the U.S. government. Chinese holdings of U.S. Treasurys account for about 11% of total outstanding U.S. government bonds, or around 20% of total foreign holdings of U.S. Treasurys, according to our calculation. About 55% of outstanding U.S. Treasurys are held by foreigners. China is also one of the largest foreign holders of U.S. of agency bonds. While its holdings only accounts for 3% of total outstanding agency bonds, they account for around 25% of the total held by foreigners. About 12% of agency and GSE-backed securities are currently held by foreigners. Chart 18 bca.cis_sr_2016_12_15_c18 bca.cis_sr_2016_12_15_c18 Chart 19 bca.cis_sr_2016_12_15_c19 bca.cis_sr_2016_12_15_c19 Chinese outward direct investments have continued to march higher in the past year, reaching yet another record high in 2015, and will likely set a new record in 2016. Total overseas direct investments amount to USD 1.4 trillion, equivalent to about half of China's official reserves. China's overseas investments have been heavily concentrated in resources-rich regions and industries. Cumulatively, the energy sector alone accounts for almost half of China's total overseas investments, followed by transportation infrastructure and base metals, which clearly underscores China's demand for commodities. China's outbound investment was originally led by state-owned enterprises. More recently, private Chinese enterprises have become more active in overseas investments and acquisitions. Chart 20 bca.cis_sr_2016_12_15_c20 bca.cis_sr_2016_12_15_c20 Chart 21 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Chart 22 Demystifying China's Foreign Assets Demystifying China's Foreign Assets Corporate China's interest in global resource space has waned in the past year. Total investment in energy space has plateaued in recent years. There has been a dramatic increase in investment in some consumer-related sectors, particularly in tourism, entertainment and technology. These investment deals are mainly driven by private enterprises, and also reflect the changing dynamics of the Chinese economy. The U.S. received by far the largest share of Chinese investment in 2016. Total U.S.-bound Chinese investment in the first half of the year already dramatically outpaced the total amount of 2015. Chinese investments in resource rich countries, such as Australia, Canada and Brazil have been much less robust. Chinese net purchase of Japanese government bonds (JGBs) increased sharply this year. In the eight months of 2016 China's net purchases of JGBs reached $86.6 billion, more than tripling the amount during the same period last year. Chinese cumulative net purchases of JGBs since 2014 reached JPY 14.5 trillion, or USD 140 billion. This amounts to 2% of total outstanding JGBs and 4% of Chinese official reserves. Chart 23 bca.cis_sr_2016_12_15_c23 bca.cis_sr_2016_12_15_c23 Chart 24 bca.cis_sr_2016_12_15_c24 bca.cis_sr_2016_12_15_c24 Chart 25 bca.cis_sr_2016_12_15_c25 bca.cis_sr_2016_12_15_c25 Cyclical Investment Stance Equity Sector Recommendations

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

Highlights Investors continue to overstate the constraints the Trump administration faces; Tax reform will happen, likely much sooner than the markets appreciate; Infrastructure spending will be modest, but will also face no constraints; Trump's de-globalization agenda - on both immigration and trade - faces few, if any, constraints; Book gains on long S&P 500 / short gold, long Japanese equities, long USD/JPY, and close long European versus global equities for a small loss. Maintain a long SMEs / short MNCs strategic outlook as a play on de-globalization. Feature "It used to be cars were made in Flint, and you couldn't drink the water in Mexico. Now, the cars are made in Mexico and you can't drink the water in Flint." - President-Elect Donald J. Trump, Flint, Michigan, September 14, 2016 Regular readers of BCA's Geopolitical Strategy know that our methodology emphasizes policymakers' constraints over their preferences. We abide by the simple maxim that preferences are optional and subject to constraints, while constraints are neither optional nor subject to preferences. President-elect Donald J. Trump is not unique. In the long term, his preferences will be cajoled and imprisoned by his constraints. However, investors may be overstating the impact of constraints in the short term. This is because Trump is a transformational - rather than merely transactional - leader whose election is a product of the yearning for significant change by the U.S. electorate.1 The key difference between the two leadership styles is that transformational leaders seek change by influencing and motivating their followers to break with convention. They make an appeal on normative and ideological grounds. Meanwhile, transactional leaders seek to maintain the status quo by satisfying their followers' basic needs. The latter use sticks and carrots, the former inspire. In the long term, even transformational leaders like Trump will be whipsawed by their material and constitutional constraints into the narrow tunnel of available options. But as we discuss in this Special Report, President-elect Trump will have a lot more room to maneuver than investors may think. That will be good for some assets, bad for others. Trump's Blue-Collar Base To understand the priorities of the Trump administration - as well his lack of political constraints - investors need to respect Trump's shock victory on November 8. Trump won the election because he was able to extend his "White Hype" strategy to the Midwest states of Ohio, Michigan, Wisconsin, and Pennsylvania (and came close to winning Minnesota) (Map 1).2 Map 1Electoral College Vote, Nov. 29, 2016 Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency To extend the Republican voting base into these traditionally "blue" states, Trump appealed to white blue-collar workers, many of whom voted for President Obama in 2012. Though he squeaked by with narrow vote-margins, he was not expected to be competitive in these states at all: Hillary Clinton did not visit Wisconsin once during her campaign (Chart 1). Trade was a chief concern of these disenchanted "Rust Belt" voters. Exit polls show that they agreed with Trump's message that globalization and neoliberal trade policies have sapped the U.S. of jobs, wages, and job security (Chart 2). Chart 1Hillary Failed To##br## Ride Obama's Coattails Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 2Trump's Winning Constituency##br## Angry About Trade Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Infrastructure, and government spending more broadly, were also major concerns - Trump's election was effectively an "anti-austerity" vote. Throughout the campaign Trump showed himself to be indifferent to budget deficits and debt, at least relative to the GOP leadership of the past six years. Instead he shattered GOP orthodoxy by promising to avoid any cuts to entitlement spending and contravened the party's fiscal hawks by promising to spend $1 trillion (later $550 billion) on infrastructure, e.g. the "bad drinking water" problem referred to in the quote at the start of this report. By contrast, Trump paid less attention to tax reform. Yes, he promised to slash taxes, even after reducing the scope of his extravagant September 2015 tax cut proposal. But no, this was not the focus of his campaign and did not get him elected. Instead, it is an area of common ground between himself and the GOP, and it has been the party's main pursuit in recent years. No one knows what Trump is going to do when he takes office. His statements are famously all over the place and he often positions himself at the opposite sides of a policy issue at the same time, prompting us to label him America's first "Quantum Politician."3 His cabinet is only beginning to take shape. Therefore, his main agenda and priorities - traditionally outlined in the upcoming Inaugural Address on January 20 - remain inchoate at best. Nevertheless, trade protections and better infrastructure were core demands of Trump's blue-collar electoral coalition and we expect him to follow through with actions, not least because he needs these states for upcoming elections in 2018 and 2020. Bottom Line: Trump's personal policy preferences are shrouded in mystery. However, investors should assume that he will take the preferences of the Midwest blue-collar voters seriously. They delivered him the presidency. Tax Reform The main reason for the market's exuberance since the election - aside from a "relief rally" given that the sky has not fallen4 - has been the prospect of substantial tax cuts. With Republicans holding all levels of government - and Democrats unable to filibuster tax reform in the Senate due to the "reconciliation procedure"5 - investors are rightly optimistic that the U.S. will finally see significant reforms. We review the plan, investigate its constraints, and assess the impact below. The Plan Trump is asking for much bigger tax cuts than the Republican Party's major alternative, House Speaker Paul Ryan's "A Better Way" plan.6 Trump would slash the corporate tax rate to 15% for all businesses, with flow-through businesses (80% of all U.S. businesses) eligible to pay the 15% rate instead of being taxed under the individual income tax rate (as currently).7 The GOP, by contrast, would set the corporate rate at 20% and the flow-through business rate at 25%. Trump and the GOP agree that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of Americans with an increase, or no change, to their marginal tax rate.8 Where Trump and the GOP differ is on how to handle deductions, the flow-through businesses, child tax credits, and other issues - with Trump generally more inclined toward government largesse. Another element of tax reform is the proposed repatriation tax on overseas corporate earnings. An estimated $2.6-$3 trillion is stashed "abroad" (often only in a legal sense), which enables companies to defer paying the corporate tax rate due upon repatriation. Trump is following in the footsteps of President Obama and presidential candidate Hillary Clinton in attempting to collect these taxes - with the Republicans also broadly on board.9 Overall, Trump's plan would cut taxes and tax revenues much more aggressively than the GOP plan. Trump would see $1.3 trillion more in personal tax cuts and $1.7 trillion more in corporate taxes than the GOP plan over the coming decade (Chart 3). The country's debt-GDP ratio would grow by 25%, well above the GOP's 10-12% increase (Chart 4). Chart 3Trump Would Outdo##br## The GOP On Tax Cuts Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 4Trump Would Outdo##br## The GOP On Debt Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency The Constraints We see no significant political or constitutional constraints facing the GOP and Trump. If we had to pick, we would assume that the ultimate deal will look a lot more like the GOP plan. The two sides will be able to hammer out a compromise for the following reasons: Given the reconciliation rules in the Senate, the Democrats cannot filibuster tax-cutting legislation. Both the Reagan and Bush administrations passed tax cuts in their first year in office - Reagan signed them into law in August, Bush in June. Trump, like Bush, has the advantage of GOP control of both houses of Congress. He and his party would have to fumble the ball very badly to fail on comprehensive tax reform in 2017. Republicans have been demanding tax reform since 2010 and have several "off-the-shelf" plans to draw from, including Ryan's plan. Staffers know the issues. Trump has also already reduced his original ambitions to meet them halfway. Since Trump's campaign did not focus on tax reform, he can afford to let the GOP take the lead on it - he will still get credit for the resulting deal and will expect GOP support on infrastructure, immigration, and trade in turn. The first constraint that does exist is complexity. Comprehensive tax reform has not occurred since 1986, under Reagan, because it is fiendishly tricky. This means the timing could be delayed - perhaps as late as the third quarter of 2017, despite the eagerness of both Congress and the White House for reform. The second constraint is one of priorities. Trump and the GOP have a busy agenda for the first half of 2017, with taxes, Obamacare, and Trump's infrastructure plan. Rumors suggest that Congress will use its first reconciliation bill to repeal Obamacare. But since they do not know what will replace the current law yet, it would make more sense to reverse the order and do tax reform first. This will be easier, again, because tax reform has been a major issue for Republicans for a decade. Third is the problem of permanence. Assuming the Republicans use reconciliation to pass their tax reform, they will not be allowed to increase the federal budget deficit beyond the ten-year time frame of the budget resolution. They will have to include a "sunset" clause on the tax cuts, as occurred with the Bush