Fixed Income

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 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 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 Chart I-2BMedium Expansions Chart I-2CA Short Expansion 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 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 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 Chart I-5Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) 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 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 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 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 Chart I-10U.S. Equities ##br##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 Chart III-2A Challenging ##br##Macro Backdrop Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 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 Chart III-5A...Adjusted For Common Sector Weights Chart III-5BJapanese Vs. U.S. Fundamentals... Chart III-6RoE Is Consistently Lower In Japan Table III-1Japanese Vs. U.S. Sector Weights 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) Chart III-7BMechanical Valuation Indicators (I) Chart III-7CMechanical Valuation Indicators (I) Chart III-7DMechanical Valuation Indicators (I) Chart III-8AMechanical Valuation Indicators (II) Chart III-8BMechanical Valuation Indicators (II) Chart III-8CMechanical Valuation Indicators (II) 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 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 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 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 Chart III-10BFundamental Valuation Indicators Chart III-10CFundamental 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 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 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.

Highlights Sweden Yield Curve: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. Swedish Rates: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. NZ Rates: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Korea vs. Japan: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Feature The surprising U.S. election victory of President-elect Trump, on a policy platform that is both reflationary and protectionist, has shaken up the global macro landscape. The shock has been even more acute for small, open and export-oriented economies like Sweden, New Zealand and Korea. This triggers a necessary re-assessment of our positions. In this Weekly Report, we revisit three previously recommended trades included in our "Overlay Trades Portfolio" that are most exposed to the changing global backdrop. Sweden: Closing Our Flattener Trade... Last year, we were of the view that the Riksbank would shift to a more hawkish policy stance during 2016.1 Fast forward to today, and this has not panned out as we expected with the Riksbank persistently sticking with its dovish bias. We are no longer comfortable facing the stiff resolve of the Riksbank and, therefore, we are closing our recommended Swedish 5-year/10-year yield curve flattener trade (Chart 1). Chart 1Closing Our Sweden Flattener Chart 2The Dovish Rhetoric Is Paying Off The message has been clear - Sweden's central bank will stay accommodative as long as it takes to get inflation back on a sustainable upward trajectory. In a unified fashion, the most senior Riksbank officials have communicated the following: 2 Monetary policy is set to escape low inflation as fast as possible. Currency intervention to weaken the Krona cannot be ruled out. There is no problem in extending the Riksbank's asset purchase program, since it has worked well so far in keeping government bond yields at accommodative levels and helping depress the Krona. The exchange rate is now notably weaker throughout the entire Riksbank forecast period than previously assumed, but this has not been sufficient to counteract the lower underlying inflationary pressures in Sweden.3 In a nutshell, the Riksbank wants to bring about higher inflation through a depreciation of the currency. The strategy has started to work of late (Chart 2). A very accommodative monetary policy, combined with rising inflation pressures from a cheapening Krona, now points to a prolonged period of low real policy rates that will keep the Swedish yield curve under steepening pressure. Aside from the monetary policy rhetoric, the global political landscape is no longer favorable for a yield curve flattening trade either, even in Sweden. In June, when Brexit surprised the planet, our Sweden flattener trade performed well, as global uncertainty spiked and a risk-off environment supported lower longer-term bond yields. Donald Trump's upset election earlier this month had the exact opposite effect, however, triggering a massive curve steepening in most bond markets, including Sweden (Chart 3).4 Going forward, if the effects of Trump's proposed policies - such as a decent fiscal impulse and protectionist trade measures - linger, as we expect, a Swedish flattener will likely underperform. Global bond markets will continue to be heavily influenced by a steepening U.S. Treasury curve. Moreover, our optimism on Swedish growth has dimmed recently, with certain parts of the economy slowing down. At the business level, weakening new orders data signal lower industrial production growth ahead. In addition, exporter order books have rolled over, resulting in a build-up of inventories (Chart 4). Chart 3Same Populism, Different Outcome Chart 4Dimming Optimism In turn, Swedish households are feeling the pinch. Slower wages and employment growth are reducing consumption. Growth in retail sales and car registrations has decelerated and private bankruptcies have started to rise (Chart 5). Since household consumption is a vital part of Sweden's economy, the recent robust expansion will moderate in the next few quarters. Consequently, the gap between the Riksbank's dovish monetary stance and the economic backdrop can no longer be deemed unsustainable, as we have described it in the past. This reality has been well depicted in the latest Riksbank Monetary Policy Report (MPR), where 2016 GDP growth is now forecasted to be only 1.8%. This seems reasonable considering the decline in actual demand - observable through the slowing growth of Swedish imports - and the Riksbank's own forward-looking economic activity index (Chart 6). The Riksbank is now projecting only a modest growth rebound to 2.5% in 2017, but this implies a meaningful reacceleration in growth to an above-trend pace later on in the year. Chart 5Swedish Households: Feeling The Pinch Chart 6Swedish GDP Growth Will Slow Further Bottom Line: The drivers behind our Sweden 5-year/10-year curve flattener trade - a Riksbank stance that appeared too dovish, a cautious global risk landscape and the strength of Sweden's economic expansion - have become less compelling. We advocate closing that trade, at a profit of +84bps. ...And Placing A New Bet On Rising Swedish Inflation Currently, the Swedish Overnight Index Swap (OIS) curve is expecting monetary policy stability in the first half of next year, pricing in only a 10% probability of a rate cut and a mere 2% chance of a rate hike by July 2017. Of the two, a rate hike is most likely, in our view, given the growing risks of upside inflation surprises stemming from a weaker Krona and rising energy prices. With such a low probability of a hike currently priced into the curve, the risk/reward potential for a trade is compelling. Today, we enter into a new position: paying 18-month Swedish OIS rates (Chart 7). Chart 7Pay 18-Month Sweden OIS Rates Chart 8Energy Prices Are Crucial For Swedish Inflation In the Riksbank's October MPR, the first rate increase was pushed forward from the second quarter of 2017 to the first quarter of 2018.5 At that point, the central bank's forecast becomes slightly lower than the interest rate expectation now priced in the OIS market. Even with our more sober view of the Swedish economy, the next rate hike is now expected to occur too far into the future. It will likely happen beforehand as upside surprises on inflation will force the Riksbank to begin tightening sooner than planned. Sweden's inflation path is mainly influenced by two factors: the Krona and energy prices. If the Krona's weakness accelerates and energy prices resume their uptrend, inflation will jump. In turn, if inflation reaches its target earlier, the central bank will start normalizing rates sooner than expected. Chart 9Can Sweden Still Overheat? As stated above, the Riksbank members' dovish rhetoric has been successful in pushing the Krona lower. Much to our astonishment, they seem ready to continue moving in that direction, despite the potential negative spillovers. The bubbly Swedish housing market - fueled by low interest rates and lacking the macro-prudential measures to stop its expansion - does not appear to be a major concern of the Riskbank for the time being. In addition to the exchange rate, the path of energy prices is crucial for inflation; it represents the bulk of the deflationary pressure over the last few years (Chart 8). Although this situation has changed recently, with a positive contribution to inflation in the last four months, energy prices will need to appreciate again to keep consumer price advances on track. This is likely to happen. Our Commodity strategists believe that the markets are understating the odds of Brent exceeding $50/bbl by the end of this year, given their expectation that Saudi Arabia and Russia will announce production cuts of 500k b/d each at the OPEC meeting scheduled for November 30th in Vienna.6 If such meaningful production cuts come to fruition, energy prices will rise and add to Sweden's inflationary pressure. Moreover, the bigger structural picture in Sweden remains very inflationary, despite the short term cyclical weakness stated earlier. GDP, employment and hours worked are all expanding faster than the Riksbank's assessment of the long-run trend growth rates. Plus, according to the Economic Tendency Survey, companies are reporting labor shortages in all major business sectors.7 In sum, with resource utilization already stretched, keeping real interest rates low for longer can only prolong the steadfast Swedish credit expansion, potentially overheating the economy and creating additional inflation surprises (Chart 9). This will set the stage for an eventual shift by the Riksbank to a more hawkish posture. Bottom Line: The Riksbank rate liftoff will start earlier than priced in the market. We recommend entering a new trade, paying the 18-month Sweden Overnight Index Swap rate. New Zealand: Inflation To Re-Surface Here, As Well Chart 10Global Output Gaps Have Narrowed On November 9th, the Reserve Bank of New Zealand (RBNZ) cut its overnight rate to 1.75% and signaled that it would probably be on hold for the foreseeable future. From here, things could go both ways; another rate cut is not inconceivable in 2017. Yet the market is expecting a stable rate backdrop, pricing in only a 5% chance of a rate cut and a 6% probability of a rate hike by June 2017. Such an "undecided" market is not surprising. On one hand, inflation remains below target. On the other hand, the economy has been humming along with no signs of any major slowdown on the horizon. In our view, monetary policy risks are tilted towards rate hikes. Similar to Sweden's case, inflation has the potential to surprise on the upside in 2017. Several factors have contributed to the current stubbornly low inflation environment. However, going forward, those forces will abate and push inflation and, eventually, short term interest rates higher. 1.A more inflationary global backdrop New Zealand's low inflation problem comes from the tradable components. Simply put, because of the global deflationary environment of the last few years, and because of the Kiwi's strength, New Zealand has imported lower prices from abroad. But this phenomenon will move in the other direction going forward. The global inflationary backdrop has slowly changed. As noted by our Chief Global Investment Strategist, Peter Berezin, spare capacity within the developed economies has shrunk substantially over the last few years (Chart 10).8 Unemployment rates are lower than the non-accelerating inflation rates of unemployment (NAIRU) in most major countries, with the exception of France and Italy. Looking ahead, the current cyclical upswing in global growth, coming at a time of narrowing output gaps and increasing supply-side constraints, will put upward pressure on global inflation. This will eventually trigger a rise in New Zealand's import price inflation, although the impact might not be felt in the very short term. 2.A continued boost from China Closer to home for New Zealand, China's backdrop has become less deflationary. As we pointed out in a recent Special Report, China has turned into a cyclical tailwind for the global economy, putting upward pressure on inflation and bond yields in the near-term.9 Our "GFIS China Check List", composed of our favored indicators, highlights that China is in the expansionary phase of its economic cycle (Table 1). Table 1The GFIS China Checklist Most striking is that Chinese final goods producer prices have turned positive. This could prove to be a major development for New Zealand tradable goods prices, if it lasts; the correlation between Chinese PPI inflation and the tradable goods contribution to New Zealand's headline CPI has historically been elevated (Chart 11). 