tax cuts in 2001, leaving them vulnerable to expiration under the next administration.10 The Impact What will a sweeping tax reform plan mean? Headline U.S. corporate taxes are higher than every other country in the OECD, so the U.S. corporate sector will ostensibly gain competitiveness (Chart 5). This factor, combined with repatriation and threats of protectionism against outsourcing multi-national corporates (MNCs), should lift corporate investment in the U.S. Chart 5U.S. Companies Will Get Competitive Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Reducing loopholes would broaden the corporate tax base, the key value of the reform from the perspective of revenues and the country's economic structure. Multinational corporations already pay a lower effective tax rate than the official 35% corporate rate, so the impact will depend on their current effective rate as well as the new rate. Trump's plan would only increase effective taxes for firms in the utilities sector, while the GOP plan could increase effective taxes for firms in finance, electronics, transportation, and leasing. In both cases, companies in construction, retail, agriculture, refining, and non-durable manufacturing stand to benefit the most (Chart 6). Chart 6Tax Cuts Benefit Some Sectors More Than Others Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency A key question is how flow-through businesses are treated: whether they get Trump's 15% or the GOP's 25%. In the latter case they would see a tax hike (from an average rate of 19%) and thereafter be punished relative to more capital-heavy "C" corporations. Trump is a "populist" insofar as his plan would support flow-through businesses. Bottom Line: The quickest and biggest impact of Trump's fiscal policies on GDP growth will come from his tax cuts. With the Republicans long preparing for tax reform, and fully controlling Congress, tax reform is all but a done deal - and probably by Q3 2017 at latest. The outstanding question is whether Trump's infrastructure spending will be included in tax reform and thus compound the positive fiscal impact in 2017, or be pushed off into 2018. Fiscal Spending Trump's proposed $550 billion in new infrastructure investment is as nebulous as many of his other promises. However, as outlined above, we believe that Trump's victory partly depended on this issue and investors should not ignore Trump's commitment to it. Constraints are overstated. The Plan Trump's first clear infrastructure proposal came from two of his special advisers, Wilbur Ross and Peter Navarro.11 They propose government tax credits for private entities who invest in infrastructure projects. They argue that $1 trillion in new infrastructure investment - the same number cited on Trump's campaign website as the country's estimated needs over the next decade - would require $167 billion in equity investment, which could then be leveraged. To raise these sums, they propose the government offer a tax credit equal to 82% of the equity amount. They contend that the plan would be deficit-neutral because payments for the government tax credit would be matched with tax revenues from the labor involved in construction and the corporate profits flowing from the projects, charged at Trump's 15% corporate rate. The other component of the Ross-Navarro plan consists in combining infrastructure financing with the tax repatriation plan - a common proposal in Washington. Companies that are repatriating their earnings at the lower 10% rate could thus invest in infrastructure projects and use the 82% tax credit on that investment to cover the cost of their repatriation taxes. If the Trump administration sticks with this proposal, it will require the GOP to include the infrastructure plan in the tax reform bill. Or, given the bipartisan support for both a new repatriation tax and building infrastructure, Trump could turn to the Democrats for a separate bill covering these two policies. However, the specifics of the Ross-Navarro plan can be chucked out the window at will. They were designed to win the election, not to bind the administration's hands. Already, Trump has reversed his stance on the possibility of a state-run infrastructure bank (one of Clinton's proposals) as a way of financing new projects. What matters is that Trump and his top advisors are enthralled by the idea of a populist or "big government"-style conservatism that takes advantage of historically low interest rates - the post-financial crisis "Keynesian" moment - to stimulate the economy and improve U.S. productivity in the long run.12 Trump's emphasis on this issue in his November 8 victory speech says it all. Thus Trump's infrastructure ambitions are likely to be prioritized and will certainly not be abandoned. Unless Trump drastically alters his handling of the issue on January 20 - which we consider highly unlikely - it should be considered a top priority. The Constraints What are the constraints? President Obama's stimulus plan passed in February 2009, immediately after taking office, but that was in the midst of a financial crisis. Now conditions are different. Infrastructure is popular, but the timing with the economic cycle is not perfect, and the fiscal hawks in the GOP will try to water down Trump's proposals. Our clients are particularly concerned that the Tea Party-linked Republicans in Congress will be a major political hurdle. We disagree. On the issue of funding, what is important for legislative passage is not whether the plan ends up being "deficit neutral" as promised, but whether it can be marketed as such. Key Republicans like Kevin Brady, chair of the House Ways and Means Committee, have already admitted that some of the revenues from repatriated earnings will go toward infrastructure. Public-private partnerships will give Republicans a way of presenting the project as deficit-friendly. And it is true that interest rates are low for borrowers (at least for now), including state and local authorities - which account for the clear majority of infrastructure spending in the U.S. Political constraints are few. Public support for infrastructure is a no-brainer, opinion polls show that the public wants better infrastructure (Chart 7). It is also one of the least polarizing issues of all the issues in a recent Pew survey (Chart 8). Chart 7The 'Right' Kind Of ##br##Government Spending: Infrastructure Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 8Infrastructure Is Not##br## A Partisan Issue Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Moreover, there is no reason to believe that modern Republican presidents are particularly fiscally austere - Nixon, Reagan, and the Bushes were not (Chart 9). And Republican voters are not so fearful of big government when their party is at the helm as when they are in opposition (Chart 10). Election results show that voters consistently approve of about 70% of local transportation funding initiatives, which means they vote in favor of higher taxes to receive better infrastructure (Chart 11). Chart 9Fact: Republicans Run Bigger Budget Deficits bca.gps_sr_2016_11_30_c9 bca.gps_sr_2016_11_30_c9 Chart 10No Ruling Party Fears Big Government bca.gps_sr_2016_11_30_c10 bca.gps_sr_2016_11_30_c10 What about the Tea Party? It is true that fiscal conservatives in the GOP are skeptical of Trump's infrastructure ambitions. The Tea Party and Freedom Caucus make up about 60 combined votes. However, Trump's combination of Eisenhower big-spending Republicanism and populism won the election and has therefore written austerity's obituary. Furthermore, voters identifying with the Tea Party voted for Trump in the Republican primaries, according to exit polls (Chart 12). Hesitancy to support Trump on ideological grounds even caused the former Chairman of the Tea Party Caucus, Tim Huelskamp (R-KS), to lose his primary election to a more Trump-friendly challenger. Given that all members of the House of Representatives must run for re-election in 2018 - with campaigning starting in merely 18 months - they will dare not oppose Trump for fear of being Huelskamped themselves. Chart 11The 'Right' Kind Of Tax Hike: Paying For Roads Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 12Trump Won The Tea Party Vote Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency The political winds against austerity were shifting even before Trump. In January 2015, the GOP-controlled Congress approved of "dynamic scoring," an accounting method that considers the holistic impact of budget measures - spending and/or tax cuts - on revenue and thus deficits.13 The GOP has also recently come close to readmitting "earmarks," legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011, but they have crept back in different guises (Chart 13). Republican members of Congress can hear the gravy train and are scrambling to ensure they get on board. They want to be able to ride the new wave of spending all the way back to re-election in their home districts. Chart 13Pork-Barrel Prohibition Is Ending Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Finally, if Congress takes up an infrastructure-repatriation tax bill separately from the more partisan tax cuts, Trump may be able to offset any holdout fiscal hawks with support from Democrats. In late 2015, Democrats and Republicans voted together on the first highway funding bill in ten years, with large margins in both houses, easily overwhelming dissent from the Tea Party and Freedom Caucus. Vulnerable Democrats in the now "Trump Blue" states of Michigan, Wisconsin, Pennsylvania, and Ohio will be particularly interested in crossing the aisle on any infrastructure spending legislation. The Impact What will be the size and impact of Trump's infrastructure spending? Currently his transition team says he will oversee $550 billion in new investments, albeit offering no details or timeframe. This would be 72% of Obama's 2009 five-year stimulus at a time when there is little or no output or unemployment gap. In other words, the plan is pro-cyclical stimulus that will likely end up generating "too much" growth at a time when inflation expectations are already rising and the output gap is closing. The downside could be a rate-hike induced recession in 12-18 months. In terms of its impact on debt levels, infrastructure spending is less of a concern. The federal share of that $550 billion - i.e. the size of the tax credit for private participants - is going to be much smaller. During the campaign Trump implied $1 trillion in new investments over ten years, but the federal tax credit would have been a "deficit neutral" $137 billion. Applying the same ratio, back of envelope, Trump now aims for a $75 billion tax credit for the $550 billion worth of projects. But there will also likely be other components to the plan, such as federal support for state and local debt-financed infrastructure. Thus the headline size of Trump's infrastructure plan is far bigger than the federal commitment. Still, investors should appreciate that despite its modest size, the plan marks a break from the austerity-focused past. Bottom Line: Trump's election signals an anti-austerity turn in U.S. politics from which the fiscal hawks in the GOP cannot hide. Trump will ultimately receive congressional support on infrastructure spending, possibly bipartisan, and this "Return of G" will mark an important inflection point in U.S. economic policy.14 Immigration Globalization is, broadly defined, the free movement of goods, services, capital, and people. Trump began his campaign in June 2015 with a blistering speech opposing illegal immigration. His anti-immigrant rhetoric ratcheted up from that point, but while the media focused on the alleged xenophobia of his comments, Trump's message was consistently focused on the economic downside of an "open borders" policy. Since the election, Trump's rhetoric on immigration has dramatically softened. The Plan There are two components of Trump's immigration plan as far as we can tell: deportation and border enforcement. On the first, Trump's primary goal is to terminate Obama's "two illegal executive amnesties," i.e. Deferred Action for Childhood Arrivals (DACA) and Deferred Action for Parents of Americans (DAPA).15 This means he opposes two programs that are already frozen. In addition, he has pledged to deport 2-3 million undocumented immigrants, emphasizing criminals and drug offenders. This is comparable to Obama's 2.5 million deportations from 2009-15, the highest clip on record. We expect Trump to accelerate the pace of deportations, but it is by no means clear that he will do so, or do so dramatically. There is as yet no clear plan to deal with high-skilled immigrants, especially those arriving on H-1B non-immigrant visas authorizing temporary employment. Trump has made conflicting statements regarding the H-1B program, saying he wanted to keep attracting highly skilled workers to the U.S. but also criticizing the program specifically during a debate. Trump's pick for the attorney general, Alabama Senator Jeff Sessions, is a big