3.A weaker kiwi dollar Donald Trump's U.S. election victory could help raise New Zealand inflation through the exchange rate. If his ambitious fiscal plan and protectionist inclinations gain traction, the Fed might have to raise rates more aggressively than expected, putting upward pressure on the U.S. dollar. Under such a scenario, the Kiwi will re-price lower, potentially reversing the prior dampening effect on import prices from a strengthening currency. This would relieve policymakers on the RBNZ, who have consistently pointed to the currency's strength as the main reason inflation has missed the target (Chart 12). Chart 11China: A New Tailwind For Prices Chart 12The Kiwi Is Problematic 4.A stronger dairy sector Over the past couple of years, the Achilles heel for New Zealand has been its dairy sector, with plunging prices eroding confidence throughout the economy. Fortunately, this bad predicament is about to change as well. The exogenous factors depressing dairy prices are abating and prices are surging anew (Chart 13). The Global Dairy Trade price index has advanced in seven out of the last eight dairy auctions.10 If this impulse is prolonged, both New Zealand's export prices and domestic wages will begin to reflate. 5.A reversal of migration inflows The massive flow of migration into New Zealand since 2013 has been the main factor capping wage growth by increasing the supply of labor (Chart 14). The bulk of this inflow has been composed of young workers, aged between 15 & 29 years old.11 It is unclear if this migration will become permanent or prove to be transitory. Chart 13NZ Dairy Prices Have Rebounded Chart 14NZ Inward Migration To Stabilize... Much of this inflow can be explained by the weakness in the Australian economy, which has triggered migration back into New Zealand from those who left for work in Australia. As such, if the Aussie economy improves, the migration flow could conceivably reverse, at least to some extent. As a result, the domestic supply of workers would recede and the invisible ceiling on New Zealand wages would progressively disappear. This scenario is highly plausible. The latest surge in Australia's terms of trade could be an early signal of a commodity sector revival. Much of this is due to China's growth upturn this year. However, the wave of optimism towards a potential fiscal stimulus in the U.S. - especially through longer-term infrastructure projects - is a possible boost to demand that could support higher global commodity prices higher over the next few years.12 If this proves correct, New Zealand migration towards Australia could be renewed, shrinking the domestic pool of skilled labor, and pushing wages higher (Chart 15). An unwind of these disinflationary forces would coincide with improving cyclical growth prospects. A mix of strong credit growth, decent construction sector activity and robust corporate earnings should support job creation and wages in the short term (Chart 16). In this environment, consumption will accelerate. Since the output gap is already closed, faster spending will cause inflationary pressures to build (Chart 17). Chart 15...If Australian Mining Revives Chart 16An Inflationary Backdrop Chart 17Inflation Surprises Ahead Traders can benefit from a turnaround in New Zealand inflation prospects by playing the Overnight Index Swap market. Since April 12th of this year, we have recommended payer positions in 6-month New Zealand Overnight Index Swap (OIS) rates.13 This trade has not worked as planned, due to the stubbornly low trend of New Zealand inflation, and today we are closing that trade recommendation at a loss of -30bps. The market is currently pricing in a 23% chance of a rate hike by the September 28, 2017 RBNZ meeting. Due to the inflation risks cited above, the probability should be higher than that, in our view. As such, we are entering a 12-month OIS payer. This trade offers modest downside risk versus for a decent potential gain, i.e. a risk/reward ratio of about 3:1. Bottom Line: New Zealand's inflation will surprise to the upside in 2017 and put upward pressure on short-term interest rates. To position for this, pay 12-month rates on the New Zealand Overnight Index Swap curve. Closing Our Japan/Korea Relative Value Trade This week, we are unwinding our Japan/Korea relative value trade, where we were long 5-year Korean government bonds versus 5-year Japanese Government Bonds (JGBs) on a currency-unhedged basis. While the currency leg did allow for a profitable trade, the Korea/Japan yield differential widened by +52bps. Several unpredictable events have negatively impacted Korean bonds since the trade was initiated. Chart 18Political Scandal = Higher Risk Premium Chart 19Trump: Catastrophic For Korean Bonds Too First, a scandal surrounding the Korean president, a.k.a. Choi-Gate, has erupted. As more details of the affair have been revealed, the president's approval rating has plunged - standing now at 5% - and the Government has become dysfunctional (Chart 18). In the near future, the geopolitical risks surrounding Korean assets should remain elevated as the prosecutors will continue the process of investigating the president and her associates; the risk premium on Korean bond yields might increase further. Chart 20The Korea 5-Year Bond Model Second, Trump's victory has been catastrophic for bond markets across the globe, including those related to open and export-oriented economies linked to the emerging markets, like Korea (Chart 19). Yet the impact on JGBs has been more contained since the Bank of Japan (BoJ) moved to a yield curve targeting framework back in September. The BoJ surprised many by adopting that policy of anchoring longer-term JGB yields. This has substantially reduced the volatility of JGBs, even during the recent backup in global yields. In turn, this has lowered the payoff potential of shorting JGBs, both in absolute terms and versus Korean bonds. Finally, the appeal of our Korea vs Japan trade has decreased from a valuation perspective. A simple model that we have developed for the Korean 5-year government bond yield now points towards rising yields in 2017 (Chart 20).14 With all of these factors now working against our trade, we are choosing to close it out. The trade has generated a profit from the currency exposure, which we decided not to hedge. However, when events move against the original reasons for putting on a trade, the prudent strategy is to unwind that position and look for other opportunities. Bottom Line: The rationale behind our recommended trade favoring 5-year Korean government debt versus 5-year Japanese government bonds has changed. We are closing the trade at a profit of +260bps. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Special Report, "Riksbank: Close To An Inflection Point", dated September 22, 2015, available at gfis.bcaresearch.com 2 Source: Bloomberg Finance L.P. NSN OG2NHA6JIJUO GO. NSN OGD9GRSYF01S GO. NSN OGFQO26S972O GO 3 http://www.riksbank.se/Documents/Protokoll/Penningpolitiskt/2016/pro_penningpolitiskt_161026_eng.pdf 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 For details, please see http://www.riksbank.se/en/Press-and-published/Published-from-the-Riksbank/Monetary-policy/Monetary-Policy-Report/ 6 Please see BCA Commodity & Energy Strategy Weekly Report, "Raising The Odds Of A KSA-Russia Oil-Production Cut", dated November 3, 2016, available at ces.bcaresearch.com 7 Private services, retail trade, construction and manufacturing 8 Please see BCA Global Investment Strategy Weekly Report, "Slack Around The World", dated November 4, 2016, available at gis.bcaresearch.com 9 Please see BCA Global Fixed Income Strategy Special Report, "How To Assess The 'China Factor' For Global Bonds", dated November 8, 2016, available at gfis.bcaresearch.com 10 https://www.globaldairytrade.info/en/product-results/ 11 For details, please see "Understanding low inflation in New Zealand", Dr, John McDermott, October 11, 2016 available at http://www.rbnz.govt.nz/news/2016/10/understanding-low-inflation-in-new-zealand 12 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2017, available at gps.bcaresearch.com 13 Please see BCA Global Fixed Income Strategy Special Report, "New Zealand: More Than Just Dairy", dated April 12, 2016, available at gfis.bcaresearch.com 14 This model is based upon a regression of Korean yields on U.S. 5-year treasury yield, Korean Trade-weighted currency, Brent crude price in USD, and Korea's headline CPI. Forecasts are based on financial market futures data and the ministry of finance's inflation forecast. Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Treasury Yields: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017 that will cause the Treasury curve to bear-steepen. Spread Product: Poor valuations and a probable Fed rate hike next month keep us cautious on spread product in the near term. But the environment for credit markets will turn more positive in the first half of 2017. Leveraged Loans: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Feature Several Fed speakers last week, including Fed Chair Janet Yellen, affirmed the case for a December rate hike, and the market has taken full notice of that message. We calculate that the market-implied odds of a rate hike next month rose to 84% as of the close of business on Friday.1 But just as critical for the path of Treasury yields is that the Fed will be taking a "wait and see" approach when it comes to the prospect of increased fiscal stimulus under the Donald Trump administration. Right now there is so much uncertainty about what the Congress will pass or not pass, what the president will propose. As a baseline, assuming a continuation of current fiscal policy has probably as good a chance as any other forecast that we are going to make up. Minneapolis Fed President Neel Kashkari2 This leads us to believe that the Fed will lift rates next month, but will also not revise its fed funds rate forecasts (dots) higher. We also expect that the Fed will be slow to respond to any pick-up in growth expectations as we head into 2017. This sets up a two-phase outlook for Treasury yields. During the next month, the uptrend in yields will meet resistance as both the market and Fed turn a more skeptical eye toward Trump's fiscal promises. But if growth picks up in early 2017, as we expect, and the Fed maintains its dovish bias, then we could enter a sweet spot where the Treasury curve resumes its bear-steepening and risk assets rally. Near-Term Pull-Back Two factors make us think it is likely that Treasury yields will at least level-off, and perhaps decline a bit, during the next month. First, market pricing has already mostly converged with the Fed's rate expectations, especially at the short-end of the curve (Chart 1). Our sense is that the Fed's dots provide a reasonable valuation anchor for yields in the absence of more concrete evidence that growth is accelerating. Second, technical measures and positioning data suggest that the rapid rise in yields is due for a pause. The fractal dimension for long-maturity Treasuries, a measure of groupthink developed by our Chief European Strategist Dhaval Joshi rests at 1.25, a level at which a trend reversal - even if only a temporary one - tends to emerge (Chart 2).3 Additionally, our composite sentiment indicator, based on the 13-week rate of change in prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a near-term reversal (Chart 3). Chart 1The Market & Dots Converge Chart 2Treasuries Face Technical Resistance Chart 3Bond Sentiment At A Bearish Extreme Cyclical Sweet Spot Once the December FOMC meeting has passed, we expect investor attention will turn toward U.S. economic growth, which should accelerate as we head into 2017 (Chart 4). Chart 4U.S. Growth: Poised To Accelerate Consumer confidence has been resilient at high levels, which supports continued strong consumer spending (Chart 4, panel 1). According to trends in public sector employment, government spending is poised to increase, even in the absence of new fiscal stimulus (Chart 4, panel 2). Inventories were an unusually large drag on growth in 2016. This drag will continue to unwind (Chart 4, panel 3). Survey measures suggest that non-residential investment will reverse its downtrend (Chart 4, panel 4). The supply of new residential housing remains tight, which will support increased construction even in the face of higher rates (Chart 4, bottom panel). On top of this, we can potentially tack on any newly enacted fiscal stimulus once Trump takes office in January. Our political strategists expect that the Trump administration will not face meaningful opposition from the Republican-controlled Congress, and will be able to enact - in relatively short order - a more stimulative fiscal policy in the form of lower taxes and increased spending for infrastructure and defense.4 A quicker pace of Fed tightening would be a powerful offset to this rosy growth outlook. In fact, Chair Yellen alluded to the notion that a large fiscal impulse would probably be counteracted by tighter monetary policy in her Congressional testimony last week: "The economy is operating relatively close to full employment at this point, so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."5 In essence, with the economy close to full employment it is more likely that a sufficiently large growth impulse will result in rising inflation, which the Fed will lean against. However, we believe this is a story for the second half of 2017. At least initially, the Fed will be in no rush to deviate from the dovish bias embedded in its current forecasts. Market-based measures of inflation compensation have increased strongly in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart 5). The 5-year, 5-year forward TIPS breakeven inflation rate is currently 2.06%, and needs to rise another 34bps before it is consistent with its average pre-crisis level. The Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. This opens a window in the first half of 2017 when improving economic growth will be met with still-accommodative monetary policy. In this environment we would expect the Treasury curve to bear-steepen and spread product to outperform. All else equal, we are likely to shift our recommended portfolio allocation in that direction (initiate curve steepeners, increase allocation to spread product) once the near-term risk of a Fed rate hike