opponent of the program. There is considerable evidence that the H-1B program hurts the wages of domestic workers, particularly in the tech sector.16 As for Trump's notorious "border wall," it is shaping up to be a change in degree, not kind. The Clinton administration's "deterrence through prevention" policy, beginning in 1994, and the Secure Fence Act of 2006, have led to extensive fencing and wall construction along the border over the past two decades. Trump will seek to fill gaps, reinforce border barriers, and probably erect better fences near population centers as more visible signs of his achievements. But he will not be building a Great Wall of Trump. The Constraints There are no major constitutional constraints on any of the proposals, since Trump is reversing the Obama administration's illegal non-enforcement of existing immigration law.17 The chief constraint Trump faces when it comes to increasing the pace of deportations and building enhanced walling and fencing is the cost. The threat to make Mexico provide all the funds is going to be watered down in negotiations.18 Trump could increase the Department of Homeland Security's budget, which slowed from 12% annual growth under Bush to 2.7% under Obama. Presumably congressional opposition would not be too virulent given the purpose. But spending on immigration enforcement already outpaces that of all other federal law enforcement agencies combined. A bigger constraint is whether, after the border is "normalized," Trump will follow through on his promise to make a "determination" on what to do with the non-criminal illegal immigrants. This language implies that he is ultimately amenable to comprehensive immigration reform and even a path to citizenship - a proposal that has already passed the Senate in an earlier form. To pass such a comprehensive reform bill, however, Trump will need to work with the Democrats in the Senate as they can and will filibuster any immigration reform bill that does not have a path towards some form of amnesty for the immigrants in the country. What of the timing? Deportations can begin promptly upon taking office - the agencies are already capable. Increasing border enforcement and structures will likely go into his first fiscal 2018 budget request - we expect the GOP Congress to be receptive. As for broader immigration reform, these will be the slowest to materialize, if ever. Previous GOP immigration reform laws passed after the midterm elections in 1986 and 1990, so 2018 may be a useful marker. The Impact On the margin, less immigration into the U.S. should raise domestic wages, particularly for the two sectors where low-skilled immigrants are most likely to be employed: agriculture and construction. Bottom Line: Trump's immigration policy is hardly revolutionary, despite his campaign focus on the issue. He has few constraints to his announced policies, but they are likely to be unimpressive in scope. There are three potential risks to our sanguine view. First, Trump decides to deport all the 11 million illegal migrants in the country, causing considerable political and social unrest. Second, he actually means what he says about Mexico paying for the wall. Third, he tries to end the H-B1 high-skilled temporary workers program. Reforming the overall immigration process - including a possible pathway to citizenship - is constrained by Democrats' control of the Senate and will therefore likely proceed on a longer timeframe (perhaps even after 2020). Trade Trump's trade protectionism is the main risk to markets and global risk assets. His victory represents a true break with the past seventy years of ever-greater globalization (Chart 14). We have expected the trend of de-globalization since, at least, 2014. However, we are surprised how quickly the issue became the electoral issue. Chart 14Globalization Peaked Before Trump Globalization Peaked Before Trump Globalization Peaked Before Trump Investors now have to re-price numerous assets for the de-globalization premium. The Plan Trump has threatened to name China a currency manipulator on day one in office, impose a 45% across-the-board tariff on Chinese goods, and a 35% tariff on Mexican goods. He has committed to canceling the U.S.'s biggest trade initiative in the twenty-first century, the Trans-Pacific Partnership (TPP), and he has threatened to renegotiate NAFTA and withdraw from the WTO, leaving U.S. tariffs with nothing but Smoot-Hawley to keep them tethered to earth. Thus Trump's victory threatens to become not only the chief symptom of "peak globalization"19 but also a great aggravator of it and cause of further de-globalization going forward (Chart 15). Chart 15De-Globalization To Continue bca.gps_sr_2016_11_30_c15 bca.gps_sr_2016_11_30_c15 There are signs that Trump may act on his rhetoric and enact a radical change in U.S. trade policy. Two of his top advisers, Dan DiMicco and Robert Lighthizer, are outspoken economic nationalists and "China bashers." DiMicco has dedicated his life to fighting Chinese mercantilism and believes that the U.S. and China are "already in a trade war; we [the U.S.] just haven't shown up yet."20 Yet there are also signs that Trump intends only to drive a hard bargain, not start a trade war. For instance, he says his first action will be to rip up the TPP, but this deal has not been ratified and was internationally controversial because it excluded China (as well as U.S. allies Korea, Thailand, and the Philippines). Moreover, while Trump says he will deem China a currency manipulator on day one in office, this is largely a symbolic act that entails no automatic, concrete punitive measures.21 Therefore Trump could take these two actions alone, or other symbolic ones, to prove that he is an economic patriot, and then settle down to "renegotiate" key trade relationships along the lines of the status quo. It is too soon to draw conclusions, but we do not think things will turn out as peachy as the best-case scenario. This is in large part due to the fact that the U.S. president has tremendous leeway on trade. The Constraints The U.S. president has few constraints when it comes to trade policy, for the following reasons:22 Delegated powers from Congress: Congress is the constitutional power that governs trade with foreign states. However, Congress passes laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies. Even when Congress approves a trade deal like NAFTA, it is the president who is empowered to lower tariffs - and therefore the president can issue a new proclamation raising them. The past century has produced a series of laws that give Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917 (Table 1).23 A president's legal advisors are only too happy to use their imaginations. Nixon invoked the Korean War, which ended in 1952, as a justification for a 10% surcharge tariff on all dutiable goods in 1971, simply because the Korean state of emergency had never officially ended! Table 1Trump Faces Few Constraints On Trade Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Executive power over foreign policy: The executive branch is the constitutional power that governs foreign relations. Since international economics are inseparable from foreign relations and national security, the president has prerogative over matters even remotely touching trade. Both Congress and the judicial branch will tend to defer to a president in exercising these powers as well - at least until a gross subversion of national interest occurs. And even then, it is not clear how the constitutional struggle would play out - the courts always bow to the executive on matters of national security. Wars do not have to be declared for wartime trade powers, so all the U.S.'s various military operations across the world provide fodder for Trump to invoke the Trading With The Enemy Act, giving him power to regulate all forms of trade and seize foreign assets. Time is on the executive's side: Even assuming that Congress or the Supreme Court move to oppose the executive, it will likely be too late to avoid serious ramifications and retaliation from abroad. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress.24 As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. The Impact Trump is deeply committed to a tougher trade stance, has few constraints, and his protectionism deeply resonated with key swing voters. We doubt he will settle for cosmetic changes and the establishment Republican "business as usual." This means China relations are a major risk, especially in the long run. We will expand on these tensions, which will become geopolitical, in an upcoming report. What happens if Trump pursues protectionism wholeheartedly? First, the good. On the margin, some trade protections could attract foreign companies to relocate to the U.S. and discourage American companies from outsourcing - boosting investment and wages. It could also help slow the decline of American manufacturing employment. A simple comparison with Europe and Japan shows that the decrease of manufacturing jobs has been more dramatic in the U.S., so policy may be able to conserve what is left (Chart 16). Second, the bad. All the developed countries have seen manufacturing jobs decrease, and not only because of globalization. Technological advancement has played a major role as well. You can block off foreign goods, but you cannot roll back the march of the automatons (Chart 17), as our colleagues at U.S. Investment Strategy recently pointed out.25 Trump's blue collar workers may realize, after four years of protectionism that jobs are not coming back while the WalMart bills are getting pricier. Who will they vote for after that realization sets in? Chart 16U.S. Manufacturing Decline##br## Sharper Than In Other DM U.S. Manufacturing Decline Sharper Than In Other DM U.S. Manufacturing Decline Sharper Than In Other DM Chart 17Reasons For Robots##br## To Replace Workers Reasons For Robots To Replace Workers Reasons For Robots To Replace Workers Third, the ugly. If the U.S. goes protectionist, it will pull the rug out from neoliberalism globally and provide cover for similar protectionist realignments around the world - retaliatory as well as copy-cat. A falling tide lowers all boats. Worse than that, the decline in trade, insofar as it forces countries to rely on domestic markets, pursue spheres of influence, and protect access to vital commodities, could spark military conflict. Germany and Japan both started World War II precisely because their autarkic fantasies required expansion and pre-emptive warfare. This would be the mercantilist future that we warned clients of earlier this year.26 None of this is a foregone conclusion. There is simply too little information to judge which way the Trump administration will go - and how fast. But the fact remains that on trade, more so than anything else, Trump will be unconstrained. Bottom Line: De-globalization is the major risk of the Trump presidency.27 How Trump handles relations with China in 2017 will be the key indicator of whether he aims to revolutionize U.S. trade policy to the detriment of global exports and growth. If he blows past the rule of law and imposes steep "retribution" tariffs or quotas right away, then fasten your seat belt. Investment Conclusions For several years we have warned clients that austerity is kaput.28 It was never politically sustainable in the post-Debt Supercycle, low -growth environment that followed the 2008 Great Recession. The pendulum is swinging hard the opposite way, with Trump's heavy-handed, somewhat haphazard approach, adding momentum. Once the U.S. moves against austerity, we expect policymakers in other countries to follow. In the near term, the carnage in long-dated Treasury markets may pause as investors overthink the constraints to "G." Bond yields have already moved quite a bit. Structurally, however, the 35-year bond bull market is over.29 We continue to recommend that clients play the 2-year/30-year Treasury curve steepener, a position that is in the black by 11.2 basis points since November 1. In the long term, Trump's anti-globalization policies will impact investors the most. More protectionism, less immigration, and dollar-bullish fiscal policies will all be negative for America's MNCs. Meanwhile, fiscal spending, a stronger USD, and corporate tax reform that benefits small and medium enterprises (SMEs) paying the high marginal tax rate will benefit Main Street. As such, the way to play de-globalization in the U.S. is to go long SMEs / short MNCs, a view that we will expand upon in an upcoming collaborative report with BCA's Global Alpha Sector Strategy. Beyond the U.S., de-globalization will favor domestic consumer-oriented sectors and countries and will imperil international export-oriented sectors and countries. We particularly fear for export-heavy emerging markets, which depend on globalization for both capital and market access. Developed markets should have an easier time transitioning into a more protectionist world. As such, we continue to recommend a structural overweight in DM versus EM. For the time being, we are booking gains on our long S&P 500 / short gold trade, for a gain of 11.53% since November 8, due to our concern that equities may have already priced-in the lifting of animal spirits but not the negatives of de-globalization. Near term risk also abounds for our high-beta positions such as our long Japanese equities trade (gain of 3.99% since initiation on September 26) and long USD/JPY (gain of 3.57%, same initiation day). We will book gains and look to reinitiate both at a later date, given that our positive view on Japan remains the same. We will also close our long European versus global equities view, for a small loss of 1.34%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 3 In physics, the Heisenberg's uncertainty principle - fundamental to quantum mechanics - supposes that the more precisely the position of a particle is determined, the less precisely its momentum can be known. Trump does not merely "flip flop" on policy issues - as his opponent Secretary Hillary Clinton was often accused of doing - but literally embodies two opposing policy views at the same time. 4 #TrumpisnotLucifer. 5 Reconciliation is a legislative process in the U.S. Senate that limits debate on a budget bill to twenty hours, thus preventing the minority from using the filibuster to veto the process. The procedure has also been used to enact tax cuts. In both 2001 and 2003, the Republican-held Senate used the procedure to pass President George W. Bush's tax cuts. 6 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. For analysis, please see Jim Nunns et al, "An Analysis of the House GOP Tax Plan," Tax Policy Center, September 16, 2016, available at www.taxpolicycenter.org. 7 A "flow-through" entity passes income on to the owners and/or investors. As such, the business can avoid double taxation, where both investors and the business are taxed. Only the investors and owners of a flow-through business are taxed on revenues. 8 Several groups would see no substantial tax cuts under the plan. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 9 A favorable rate of 10% (4% for non-cash assets) will be applied to accumulated earnings prior to 2017, while future overseas earnings will be subject to the corporate tax rate of 15%. The Tax Policy Center projects that $148 billion worth of unpaid tax revenue can be collected through the "deemed" (mandatory) repatriation. 10 The Bush tax cuts were extended in the American Taxpayer Relief Act of 2012, with some exceptions, like for the highest income groups. 11 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. The Trump campaign initially implied a decade-long total investment of $1 trillion "Trump Infrastructure Plan," with the government contributing a seed amount. The $1 trillion infrastructure-gap estimate comes from the National Association of Manufacturers, "Build to Win," dated 2016, available at www.donaldjtrump.com. The Trump team has reduced its total infrastructure investment goal to $550 billion, a number reaffirmed on Trump's White House transition website, www.greatagain.gov. 12 Please see Daniella Diaz, "Steve Bannon: 'Darkness is good,'" CNN, November 19, 2016, available at edition.cnn.com. Bannon, Trump's chief strategist, said: "Like (Andrew) Jackson's populism, we're going to build an entirely new political movement ... It's everything related to jobs. The conservatives are going to go crazy. I'm the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it's the greatest opportunity to rebuild everything. Shipyards, iron works, get them all jacked up. We're just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution - conservatives, plus populists, in an economic nationalist movement." 13 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. However, there is no reason why Republicans, under Trump, could not use the methodology for infrastructure spending as well. 14 Please see BCA Geopolitical Strategy Monthly Report, "Nuthin' But A G Thang," dated August 12, 2015, available at gps.bcaresearch.com. 15 By these executive orders, the Obama administration sought to prioritize the deportation of "high-risk" illegal immigrants while delaying action on more sympathetic groups. However, only one program was actually implemented (DACA), and both ground to a halt when the Supreme Court ordered an injunction. The justices concurred with lower courts that halted the programs as a result of the burden they would place on state finances. 16 Please see BCA Geopolitical Strategy Special Report, "Immigration Wars: The Coming Battle For Skilled Migrants," dated March 13, 2013, available at gps.bcaresearch.com. 17 The courts have already done the heavy lifting. Moreover the nullification of DACA only makes illegal immigrant children eligible for deportation, it does not necessitate that Trump actually deport them - that would require increasing the budget and capacity of Immigration and Customs Enforcement to cope with an additional four million deportees, all "low risk" and politically sympathetic. We doubt Trump will do this. 18 If Trump acts on his promise to make Mexico pay for the wall - a claim notably missing from his transition website greatagain.gov - then he may need to precipitate a foreign policy crisis (not to mention court opposition) through his own series of controversial executive orders. Alternatively, he could try to get Congress to amend the Patriot Act to allow the U.S. to extract payments from remittances from the U.S. to Mexico, but he would be at risk of a Senate filibuster. Both pose significant constraints. 19 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 20 Please see Lisa Reisman, "Nucor Provides Testimony To US House Ways And Means Committee On China Exchange Rate Policy," Metal Miner, September 16, 2010, available at www.agmetalminer.com. 21 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 22 In what follows we are indebted to an excellent paper by Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 23 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 24 A Federal District Court and the Supreme Court ruled against Harry Truman's executive orders to seize steel mills during the Korean War, but Truman's lawyers did not provide a statutory basis for his actions - they simply argued that the constitution did not limit the president's powers! 25 Please see BCA U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," dated November 14, 2016, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Monthly Report, "Austerity Is Kaput," dated May 8, 2013, available at gps.bcaresearch.com. 29 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.

Recommended Allocation Monthly Portfolio Update Monthly Portfolio Update The Meaning Of Trump Sudden large shocks in markets are rare. But the election of Donald Trump as U.S. President is one such. After a shock of this magnitude, markets tend initially to overreact, then correct, before settling on a new course. Market action since November 9th has caused many asset prices to overshoot short term. It is likely that U.S. bond yields, inflation expectations, the performance of bank and materials stocks, and the U.S. dollar (Chart 1) will correct over the next month or so, perhaps triggered by the Fed's likely rate hike on December 14th or simply by shifting expectations for Trump's economic policies. But what is the likely long-term course, which should set our asset allocation for the next 6 to 12 months? We think investors should take Trump at least partly at his word when he says he will enact tax cuts and increase infrastructure investment. BCA's Geopolitical Strategy service sees few constraints on Trump from Congress in the short term.1 The OECD in its latest Economic Outlook has given its imprimatur, arguing that "a stronger fiscal policy response is needed," and estimating that U.S. fiscal stimulus could add 0.1 percentage point to global growth next year and 0.3 points in 2018.2 If such a policy boosted growth and inflation, it would be negative for bonds. The only question, with 10-year U.S. Treasury bond yields having already risen by almost 100 bps since July, is how much of this is priced in. In the long run, government bond yields are broadly correlated with nominal GDP growth (Chart 2). In H1 2016, U.S. nominal GDP growth was 2.7%, and for 2016 as a whole probably about 3.2%. If it picks up to 4-5% in 2017 (2.5-3% real, plus inflation of 1.5-2%), an additional rise of 50-100 bps in the 10-year yield would not be surprising (though ECB and BoJ asset purchases might somewhat limit the rise in yields). Moreover, growth was already accelerating before Trump's victory. The effects of 2015's commodity shock and industrial and profits recessions have passed, with U.S. Q3 GDP growth revised up to 3.2% and the Fed's NowCasting models suggesting 2.5%-3.6% for Q4. The Citi Economic Surprise Index has surprised on the upside in recent weeks both in the U.S. and Europe - though not in emerging markets (Chart 3). And the Q3 earnings season in the U.S. was well above expectations, with EPS coming in at +3.3% YoY (compared to a consensus forecast pre-results of -2.2%). Analysts' forecasts for 2017 EPS growth are a comparatively modest 11%. Chart 1Some Short-Term Overshoots bca.gaa_mu_2016_11_30_c1 bca.gaa_mu_2016_11_30_c1 Chart 2Bond Yields Relate To Nominal Growth bca.gaa_mu_2016_11_30_c2 bca.gaa_mu_2016_11_30_c2 Chart 3Growth Was Already Surprising On The Upside Growth Was Already Surprising On The Upside Growth Was Already Surprising On The Upside But whether this new world will be positive for equities is harder to answer. Trump's unpredictability raises policy uncertainty: how much emphasis, for example, will he put on trade protectionism or confrontational foreign policy? This should raise the risk premium. The Fed's response will also be key. Futures have now priced in the rate hike in December and (almost) the two further rate hikes in the Fed's dots for 2017 (Chart 4). But the market still sees the long-term equilibrium rate (as expressed in five-year five-year forwards) as only just over 2%, compared to the Fed's 2.9%. And, although Janet Yellen has suggested that the Fed will act only after Trump's policies take effect ("We will be watching the decisions that Congress makes and updating our economic outlook as the policy landscape becomes clearer," she said), if core PCE inflation continues to pick up in 2017 beyond the current 1.7% and a strong stimulus package is implemented, the Fed might accelerate its rate hikes. More worryingly, Trump's fundamental views on monetary policy are unknown: does he, as a businessman, like low rates, or will he listen to his "hard money" advisers who believe the Fed has been too lax? Since he can appoint six FOMC governors in his first year in office, he will be able to influence monetary policy. Too fast a rise in Fed rates would be negative for equities. On balance, in this environment we see equities outperforming bonds over the next 12 months. It is unusual for the stock-to-bond ratio to decline outside of a global recession (Chart 5) - and, with the extra boost from fiscal policy (with Trump possibly joined by Japan, the U.K., China and others), a recession is unlikely over our forecast horizon. Chart 4Market Has Priced In 2017 Fed Hikes - ##br##But Not The Long-Term bca.gaa_mu_2016_11_30_c4 bca.gaa_mu_2016_11_30_c4 Chart 5Stocks Don't Often ##br##Underperform Outside Recession bca.gaa_mu_2016_11_30_c5 bca.gaa_mu_2016_11_30_c5 Accordingly, we are raising our recommendation for global equities to overweight, and lowering bonds to underweight. The problem is timing: we recognize that there may be a better entry point over the next couple of months. Some investors may, therefore, want to implement the change gradually. In addition, some recent market moves are not fundamentally justified: for example, we cannot see how the materials sector would be a significant beneficiary from a Trump fiscal stimulus. We plan to make further detailed adjustments to our equity country and sector recommendations and bond-class recommendations in the next Quarterly Portfolio Update, to be published on December 15th. Currencies: Stronger U.S. growth and tighter monetary policy suggest that the USD will continue to appreciate. The dollar looks somewhat expensive but is still well below the peak of overvaluation at the end of previous bouts of strength in 1985 and 2002. The Bank of Japan's policy of capping the 10-year JGB yield at 0% has worked well (pushing the yen down by 12% against the dollar in the past two months) and, as rates elsewhere rise, this implies further long-run yen weakness. The euro is likely to weaken less, with eurozone growth recently surprising on the upside and the ECB therefore likely to reconsider the amount of asset purchases at some point next year, though probably not at its meeting on December 8th. Emerging market currencies continue to look particularly vulnerable. Equities: In common currency terms, U.S. equities are more attractive