is behind us. The major risk to the view that a cyclical sweet spot opens up in the first half of 2017 is that any improvement in growth might be quickly cut-off by overly restrictive financial conditions, specifically in the form of a much stronger dollar (Chart 6). The pace of dollar appreciation has increased since the election and overall indexes of financial conditions have tightened, but so far the tightening has not been as sharp as that which occurred around the time of last year's Fed rate hike. We anticipate that this time around, due to the improved trajectory of growth outside of the U.S., tightening of overall financial conditions will not be as severe. A second related risk is that the recent surge in bond yields will harm cyclical sectors of the economy such as housing and consumer spending on durable goods (Chart 7). This is undoubtedly true, but it is important to recall that this process is self-limiting. If yields rise too far, then growth will decelerate and yields will reverse course. Then lower yields will cause growth to re-accelerate, leading to higher yields. As long as the Fed is perceived to be "behind the curve" on inflation then the underlying trend will be one of improving growth and a bear-steepening of the Treasury curve. Chart 5Breakevens Still Too Low Chart 6A Strong Dollar Is The #1 Risk Chart 7Higher Yields Also A Drag On Growth Bottom Line: The uptrend in Treasury yields has run into extreme technical resistance and is likely to abate during the next few weeks. Beyond that, a cyclical sweet spot of improving growth and accommodative monetary policy will open up during the first half of 2017. This will cause the Treasury curve to bear-steepen and will be positive for spread product. Leveraged Loans: Still A Buy We recommended that investors favor leveraged loans over fixed-rate junk bonds on July 19.6 In large part, this recommendation was predicated on a high conviction view that Treasury yields were poised to increase, thus benefitting floating rate loans over fixed rate bonds. Since July 19, the S&P/LSTA Leveraged Loan 100 index has returned +196bps, compared to +176bps of total return from the Bloomberg Barclays High-Yield bond index, and flows into the largest leveraged loan ETF (BKLN) have outpaced flows into the largest junk bond ETF (HYG) since August (Chart 8). Historically, there are two reasons that leveraged loans might be expected to outperform fixed rate junk bonds (Chart 9). The first is that 3-month LIBOR is rising, causing loan coupons to reset higher. The second is that the default rate is elevated. Loans tend to benefit relative to bonds when the default rate is elevated because their senior position in the capital structure means they earn a higher recovery rate (Chart 10). Chart 8Loan Performance Is Lagging Fund Flows Chart 9Leveraged Loans Will Outperform Chart 10Loans Benefit From Higher Recoveries Taking a closer look at Chart 9 we can see that the above two factors have only led to two periods of sustained leveraged loan outperformance since 1991 (denoted by shaded regions). In 1994, loans outperformed bonds because the pace of Fed tightening surprised markets to the upside and 3-month LIBOR moved sharply higher. In this instance higher coupons were sufficient for loans to outperform even though corporate defaults were low. Loans also outperformed bonds between 1997 and 2002. In this case it was a prolonged uptrend in corporate defaults that drove the outperformance. Loans benefitted from higher LIBOR in the early stages of this period, but then the Fed began cutting rates in 2001. Loans did not outperform bonds during the 2004-2006 rate hike cycle, as defaults were very low and the rate hikes were well telegraphed - meaning that asset prices already reflected the up-move in 3-month LIBOR before it occurred. Likewise, loans did not outperform bonds during the 2008 default episode because the Fed was cutting rates sharply and, unlike in the 1990s, the spike and reversal in the default rate occurred over a relatively short period of time. The good news for loans is that the current environment very much resembles the early part of the 1997-2002 period insofar as the Fed is in the early stages of a rate hike cycle - so 3-month LIBOR can be expected to move higher - and corporate defaults have already started to increase. So far loans have only benefitted marginally from the rise in 3-month LIBOR because most have LIBOR floors. This means that the loan's coupon is only reset higher once 3-month LIBOR is increased above the stated floor. Bloomberg calculates that $221 billion of outstanding leveraged loans have LIBOR floors of 75bps and $690 billion of outstanding loans have LIBOR floors of 100bps. With 3-month LIBOR at 91bps currently, it will only take one more Fed rate hike before the floors on most loans are breached. Bottom Line: The combination of Fed rate hikes and elevated defaults should allow leveraged loans to outperform fixed rate junk bonds on a 12-month horizon. High-Yield Munis: Stay Away We detailed our longer-term outlook for municipal bonds in a recent Special Report,7 and then downgraded our muni allocation to underweight (2 out of 5) following Trump's surprise election win. Our expectation is that the combination of lower tax rates and increased infrastructure spending will be toxic for municipal debt. That analysis, however, focused on investment grade municipal debt. This week we investigate the relative value in high-yield municipal bonds relative to high-yield corporates. The starting point of our analysis is an examination of the spread differential between high-yield munis and high-yield corporates (Chart 11). The second panel of Chart 11 shows that, compared to history, munis offer a sizeable spread advantage over similarly-rated corporate debt. However, this comparison does not adjust for differences in duration and convexity between the two indexes. In the bottom panel of Chart 11 we show the residual from a model where the spread differential between high-yield munis and high-yield corporates has been regressed against differences in duration and convexity. We see that high-yield munis look even more attractive after making these adjustments. These simple adjustments reveal that high-yield munis are attractive relative to high-yield corporates, but they do not consider the impact of a macro environment that is about to turn extremely negative for municipal debt. To control for this we created an augmented model of the spread differential between high-yield munis and corporates, adjusting for duration, convexity, the effective personal tax rate, relative ratings migration and several other factors (Chart 12). Chart 11High-Yield Muni Valuation I Chart 12High-Yield Muni Valuation II High-yield munis still appear quite attractive based on this model, but if we assume that the effective personal income tax rate reverts even to 2011 levels, then the a good chunk of the spread advantage vanishes (Chart 12, panel 2). This is an extremely conservative assumption. In reality, we expect the effective personal tax rate will fall much below 2011 levels under the new administration. Bottom Line: An examination of spreads alone suggests that high-yield munis are attractive compared to high-yield corporate debt, but the attractiveness is not sufficient to compensate for lower tax rates under President Trump. Avoid high-yield municipal debt. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Our internal calculation differs somewhat from the widely reported probability that is available on Bloomberg terminals. The reason is that the Bloomberg calculation assumes a baseline fed funds rate of 37.5 bps (the midpoint of the Fed's current target range), while we use the current effective fed funds rate which has recently been stable at 41 bps. 2 http://www.bloomberg.com/news/articles/2016-11-16/fed-s-kashkari-says-election-hasn-t-changed-economic-outlook-yet 3 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 4 Please see BCA Special Report, "U.S. Elections: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 5 https://www.c-span.org/organization/?63944 6 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 Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Chart 9Americans Like Voting, Just Not These Candidates 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.

Highlights The blistering dollar rally has mimicked the selloff in U.S. and global bonds. The dollar and bonds may have gotten ahead of themselves. A short-term reversal or a pause in the recent trend is becoming our base-case scenario for the rest of the year. If a dollar correction materializes, USD/CNY will also retreat, temporarily diminishing pressures on EM currencies. The yen weakness illustrates the importance of the September policy change by the BoJ. AUD/SEK is a short. We are re-introducing our back sections, but now covering all the G10 currencies. Feature In recent weeks, we have developed the view that a Trump victory would embolden our cyclically bullish stance on the dollar. We re-iterated this sentiment last week.1 Since then, we have received many questions about the very short-term outlook for FX markets. Our view is that from now to the end of the year, the dollar is likely to stabilize and may even weaken somewhat. This should create a buying opportunity for investors that have missed the dollar rocket. It's All About Bonds The dollar rally since Trump's election has been so torrid that the broad trade-weighted dollar has made new highs. DXY is now flirting with the top of the trading range established since March 2015 (Chart I-1). If the dollar can significantly punch above this resistance, or EUR/USD falls below 1.055, another violent dollar rally could ensue. While we do ultimately expect such a move to materialize, we do not expect it to happen just yet. The main reason for our skepticism is the bond market. Much of the appreciation in the dollar has been explained by the sharp rally in U.S. bonds, which has caused interest rates differentials to move massively in favor of the greenback (Chart I-2). For DXY to meaningfully punch above 100, bonds have to sell-off further. Chart I-1The Return Of The King Chart I-2Dollar And Bond Yields: Same Fight Our U.S. Bond Strategy service remains cyclically underweight duration, but the short-term outlook is murky. The move in bonds has been extremely one-sided. The bond market's behavior displays the hallmark of groupthink, where long-term and short-term traders have uniformly been selling Treasurys. The fractal dimension for bonds, a measure of groupthink developed by Dhaval Joshi, our European Chief Strategist, rests at 1.25, a level at which a trend reversal - even if a temporary one - tends to emerge (Chart I-3).2 Chart I-3Groupthink In The Bond Market Additionally, our composite sentiment indicator, based on the 13-week rate of change of prices, investor sentiment, and net speculative positions, is deeply oversold, highlighting the risk of a backup in prices (Chart I-4). Fundamentals also warrant a careful stance. A December Fed hike is fully priced in, and the expected Fed funds rates 12-months from now is already near the levels hit before the Fed raised rates in 2015 (Chart I-5). A catalyst is now needed to push rate expectations materially higher. Chart I-4Bond Sentimen##br##t Is Depressed Chart I-5Interest Rates Priced In A Lot##br## In A Short Time Span However, the recent backup in yields and the dollar has massively hit EM currencies (Chart I-6). EM currencies are falling because investors are taking funds out of these economies. Consequently, EM liquidity and financial conditions are tightening, a dark omen for economic activity in that space (Chart I-7). The more than 10% fall in gold prices since July 8, also paints a picture of deteriorating global liquidity conditions. Chart I-6Bond Yields Are Hurting##br## EM Financial Conditions Chart I-7A Dark ##br##Omen An EM correction may compel the Fed to worry about the short-term outlook. This development, along with the tightening in U.S. financial conditions resulting from the 7% back up in the broad trade-weighted dollar and 77 basis points in bond yields since mid-August, heighten the risk of a correction in risk assets. The Fed is aware of this and the market knows it. Chart I-8CPI Swaps Can Rebound More Additionally, U.S. 5y/5y forward CPI swaps have backed up 60 basis points from their lows to 2.4%, but they still remain below their historical norm of 2.5% to 3.3% (Chart I-8). The Fed probably wants to see them closer to these levels before aggressively ramping up its rhetoric and "dot-plot" forecasts. A Trump presidency will result in a large dose of fiscal stimulus, but we still have little clarity regarding the size of any packages, their composition, or their timing. Neither does the Fed. If there was any clarity, the Fed would likely be in a position to increase its "dot-plot" even without inflation expectations being in their normal range. Additionally, this week, the Bank of Japan put actions behind its words and announced an unlimited bond buying program at fixed prices, a process that should cap the upside on this anchor for global yields. Thus, in the very near term, the burden of proof is now elevated for rates to rise higher without the Fed's rhetoric becoming clearly more hawkish. While we expect this outcome to ultimately materialize, the next few weeks are not when we see it happening. This implies that the dollar's rip-roaring rally is likely to take a pause and even retrace some of its exceptional gains. However, a key risk remains, and that is China. Since Trump's victory, the Chinese RMB has accelerated its downward path, depreciating 1.7% in nine days. This move reflects the fear that Trump will impose large tariffs on Chinese-made goods. In the process, the fall in the yuan has dragged Asian currencies lower than the DXY appreciation would have warranted (Chart I-9). If these moves were to continue, EM currencies, the