than European ones. In local currency terms, however, the call is closer since the strong dollar will depress U.S. earnings relative to those in Europe, and an acceleration of global economic growth should help the more cyclical eurozone stock market. On the other hand, Europe faces structural issues, such as the chronically poor profitability of its banking system, and political risk from a series of upcoming elections (starting with the Italian referendum on December 4th). We continue to like Japan (on a currency hedged basis) and expect that the BoJ's policy will be bolstered by government fiscal and employment policies. We remain underweight on emerging markets. They have always been vulnerable during periods of dollar strength, and political side-effects from their bout of economic weakness in 2011-5 are starting to spread, recently to Turkey, Malaysia, India, Brazil, Korea and South Africa. Fixed Income: The risk of tighter Fed policy and higher yields suggest investors should remain underweight duration. We have liked U.S. TIPS over nominal bonds all year and, with 10-year breakeven inflation still only at 1.8%, they remain attractive in the current environment. We reduced high-yield bonds to neutral on September 30th, on the grounds that investors were no longer being sufficiently compensated for default risk: they have subsequently given -3% return, while equities rallied. We recommend investment grade credits for those investors who need to pick up yield (Chart 6). Commodities: After the OPEC agreement on production cuts, we expect the oil price to move towards $55 in the first few months of 2017 as inventories are drawn down. Over the longer run the risk is to the upside as a dearth of new projects, following cancellations last year, will tighten the supply/demand balance. Metals prices have strengthened since Trump's victory, with the CRB Raw Industrials Index up sharply (Chart 7). This makes little sense. Trump's stimulus will be centered on tax, not infrastructure. China remains a far more important factor: the U.S. represented only 7% of global steel consumption in 2015, for example, compared to 43% for China. And China's recent stimulus is running out of steam. Chart 6Yield On Investment Grade Credits ##br##Still Attractive Yield On Investment Grade Credits Still Attractive Yield On Investment Grade Credits Still Attractive Chart 7Trump Shouldn't Have ##br##This Much Effect On Metals Prices bca.gaa_mu_2016_11_30_c7 bca.gaa_mu_2016_11_30_c7 Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com 1 Please see Geopolitical Strategy Special Report,"U.S. Election: Outcomes and Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see OECD Global Economic Outlook, November 2016, available at http://www.oecd.org/economy/outlook/economicoutlook.htm. Recommended Asset Allocation

Highlights Investors are betting that Trump's expansionary agenda will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. We doubt that Trump's fiscal and regulatory plan will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place. We expect that Trump will find most common ground with Congress on the fiscal side. It will be difficult, politically, for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform. We expect a meaningful fiscal stimulus package to be passed in the U.S. that will boost growth temporarily. We cannot rule out a trade war that more than offsets the fiscal impulse. Nonetheless, Trump's desire for growth means that he may tread carefully on protectionism. A window may open next year that will favor risk assets for a period of time. A temporary U.S. growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Our bias is to upgrade risk assets to overweight, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new Administration's policy intentions. In the meantime, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. The bond selloff is likely to pause until there is more concrete evidence that Congress will accept tax cuts and infrastructure spending, but global yields eventually have more upside potential. Value and relative monetary policies favor the Japanese and European stock markets versus the U.S., at least in local currencies. We are less bearish on high-yield bonds in relative terms, although we are still slightly below-benchmark. Feature Initial fears that a Trump victory would be apocalyptic for the economy and financial markets quickly morphed into an equity celebration on hopes that the Republican sweep would usher in policies that will shift American growth into high gear. Major U.S. stock indexes have broken above recent trading ranges, despite the surge in the dollar and the devastation in bond markets. Investors are betting that Trump's expansionary policies will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. In the meantime, investors should remain long the dollar and short duration within bond portfolios, although a near-term correction of recent market action appears likely. Our geopolitical strategists argued through the entire campaign that Trump had a better chance of winning than the consensus believed because he was riding a voter preference wave that is moving left. Trump campaigned as an unorthodox Republican, appealing to white, blue collar voters by blaming globalization for their job losses and low wages, and by refusing to accept Republican (GOP) orthodoxy on fiscal austerity or entitlement spending. Chart I-1Big Government Is Only ##br##A Problem For The Opposition bca.bca_mp_2016_12_01_s1_c1 bca.bca_mp_2016_12_01_s1_c1 The polarization of U.S. voters and comparisons with the U.K. Brexit vote are well trodden themes that we won't rehash here. The important point is that the GOP now holds both the White House and Congress. The investment implications hinge critically on how friendly Congress is to Trump's policy prescriptions. Many pundits argue that House and Senate Republican's will block Trump's ambitious tax cut and infrastructure spending plan because it would blow out the budget deficit. The reality is more complex. It will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Our post-election Special Report pointed out that, over the past 28 years, each new president has generally succeeded in passing their signature items.1 Moreover, the GOP is less fiscally conservative than is widely believed. Fiscal trends under the Bush and Reagan administrations highlighted that Republicans do not always keep spending in check (Chart I-1). The key pillars of Trump's campaign were renegotiating trade deals, immigration reform, increased infrastructure and defense spending, tax cuts, protecting entitlements, repealing Obamacare and reducing regulations. However, there is a big difference between election promises and what can actually be delivered. It is early going, but our first Special Report, beginning on page 19, presents a Q&A from our geopolitical team on what we know in terms of political constraints and possible outcomes in the coming year. Common Ground On Fiscal Policy We expect that Trump will find most common ground with Congress on the fiscal side. Infrastructure spending has bipartisan support, as highlighted by last year's highway funding bill. Democratic senators and House Republicans have promised to work with the new President on infrastructure spending. Trump is likely to offer tax reform in exchange for his infrastructure plan. Trump wants to cut the top marginal corporate tax rate (from 39.6% to 33%), repeal the Alternative Minimum Tax, and slash the corporate tax rate (from 35% to 15%). His plan also includes increased standard deduction limits and a full expensing of business capital spending. The Tax Policy Center estimates that Trump's tax plan alone would increase federal debt by $6.2 trillion over the next ten years (excluding additional interest).2 An extra $1 trillion in infrastructure outlays over the next decade, together with a growing defense budget, could add another $100-$200 billion to total federal spending per year. The problem, of course, is that few sources of new revenue have been suggested to cover the costs of these policy changes. The Tax Policy Center's scoring of the Trump plan implies a jump in the U.S. debt/GDP ratio from 77% today to 106% in 2026. Other studies claim that the budget damage will be far less than this because government revenues will boom along with the economy. We doubt that will be the case. The outlook for U.S. trade policy is even more nebulous. Trump has threatened to kill the Trans-Pacific Partnership (TPP), renegotiate the North American Free Trade Agreement (NAFTA) and potentially place tariffs of 35% and 45%, respectively, on imports from Mexico and China (among other protectionist measures). He has even threatened to take the U.S. out of the WTO.3 These threats are no more than posturing ahead of negotiations, but Trump needs to show his base of support that he is working to "make America great again". Protectionism will probably generate more pushback from Republicans in the House and Senate than Trump's fiscal measures. The Economic Implications Of Trumponomics Table I-1Ranges For U.S. Fiscal Multipliers December 2016 December 2016 In terms of the overall economic impact, there are many moving parts and it is unclear how much the Trump Administration will push fiscal stimulus versus trade protectionism. As discussed in the Special Report, it is possible that the tax cuts will be implemented as quickly as the second quarter of 2017, while infrastructure spending could begin ramping up in the second half of the year. However, we cannot rule out a lengthy bargaining process that would delay the economic stimulus into 2018. We doubt that Trump will get everything on his wish list. Moreover, the multiplier effects of tax cuts, which will benefit the upper-income classes the most, are smaller than for direct government spending (Table I-1). Nevertheless, even if he gets one quarter of what he is seeking, it could be enough to boost aggregate demand growth by up to 1% per year over a two year period. In terms of trade, Trump will undoubtedly kill the TPP immediately following his inauguration to show he means business. The President also has the power to implement tariffs without Congressional consent. It is unclear whether he can also cancel NAFTA unilaterally, but at a minimum he can impose higher tariffs and trade restrictions on Canada and Mexico. Nonetheless, comments from his advisors suggest that president-elect Trump wants stronger growth above all else. This means that he may tread carefully to avoid the negative growth effects of a trade war. Some high-profile studies of the impact of the Trump economic plan paint a grim picture. The Peterson Institute points out that "withdrawal from the WTO would lead to the unraveling of all tariff negotiations and the reversion of rates to the MFN level of a preexisting agreement, conceivably all the way back to the Smoot-Hawley rates that were in effect in 1934." Another Peterson study reported the results of a simulation of the impact of returning to the Smoot-Hawley tariff levels, using a large general equilibrium global model.4 They find that U.S. real GDP would contract by about 7½%, or roughly $1 trillion. Thus, a "doomsday trade scenario" is possible, but it seems inconceivable that Trump would withdraw from the WTO given his desire for growth. More likely, he will settle for higher tariffs placed on Mexico and China. Such tariffs would undermine U.S. growth on their own, but we believe that some recent studies discussed in the press overstate the negative impact of these tariffs. Back-of-the-envelope estimates suggest that the tariff increases would reduce U.S. real GDP by roughly 1.2%, including retaliation by Mexico and China in the form of higher tariffs on U.S. exports (see Box I-1 for more details). The negative shock would likely be stretched over a couple of years.5 Box 1 Importantly, not all of any tariff increase would be "passed-through" to U.S. businesses and households. Studies show that, historically, the pass-through of tariff increases into U.S. prices was actually quite low, at about 0.5. A large portion of previous tariff hikes have been absorbed by foreign producers as they endeavored to protect market share. This means that a 35% tariff on Mexican imports would result in a roughly 17½% rise in import prices from Mexico. A 45% tariff on Chinese goods would result in a 22½% rise in import prices from China. Moreover, the import price elasticity of U.S. demand, or the sensitivity of U.S. demand to a change in the price of imported goods, is estimated to be about 1. That is, a 22½% rise in import prices from China leads to a 22½% drop in import volumes from that country. Roughly one-half of the drop in imports is replaced by purchases from other countries and one-half from U.S. sources. This so-called "expenditure switching" effect actually boosts U.S. real GDP on its own. Of course, this lift is more than offset by the fact that households and businesses suffer a loss of purchasing power due to higher import prices. Chinese and Mexican imports represent 2.7% and 1.7%, respectively, of U.S. GDP. With these figures and the elasticities discussed above, we can calculate a back-of-the-envelope estimate of the impact of the Trump tariffs. The expenditure switching effect would boost U.S. real GDP by about 0.4%. This is offset by the purchasing power effect of -0.7% (including a multiplier of 1.5), leaving a net loss of only 0.3%. Of course, China and Mexico will retaliate by imposing higher tariffs on U.S. exports. This has a larger negative impact on the U.S. because American export volumes decline and there is no offsetting expenditure-switching effect. We estimate that retaliation with equal tariffs on U.S. exports would reduce U.S. GDP by about 1% using reasonable elasticities. Adding it all up, the proposed Trump tariffs on China and Mexico would result in a roughly 1.2% hit to U.S. real GDP. This could overstate the negative shock to the extent that the tariff revenues are spent by the U.S. government.6 Moreover, some studies of the Trump agenda assume that business spending would wither under a stronger dollar, waning business confidence and higher interest rates. We are not so pessimistic. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. Moreover, U.S. corporate capital spending has been lackluster since the Great Recession due to "offshoring". Higher tariffs would promote "onshoring", helping to lift capital spending within the U.S. economy. We are not arguing that trade protectionism will be good for the U.S. economy. We are merely pointing out that there are positive offsets to the negative aspects of protectionism, and that many studies are overly pessimistic on the impact on growth. That said, all bets are off if Trump does the unthinkable and cancels NAFTA outright and/or takes the U.S. out of the WTO. The Fed's Reaction The economic and financial market dynamics over the next couple of years depend importantly on how the Fed responds to the Trump policy mix. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked the Fed Chair and current monetary policy settings. A review of the Fed may happen at some point, but we assert that an investigation will not be a priority early in Trump's mandate. Some have raised concerns that Trump could stack the FOMC with hawks when he fills the openings next year. More likely, he will opt for doves because he will not want a hawkish Fed prematurely shutting down the expansion. The studies that warn of a major U.S. recession under Trump's policies assume that the Fed tightens aggressively as fiscal stimulus lifts the economy's growth rate. For example, the Moodys' report assumes that the fed funds rate rises to 6½% by 2018!7 No wonder Moodys' foresees a downturn that is longer than the Great Recession. No doubt, it would have been better if fiscal stimulus arrived years ago when there was a substantial amount of economic slack. With the economy close to full employment today, aggressive government pump-priming could set the U.S. up for a typical end to the business cycle; overheating followed by a Fed-induced recession. Indeed, many investors are wondering if the U.S. is overdue for a recession anyway. The current expansion phase is indeed looking long-in-the-tooth by historical standards. However, the old adage is apt: "expansions don't die of old age, they are murdered by the Fed". In Charts I-2A, Chart I-2B and Chart I-2C, we split the U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from the medium and long expansions is the speed by which the most cyclical parts of the economy accelerate, and the time it takes for the unemployment rate to reach a full employment level. Long expansion phases were characterized by a drawn-out rise in the cyclical parts of the economy and a slow return to full employment in the labor market, similar to what has occurred since the Great Recession (Chart I-2C). Chart I-2ALong bca.bca_mp_2016_12_01_s1_c2a bca.bca_mp_2016_12_01_s1_c2a Chart I-2BMedium Expansions bca.bca_mp_2016_12_01_s1_c2b bca.bca_mp_2016_12_01_s1_c2b Chart I-2CA Short Expansion bca.bca_mp_2016_12_01_s1_c2c bca.bca_mp_2016_12_01_s1_c2c Of course, the Fed did not begin to tighten policy immediately upon reaching full employment in the past. The Fed began hiking rates an average of 13 months after reaching full employment in the short cycles, 30 months for medium cycles, and more than 60 months in the "slow burn" expansions (Table I-2). Even if we exclude the 1960s expansion, when the Fed delayed for too long and fell behind the inflation curve, the Fed has waited an average of 45 months before lifting rates in the other long expansions (beginning in 1982 and 1991). The longer delay compared to the shorter expansions reflected the slow pace at which inflationary pressures accumulated. During these periods, inflation-adjusted earnings-per-share (EPS) expanded by an average of 25% and the real value of the S&P 500 index increased by 28%. Table I-1U.S. Expansions Can Last Long After Full Employment Is Reached December 2016 December 2016 The lesson is that risk assets can still perform well for a long time after the economy reaches full employment. Admittedly, however, equity valuation is more stretched today than was the case at similar points in past long cycles. Before the U.S. election, the current expansion appeared to be heading for a similar long, drawn-out conclusion. Inflationary pressures are beginning to emerge, but only slowly, and from a low starting point. Moreover, evidence suggests that the Phillips curve8 is quite flat at low levels of inflation. This implies that the Fed has plenty of time to normalize interest rates because inflation is unlikely to surge. However, a sea change in trade and fiscal policy could change the calculus. To the extent that fiscal stimulus is front-loaded relative to trade protection, and that any trade restrictions add to inflation, Trump's policy agenda could force the Fed to normalize rates more quickly. The FOMC Will Wait And See Chart I-3Inflation Expectations Moving To Target Inflation Expectations Moving To Target Inflation Expectations Moving To Target Yellen's congressional testimony in November revealed that the Fed is not yet preparing for a more aggressive tightening cycle. There was nothing to suggest that the Fed is revising its economic forecasts following the election. Similarly, the Fed is not making any upward revisions to its estimate of the long-run neutral rate, which remains "quite low by historical standards." The implication is that the Fed will raise rates in December, but it will keep its "dot" forecast unchanged. The FOMC is prudently awaiting the details of the fiscal package before changing its economic and interest rate projections. We doubt that the Fed will be aggressive in offsetting the fiscal stimulus. We have argued in the past that the consensus on the FOMC would not follow the Bank of Japan and officially target a temporary overshoot of the 2% inflation target. Nonetheless, most Fed officials would not be upset if, with hindsight, they tighten too slowly and inflation overshoots modestly. The inflation target is supposed to be symmetric, which means that 2% is not meant to be a hard ceiling. Moreover, the Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. Market-based measures of inflation compensation have surged in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart I-3).9 Investors should continue to hold inflation protection in the bond market. A window may open sometime in 2017 in which improving economic growth is met with a cautious Fed. In this environment, we would expect the Treasury curve to bear-steepen and risk assets to outperform. The window will likely close once inflation moves up and inflation expectations converge at a level consistent with the 2% target. Bond Strategy The implications of Trump's policy agenda are clearly bond bearish, although yields have shifted a long way in a short time. The gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart I-4). The 5-year/5-year forward overnight index swap rate is now 2.1%, only 82 bps below the Fed's median estimate of the equilibrium fed funds rate. The U.S. 10-year yield has already converged with two measures of fair value, although yields remain well below fair value in the other major countries according to estimates of nominal potential output growth (Charts I-5 and I-6). The fact that the gap between the Fed's dots and market expectations has almost closed, means that a lot of bond-bearish news has been discounted in the U.S. We would not be surprised to see a partial retracement of the recent bond selloff. Investors will want to see concrete plans for substantial fiscal stimulus before the next leg of the bond bear market takes place. Speculators may wish to take profits on short bond plays, but investors with a 6-12 month horizon should remain short of duration benchmarks. Chart I-4Market Expectations Converging With Dots Market Expectations Converging With Dots Market Expectations Converging With Dots Chart I-5Bond Fair Value Method (I) Bond Fair Value Method (I) Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) bca.bca_mp_2016_12_01_s1_c6 bca.bca_mp_2016_12_01_s1_c6 On a long-term horizon, the Trump agenda reinforces our view that the secular bull market in bonds is over. Larry Summers' Secular Stagnation thesis will be challenged and investors will come to question the need for ultra-low real interest rates in the U.S. well into the next decade. A blowout in the U.S. budget deficit will temper the excess global savings story to some extent. Tax cuts, infrastructure spending, full expensing of capital goods and reduced regulation may also boost the long-run potential growth rate in the U.S. All of this suggests that equilibrium interest rates and bond yields will shift higher. Nonetheless, poor demographic trends and other impediments to both the supply- and demand-sides of the U.S. and global economies have not disappeared. The ECB is likely to extend its bond purchase program beyond next March, while the Bank of Japan has capped the 10-year JGB yield at close to zero, both of which should limit the amount by which yields in the other developed markets can rise. We could even see global yields fall back to near previous lows if the Fed winds up tightening too aggressively and sparks the next recession. Is Trump Bullish For Stocks? Chart I-7Equity Market Breakouts Equity Market Breakouts Equity Market Breakouts Developed country stock markets cheered the U.S. election outcome, presumably betting that the positives will outweigh the negatives. The main indexes in the U.S. and Japan have broken out of their trading ranges (Chart I-7). Bourses in Europe have also moved higher, but have not yet broken out. On the plus side, deregulation and stronger growth are bullish for U.S. corporate profits. Trump's proposal for a major corporate tax cut is another positive for equities, although the effective corporate tax rate in the U.S. is already at multi-decade lows. Cutting the marginal rate will thus not affect the effective rate much for large corporations. Any lowering of the marginal rate will benefit small and medium enterprises, as well as domestically-oriented S&P 500 corporations. On the negative side, dollar strength will be a headwind given that about a third of S&P 500 earnings are sourced from abroad. This raises the question of which factor will dominate profit growth over the next year; better economic growth or dollar strength? Table I-3 presents a matrix of different scenarios for the dollar and economic growth applied to our U.S. EPS model. Our base-case assumptions, implemented before the election, generated 5-6% earnings growth in 2017. We assumed that real and nominal GDP growth would be on par with the conservative IMF forecast. The bullish case assumes that real GDP growth is about a percentage point stronger, with modestly higher inflation. The opposite is assumed in the bear case. These three cases are combined with various scenarios for the dollar. The key point of Table I-3 is that the growth assumptions dominate the dollar effects. If growth is significantly stronger than the base case, then it would require a massive dollar adjustment to offset the positive impact on earnings. For example, our EPS estimate rises from 5-6% in the base case to almost 13% in the strong growth scenario, even if the dollar appreciates by 5%.10 The elephant in the room is the prospect of a trade war. Anti-globalization polices are negative for equities generally, although the boost for domestically-oriented firms provides some offset. As we argued above, higher tariffs on Mexico and China alone would not fully counteract a major fiscal push next year, especially if the trade impediments are implemented with a lag. Nonetheless, a broader anti-trade initiative that draws retaliation from many of America's trading partners cannot be ruled out. This is the main reason why we remain tactically cautious on equities. Table I-3U.S. Earnings Scenarios December 2016 December 2016 Country Equity Allocation In common currency terms, the U.S. equity market has a lot going for it relative to Japan and Europe. There will be spillovers from stronger U.S. growth to other countries, but the U.S. will benefit the most from Trump's fiscal stimulus plan. Continuing policy divergence will prop up the dollar, boosting returns in common-currency terms. The dollar has appreciated by about 4% in trade-weighted terms since we first predicted a 10% rise, suggesting that there is another 6% to go. Chart I-8Eurozone Still Has Lots Of Slack bca.bca_mp_2016_12_01_s1_c8 bca.bca_mp_2016_12_01_s1_c8 However, it is a tougher call in local currency terms. Monetary policy will remain highly accommodative in both Japan and Europe. As we highlighted in last month's Overview, we still expect Japan to implement a major fiscal stimulus plan. In the context of the Bank of Japan's fixing of the 10-year yield, government spending will amount to a helicopter drop policy that could generate a substantial yen depreciation. The central bank will continue to hold the yield curve down even when growth picks up, to drive real yields lower via rising inflation expectations. In the Eurozone, the ECB is likely to extend its asset purchase program beyond next March because it cannot credibly argue that inflation is on track to meet the target on any reasonable timetable. While the Eurozone economy has been growing well above trend this year, the fact that wage growth is languishing highlights that significant labor market slack persists (Chart I-8). Easy-money policies in Europe and Japan will be bullish for stocks in both markets in absolute terms and relative to the U.S. Stocks are also cheaper in Japan and the Eurozone. Earlier this year, we presented a methodology for valuing Eurozone stocks relative to the U.S. from a top-down perspective. The methodology accounted for different sector weightings and the fact that European stocks generally trade at a discount to the U.S. This month's second Special Report, beginning on page 27, applies the same methodology to Japanese/U.S. relative valuation. Combining seven relative valuation measures into a single composite metric, we find that both the Eurozone and Japanese equity markets are about one standard deviation cheap relative to the U.S. (Chart I-9). History shows that investors would have made substantial (currency hedged) excess returns if they had favored Eurozone and Japanese stocks to the U.S. on a six-month or longer investment horizon whenever our composite valuation index reached one standard deviation on the cheap side. Our recommended (hedged) overweight in Europe and Japan has not worked out yet, as tepid global growth has instead flattered the lower-beta U.S. market. That tide should turn, however, if the rise in global bond yields reflects a credibly reflationary growth pulse in the U.S. A stronger dollar would redistribute some of that growth to other countries. Chart I-10 shows that higher beta markets like Europe and Japan can outperform the U.S. when bond yields rise. The financial sectors in both Europe and Japan, so punished relative to the broad market as a result of deleveraging and negative interest rates, would then be poised to outperform as well. Chart I-9Equity Valuation Equity Valuation Equity Valuation Chart I-10U.S. Equities ##br##Underperform When Yields Rise U.S. Equities Underperform When Yields Rise U.S. Equities Underperform When Yields Rise Investment Conclusions: Hopes are running high that fiscal stimulus and a more business-friendly regulatory framework will stir animal spirits, rekindle business investment and lift the U.S. economy out of its growth funk. The violent reaction in financial markets to the election has probably gone too far in discounting a transformative policy change. We doubt that Trump's fiscal and regulatory agenda will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place, such as: the end of the Debt Supercycle; deteriorating demographics; elevated corporate leverage; and nose-bleed levels of government debt. A lot of good (policy) news is already discounted in equity prices, implying that the market is vulnerable to policy or economic disappointments. That said, a window may open next year that would favor risk assets for a period of time. A temporary growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Markets will front-run the growth pulse (some of it is admittedly already discounted). Our bias is therefore to upgrade these asset classes, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new administration's policy intentions. Until there is more clarity, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. EM assets appear to us like a lose-lose proposition. A trade war would obviously be disastrous for this asset class. But EM also loses if U.S. protectionism takes a back seat to growth initiatives to the extent that this results in a stronger dollar. EM risk assets have never escaped periods of dollar strength unscathed. The possibility of RMB depreciation versus the U.S. dollar adds to EM vulnerability. Our other investment recommendations include the following: avoid peripheral European government bonds within European bond portfolios due to Italian referendum risk; avoid U.S. municipal bonds, as tax cuts would devalue the tax advantage of muni debt; remain overweight inflation-linked bonds versus conventional issues within government bond portfolios, as inflation expectations have more upside potential; we are marginally less bearish on high-yield bonds since better growth will temper defaults. We also see less near-term risk of a Fed-driven volatility event. Nonetheless, concerns about corporate health still justify a slight underweight relative to Treasurys in the U.S. Overweight investment-grade corporates in Europe versus European governments due to ongoing ECB support; overweight European and Japanese equities versus the U.S. in currency-hedged terms. within the U.S. equity market, remain overweight small caps since Trump's corporate tax reform will benefit small firms disproportionately. Dollar strength also favors small versus large caps. Mark McClellan Senior Vice President The Bank Credit Analyst November 24, 2016 Next Report: December 20, 2016 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes and Investment Implications," November 9, 2016, available at gps.bcaresearch.com 2 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 3 World Trade Organization. 4 Scott Bradford, Paul Grieco and Gary Clyde Hufbauer, "The Payoff to America from Global Integration," Peterson Institute for International Economics. 5 These calculations capture the demand-side effects of the tariffs. There will also be supply-side effects, in terms of reduced productivity, but this will be relatively small and affect the economy largely over the medium term. 6 The elasticities and methodology for these calculations are based on the report; "Trump's Tariffs: A Dissent," J.W. Mason, November 2016. 7 "The Macroeconomic Consequences of Mr.Trump's Economic Policies," Moody's Analytics, June 2016. 8 The short-term tradeoff between unemployment and inflation. 9 Inflation breakeven rates have historically exceeded 2% because of the presence of risk premia. 10 The impact of dollar appreciation on profits shown in Table 3 may seem too low to some readers given that S&P 500 companies derive a third of their earnings from abroad. However, some of these earnings are hedged, while dollar strength will benefit the earnings of domestically-oriented U.S. companies. II. A Q&A On Political Dynamics In Washington In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu. III. Japanese Equities: Good Value Or Value Trap? Japanese stocks have experienced a long stretch of underperformance versus the U.S. since the early 90's. The deflationary macro backdrop and poor corporate profitability are the main underlying factors, although there are many others. More recently, some corporate fundamentals have shifted in favor of Japanese stocks relative to the U.S., but investors remain skeptical, sending Japanese valuations to near all time lows in absolute terms and relative to the U.S. In this Special Report, we take a top-down approach to determine whether Japanese stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. Our mechanical and fundamental valuation indicators provide an impressive historical track record of "buy" and "sell" signals when the metrics reach extreme levels. The story is corroborated at the sector level. The implication is that there is plenty of "kindling" to drive a reversal in Japanese stock relative performance, but it needs a spark. We believe the catalyst could be a major fiscal push that would be like a "helicopter drop" under the current monetary regime. Unfortunately, the timing is uncertain. A major fiscal package may not occur until the spring. Japanese equities have been a perennial underperformer versus the U.S. for almost three decades, in both local- and common-currency terms (Chart III-1). There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to both the U.S. and world. Equity multiples also rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets has since faded. Yen strength, collapsing inflation expectations and weakening business confidence have caused investors to question the upside potential for Japanese corporate top-line growth (Chart III-2). EPS have fallen by 11% percent this year in absolute local currency terms, and are down by 10.7% versus the U.S. In turn, Japanese equities have dropped from the mid-2015 peak (Chart III-3). The decline in Japanese multiples this year is in marked contrast to a rise in the U.S. Chart III-1Japanese Equities ##br##Have Underperformed Japanese Equities Have Underperformed Japanese Equities Have Underperformed Chart III-2A Challenging ##br##Macro Backdrop bca.bca_mp_2016_12_01_s3_c2 bca.bca_mp_2016_12_01_s3_c2 Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 bca.bca_mp_2016_12_01_s3_c3 bca.bca_mp_2016_12_01_s3_c3 Japanese equities currently appear very cheap to the U.S. market based on standard valuation measures (Chart III-4). However, these ratios are always lower in Japan, except for price-to-forward earnings. Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan (Chart III-5A). Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets (Chart III-6). Table III-1 shows that Japan has a much larger sector weighting in consumer discretionary and a much lower weighting intechnology. Still, the story does not change much when we adjust financial ratios for differences in sector weights between the two markets (Chart III-5B). Chart III-4Japan Is Always Cheaper Japan Is Always Cheaper Japan Is Always Cheaper Chart III-5A...Adjusted For Common Sector Weights Japanese Vs. U.S. Fundamentals... Japanese Vs. U.S. Fundamentals... Chart III-5BJapanese Vs. U.S. Fundamentals... ...Adjusted For Common Sector Weights ...Adjusted For Common Sector Weights Chart III-6RoE Is Consistently Lower In Japan bca.bca_mp_2016_12_01_s3_c6 bca.bca_mp_2016_12_01_s3_c6 Table III-1Japanese Vs. U.S. Sector Weights December 2016 December 2016 The lower level of RoE by itself justifies a price discount on Japanese equities. But by how much? Are Japanese stocks still cheap once they are adjusted for structurally depressed profitability relative to the U.S.? This report assesses relative valuation, employing the same methodology used in our previous work on Eurozone equity valuation.1 While many cultural nuances make direct comparison of the Japanese market difficult, investment decisions are made within the scope of the available set of alternatives. With Japanese equity valuations at the lowest levels in recent history, the key question is whether this represents an opportunity to load up, or an example of a "value trap". We conclude that valuation justifies an overweight in Japanese equities (currency hedged), although the fiscal stimulus required to unlock the value may not arrive until February. Mechanical Approach We excluded the financial sector from our market valuation work since analysts use different fundamental statistics to judge profitability and value compared to non-financial companies. We also recalculated all of the Japanese aggregates using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The mechanical approach adjusts the valuation measures by subtracting the 5-year moving average (m.a.) from both markets. For example, the calculation for the price-to-sales ratio (P/S) is: VG = (US P/S - 5-year m.a.) - (EMU P/S - 5-year m.a.) Then we divided the Valuation Gap (VG) by the 5-year moving standard deviation of the VG. This provides a valuation indicator that is mean-reverting and fluctuates roughly between -2 and +2 standard deviations: Valuation Indicator = VG/(5-year moving standard deviation of VG) The same methodology is applied to the other valuation measures shown in Charts III-7A, 7B, 7C, 7D and III-8A, 8B, 8C. This approach suggests that the U.S. market is trading expensive to Japan in all seven cases except for the Shiller P/E. Japan is around 1-sigma cheap on most of the other valuation measures, with forward P/E the highest at almost 2 standard deviations. Chart III-7AMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7a bca.bca_mp_2016_12_01_s3_c7a Chart III-7BMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7b bca.bca_mp_2016_12_01_s3_c7b Chart III-7CMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7c bca.bca_mp_2016_12_01_s3_c7c Chart III-7DMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7d bca.bca_mp_2016_12_01_s3_c7d Chart III-8AMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8a bca.bca_mp_2016_12_01_s3_c8a Chart III-8BMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8b bca.bca_mp_2016_12_01_s3_c8b Chart III-8CMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8c bca.bca_mp_2016_12_01_s3_c8c The underlying logic is that using a longer-term moving average should remove the structurally lower bias in Japanese valuations. Standardizing relative valuations in such a way should provide extreme valuation signals that can be used to gauge major trading opportunities. One potential pitfall of using a 5-year moving average to discount the structurally lower valuation of Japanese equities versus U.S. is that it fails to capture an extended period of either over- or under-valuation. For example, the U.S. may enter a bubble phase that does not occur in Japan. The 5-year moving average would move higher over time, eventually giving the false signal that the U.S. is back to fair value if the bubble persists. This is a fair criticism, although the track record of these valuation metrics shows that extended bubbles have not been a large source of false signals. Valuation By Sector We applied the same methodology at the sector level. Due to space constraints, we cannot present the 70 charts covering the seven relative valuation metrics across the 10 sectors. However, we present the latest reading for the 70 indicators in Table III-2, which reveals whether the U.S. is expensive (e) or cheap (c) versus Europe. A blank entry means that relative valuation is in the range of fair value. Table III-2Story Holds At The Sector Level December 2016 December 2016 The sector valuation indicators corroborate the message from the aggregate valuation analysis; over 60% of valuation metrics suggest that the U.S. is at least modestly expensive versus Japanese stocks. The U.S. is cheap in only 13% of the cases, with 26% at fair value. Value measures that most consistently place U.S. sectors in expensive territory are P/CF, P/B and EV/EBITDA. The U.S. sectors that are most consistently identified as expensive are financials, consumer discretionary, industrials, utilities, tech and basic materials. U.S. healthcare received a fairly consistent "cheap" rating while U.S. telecoms were consistently "cheap" or "fair" across all valuation measures. Predictive Value? Having a standardized tool of relative valuation is well and good but multiple divergence between regions is only useful if it translates into excess returns. Valuation is generally a poor timing tool but proves to be useful in predicting returns over a longer investment horizon. Theoretically, forward relative returns between Japanese and U.S. equities should be positively correlated with the size of the gap in their relative valuation metrics. In order to test the efficacy of the mechanical valuation indicator we calculated forward relative returns at points of extreme valuation divergences (in local currency). The trading rule is set such that, when the mechanical indicator reaches positive one or two standard deviations, we short the more expensive U.S. market and go long Japanese equities. Conversely, the opposite investment stance is taken for value readings of negative one and two standard deviations. Forward returns are calculated on 3, 6, 12, and 24 month horizons. Overall, the indicators performed well when the valuation gap between U.S. and Japanese multiples reached (+/-) 1 and 2 standard deviations from the long-term mean. Valuation measures exhibiting the highest returns were P/CF and forward P/E. For brevity, we present only these two measures in Table III-3. At two standard deviation extremes, the mechanical indicator produced a two-year forward return of 84% and 44% for P/CF and forward P/E, respectively. Table III-3 also presents the indicator's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For P/CF, the batting average is between 50-60% for a 1 standard deviation valuation reading and mostly 100% for 2 standard deviations. The batting average for the forward P/E ranges from 53-92% for 1 standard deviation, and 83-100% for 2 standard deviations. Table III-3Select Mechanical Indictor Returns And Batting Averages December 2016 December 2016 Presently, all of the indicators are at or above the zero line signaling that the U.S. market is overvalued versus Japan. The valuation metric sending the strongest signal of U.S. overvaluation has interestingly been one of the better predictors of positive excess returns; the forward P/E mechanical indicator has just recently touched the +2 standard deviation level. Given the information provided by our back tested results above, investors are poised to enjoy strong positive returns by overweighting Japanese equities versus their U.S. peers. Fundamental Approach Chart III-9Japan Has A Lower Cost Of Debt bca.bca_mp_2016_12_01_s3_c9 bca.bca_mp_2016_12_01_s3_c9 Japanese companies trade at a discount relative to their U.S. peers due to more volatile Japanese profit fundamentals and a structurally depressed RoE. To compensate for structural differences in fundamentals we regressed U.S./Japanese value gaps on spreads in underlying financial statistics such as earnings-per-share growth, the interest coverage ratio, free-cash-flow growth, operating margins, and forward earnings-per-share growth. A dummy variable was used to exclude the "tech bubble" years in the late 90's to early 00's since the surge in tech stocks had an outsized effect on overall relative valuations, distorting the true underlying trend. The fundamental approach used in our previous Special Report comparing the U.S. and Eurozone did not work as well as hoped and we had an inkling that an analysis of Japan versus the U.S. might yield similar results. Once again we were underwhelmed by the results, although some valuation measures did produce decent outcomes. These included P/S, P/B, and P/CF. Unfortunately, fundamental models for EV/EBITDA, P/E and forward P/E either had low explanatory power or had coefficients with the wrong sign. The financial variable that appears most frequently as being significant in our fundamental models is the interest coverage ratio. Japanese firms have experienced a massive reduction in net debt post-GFC, while those in the U.S. have been taking advantage of lower rates to issue debt and perform share buybacks. Weak aggregate demand has dissuaded Japanese corporations from performing any sort of intensive capital expenditure programs and they have therefore been using free cash flow to build up cash reserves on their balance sheet and pay down debt. Not to mention, the more dramatic decrease in borrowing rates for Japanese firms has reduced their interest burden vis-à-vis U.S. corporates (Chart III-9). Chart III-10 presents the modeled fair values along with the corresponding valuation indicator. The U.S. market is expensive compared to Japan for all three models, with the most extreme cases being P/S and P/CF. Chart III-10AFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators Chart III-10BFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators Chart III-10CFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators While the fundamental approach gave results that are less than spectacular, they still corroborate the message given by the mechanical approach. Japanese equities are undervalued compared to their U.S. peers and are reaching extreme levels, even after adjusting for structural trends in the underlying financials. Chart III-11Combined Fundamental Indicator Returns December 2016 December 2016 The next step is to verify the predictive power of our fundamental models. We analyzed forward returns implementing the same methodology used for the mechanical indicators. A (+/-) 1 standard deviation threshold was used as an investment signal to either overweight Japanese equities versus the U.S., if positive, or take the opposite stance if negative. Chart III-11 shows the returns categorized by time horizon and the number of valuation measures flashing a positive investment signal. The results were mixed; strong positive returns occurred when only one or two measures displayed valuation extremes, but excess returns were less than spectacular during periods when all three metrics provided the same signal. This is counter-intuitive, but when analyzing Chart III-10 it becomes apparent that the periods where all three indicators simultaneously entered extreme territory are concentrated in the last two years of history when U.S. market returns have trounced Japan. For periods during which our indicator flashed one or two positive signals, mostly before the past two years, returns were in line with those achieved by the mechanical indicators. Table III-4 shows the probability of success for the combined fundamental approach. Overall it has a batting average lower than that of the mechanical approach, with 60-89% for one signal and 70-86% for two signals. The batting average was generally poor when there were three signals for the reason discussed above.2 Since the beginning of 2015, all three indicators have been signaling that Japanese stocks are extremely cheap versus the U.S. Indeed, relative valuation continues to stretch as U.S. equity prices rise versus Japan, bucking the recent relative shifts in balance sheet fundamentals that favor the Japanese market. Table III-4Combined Fundamental Indicator Batting Averages December 2016 December 2016 Conclusion We are pleased with the results of the mechanical approach. The majority of valuation measures show that investors will make positive returns by overweighting and underweighting Japanese equities versus the U.S. when relative valuation reaches extreme levels. The consistency of these excess returns highlights that the indicators add value to global equity investors. We had hoped that a fundamentals based approach to valuation would have worked better. Conceptually, it would be more intellectually gratifying for company financials to better explain excess returns compared to technical measures. In a liquidity-driven world, this may be too much to ask. Although our fundamental models did not pan out perfectly, they still provided support for our underlying thesis that Japanese equities offer excellent value relative to the U.S. market. These models highlight that Japanese balance sheet and income statement trends favor this equity market versus the U.S. at the moment. Investors have been ignoring the fundamentals, frowning on Japanese equities in absolute terms and, especially, relative to the U.S. The sour view on Japan likely reflects disappointment in Abenomics. This includes not only fears that Abenomics is failing to lift the economy out of the liquidity trap, but also fading hopes for changes in corporate governance that would force firms to make better use of their cash hoards to the benefit of shareholders. All the valuation metrics presented above say that it is a good time to overweight Japan versus the U.S. in local currency terms. Of course, so much depends on policy these days. Our valuation metrics highlight that there is plenty of "kindling" in place for a reversal in relative performance given the right spark. As discussed in the Overview section, the catalyst could be a major fiscal stimulus package. When combined with a yield curve that is fixed by the Bank of Japan, it would amount to a "helicopter drop". Such a policy would drive up inflation expectations, push down real borrowing rates and dampen the yen. This self-reinforcing virtuous circle would be quite positive for growth in real and nominal terms, lifting the outlook for corporate profit growth and sparking a substantial re-rating of Japanese stocks. The timing is admittedly uncertain. A smaller fiscal package could be implemented as part of a third supplementary budget before year-end. A major fiscal push is most likely to occur only in February, when the next full budget is announced. Still, rock-bottom valuations make Japan an attractive market for longer-term investors, although the currency risk must be hedged. Michael Commisso Research Analyst 1 Please see The Bank Credit Analyst, "Are Eurozone Stocks Really Cheap?" July 2016, available at bca.bcaresearch.com 2 Except for the 24-month column, which shows a 100% batting average. However, this can be ignored. There was only a single episode of three positive signals that occurred more than 24 months ago, allowing a 24-month return calculation.