yen, and the AUD would fall further even without U.S. bond yields rising much. In the short-term this remains more a risk rather than a base-line scenario. While USD/CNY has rallied, the yuan has been stable relative to the currency basket targeted by the PBoC (Chart I-10). Therefore, if our view that the U.S. bond sell-off pauses temporarily is correct, the USD/CNY rally will also take a breather. Chart I-9Tariff Risk Weighing On Asian Forex Chart I-10Mind The Gap! The currencies most likely to benefit from any dollar bull-market pause are JPY, SEK, and EUR as they have become hyper-sensitive to U.S. bond yields. EM currencies too could see a temporary rally, especially if USD/CNY stops appreciating in line with the DXY. Bottom Line: The dollar bull market is intact. However, the tactical outlook points toward a pause in the greenback's upswing. In light of the fast repricing of the market's expectations for Fed policy, and the lack of clarity regarding Trump's plans, bond yields and interest-rate expectations have gotten ahead of themselves. Even the rally in USD/CNY, which has contributed to devaluation pressures on other Asian currencies, could pause if DXY stops rallying for a period of time. Why is the Yen So Weak? We have articulated a very bearish view on the yen since September 23.3 To our way of thinking, the Bank of Japan pegging 10-year JGB yields to 0% until Japanese inflation significantly overshoots 2% was a sea-change. However, we have been surprised by the violence of the recent yen sell-off. After all, wouldn't a selloff in EM currencies support the yen? A few factors have been at play. First, Japanese preliminary Q3 GDP numbers have come in at 2.2% on a year-on-year basis, handily beating expectations of 0.9%. Moreover, industrial production has picked up, and our model forecasts further acceleration, despite the recent strength in the yen (Chart I-11). With the employment market being tight - the unemployment rate stands at 3.1% and the active-job-openings-to-applicants ratio is at a 25-year high - this raises the risk that inflation begins to emerge. With nominal bond yields pegged at zero, this would weigh on Japanese real rates, and thus the yen, which continues to closely correlate with Japanese real rates differentials. Second, the recent global sell off in bonds has been an additional weight on the yen. In our communications with clients, we are often reminded how USD/JPY and bond yields are essentially one and the same, a heuristic borne by the facts (Chart I-12). Chart I-11Japanese IP Is ##br##Picking Up Chart I-12USD/JPY And Bond Yields ##br##Are One And The Same But right now, there is more to the relationship with bond yields than in previous episodes. The September promise of a cap on 10-year JGB yields is causing Japanese yield differentials to stand at mid-2015 levels, despite global yields being lower than they were then (Chart I-13). Also, the sell-off in global bonds has caused 10-year JGB yields to move slightly above 0%. However, having announced unlimited bond purchases at capped yields, the BoJ is about to begin purchasing JGBs to prevent yields from punching above 0% meaningfully. This will result in growing Japanese liquidity, compounding already existing JPY weaknesses. Chart I-13The BoJ Policy In Action Finally, the government is talking up fiscal stimulus. The third revision of the second supplementary budget has been passed, and the executive is already pushing for a third supplementary budget. Additionally, both Abe and Kuroda are ramping up their rhetoric regarding next year's wage negotiations, highlighting the growing risk that the government will implement wage policies in 2017.4 Short-term risks are skewed toward a yen rebound. When the BoJ announced its new policy in September, USD/JPY was 7% undervalued according to our short-term model. This is not the case anymore. Also, if global bond yields stop their ascension until year end, the BoJ will not purchase any bonds. Moreover, falling global bond yields will push Japanese rate differentials in favor of the yen, supporting the currency further. Finally, a continuation of EM stresses could prompt Japanese investors to repatriate funds into the country, putting upward pressures on the yen. Bottom Line: The extraordinary weakness in the yen reflects the improvement in Japanese economic activity. Also, the change in monetary policy executed earlier this year is limiting the upside for JGB yields, and the BoJ is now setting up an unlimited purchase program to back its words. However, a short term pull-back in USD/JPY grows increasingly likely if the global bond implosion takes a breather. Going Short AUD/SEK Shorting AUD/SEK here makes sense. To begin with, AUD/SEK is trading 16% above its long-term fair value as well as 5.2% above its short-term equilibrium (Chart I-14). Additionally, the current account differential is 9.4% of GDP in favor of Sweden. In terms of the economy, the Swedish consumer is displaying stronger resilience than the Australian one, powered by an outperforming Swedish labor market (Chart I-15). Additionally, Swedish house prices are growing 5% faster than in Australia. With Swedish consumer confidence outperforming that of Australia, and Swedish household credit overtaking Australian household credit growth, inflationary forces could emerge, resulting in a tightening of Swedish policymakers' rhetoric relative to Australia. On this front, the recent pick up in Swedish inflation is telling. Having rebounded to 1.2% annually, Swedish headline CPI is at a four-and-a-half-year high, suggesting that the emergency measures put in place by the Riksbank are beginning to outlive their usefulness. Meanwhile, Australia is moving away from its easing bias. But a move toward less accommodation is still not in the cards, especially as employment growth underperformed and total hours worked contracted at a 1% annual pace. Financial market dynamics also favor a weaker AUD/SEK. This cross has moved much ahead of nominal interest rate differentials, and real-interest-rate differentials have moved in the opposite direction, pointing to a lower AUD/SEK. Additionally, the Swedish broad market as well as financial equities have been outperforming Australian stocks. This suggests that Swedish financial conditions are too easy relative to Australia. Finally, technicals point to a negative short-term outlook for this cross. AUD/SEK is massively overbought on a 52-week-rate-of-change measure. On a shorter-term basis, the MACD indicates an overbought condition and is forming a negative divergence with prices, exactly as the stochastic indicator has broken down (Chart I-16). Chart I-14Poor Risk/Reward Tradeoff ##br##For Holding AUD/SEK Chart I-15The Swedish Labor ##br##Market Is On Fire Chart I-16AUD/SEK:##br## Poised For A Shakeout Bottom Line: The outlook for AUD/SEK is problematic. This cross is pricey and the Swedish consumer is outperforming that of Australia. This is happening exactly as the Riksbank may begin moving away from its hyper-accommodative stance, as inflation is hitting four-and-a-half year highs. Finally, financial market dynamics and currency technicals are flagging a short in this cross. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Raeganomics 2.0?", dated November 11, available at fes.bcaresearch.com 2 Please see European Investment Strategy Special Report, "Fractals, Liquidity & A Trading Model", dated December 11, 2014, available at eis.bcaresearch.com 3 Please see Foreign Exchange Strategy Weekly Report, "How Do You Say "Whatever It Takes" In Japanese?", dated September 23, 2016 available at fes.bcaresearch.com 4 Ibid. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Last week, equities and the dollar rallied as Trump's unexpected victory was taken as a positive for the U.S. economy in the hopes of promised fiscal stimulus. Both the market and Fed officials therefore remain tenacious on the prospects of a 25bps hike in December, with a 98% probability currently priced in. In a speech on Thursday, Yellen confirmed the gradual normalization of policy and acknowledged the strength of the U.S. labor market. Initial jobless claims declined to 235,000 from 254,000 and continuing jobless claims declined to 1.977 million from 2.043 million. This has further solidified our bullish stance on the dollar. On a technical basis, the DXY Index has hit a key resistance level of 100, which suggests a temporary halt to last week's surge. However, longer-term momentum is indicating a possible break-out from the key 100 level in the near future. Report Links: Reaganomics 2.0? - November 11, 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 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 The Euro continues to mirror the U.S. Dollar, losing more than 3% in a week since the U.S. Presidential Election. This move seems to be a function of the election only, as European data has come out reasonably strong this week: Economic sentiment from the ZEW Survey shot up to 15.8, beating expectations, while current conditions declined to 58.8 from 59.5. The trade balance increased by €8.2bn to €26.5bn. European GDP growth remains solid at 1.6%. Data points to EUR strength, so the Euro should remain somewhat neutral on a trade-weighted basis as its economy remains strong. Monetary policy divergence and technicals, however, should continue to weigh on EUR/USD in the short term, suggesting that cross-currency plays are the best way to capture any Euro strength. 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-5JPY Technicals 1 Chart II-6JPY Technicals 2 The yen has been one of the worst performing currencies in the G10 following Trump's election, with USD/JPY appreciating by about 5%. After this down-leg, we will not be surprised if the yen recovers some ground in the short-term. USD/JPY has already reached overbought technical levels and the sell-off in EM caused by the rising dollar may eventually trigger a risk-off period from which the yen will benefit. However, past the short term, we continue to be yen bears. Although the policies that the BoJ implemented in September did not seem as radical back then, a cap on Japanese 10-year rates takes a whole different meaning for the yen in the recent environment where interest rates are rising in the U.S, since it exerts considerable pressure on Japanese real rates vis-à-vis the rest of the world. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 An interesting trend has caught our attention: the British economy continues to be very resilient, beating not only market expectations but also projections by the BoE. Recent October data confirms this view: Retail sales and retail sales ex-fuel grew at an annual rate of 7.4% and 7.6% respectively, blowing past expectations. Additionally Markit Services PMI was 54.5, also beating expectations. This is particularly surprising given that the service sector is likely getting very little support from the weak pound. We are reticent to be bullish on the pound, at least on the short term, given that political risks continue to dominate the movements of this currency. Nevertheless, the cable is very cheap from a valuation standpoint, and if the British economy continues to beat expectations, the pound could become an attractive buy. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The RBA left its cash rate unchanged at 1.5% at their November meeting, and clarified that their easing cycle has come to an end. Recent data, however, is showing signs of weakness in the Australian economy: the Westpac Consumer Confidence Index came in last week at -1.1%; wage pressures remain subdued at 1.9% yoy in Q3 from 2.1% in Q2; employment change was weaker than expected at 9,800 with the unemployment rate unchanged at 5.6% in October. Labor market slack remains a fundamental concern for the Australian economy, something the RBA also pointed out in their November statement. Inflationary pressures, if any, will likely emanate only from commodity prices, for which the outlook remains questionable due to a rising USD. Deteriorating consumer confidence and continued labor market slack will translate into deflationary tendencies, which will cap rates and add downward pressure on the AUD. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 In line with expectations, The RBNZ cut rates by 25 basis points to 1.75% at its latest policy meeting. Shortly after, a speech by Governor Wheeler lifted the NZD, as he appeared to signal that the RBNZ might be done easing by stating that "at this stage we think that we won't need another cut". We are unfazed by this change of rhetoric, and continue to be bearish on the kiwi. The NZD has formed a head-and-shoulders pattern which, along with fading momentum, foretells a downside leg for this antipodean currency. Moreover, a sell-off in Asian currencies and deteriorating financial conditions in Emerging markets following Trump's election should put further downward pressure on the kiwi, given that the NZD is the most sensitive currency to Asian spreads in the G10. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data points south for CAD: The merchandise trade deficit increased to CAD 4.1bn in September, with imports rising 4.7% to a record CAD 47.6 bn, and exports only up 0.1% to CAD 43.5 bn. The housing market continues to display warning signs as housing starts decreased in October to 192,900 and building permits declined by 7% in September from August, showing signs of supply decreases and rising prices. Although the labor market seems to be picking up, with net change in employment increasing by 43,900 and the participation rate at 65.8%, the setback in growth from the commodity slump and the Q2 Alberta wildfires will keep the BoC from raising rates. Nevertheless, we remain bullish on oil in the commodity space, and the CAD will likely display strength against the antipodeans. 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-15CHF Technicals 1 Chart II-16CHF Technicals 2 The rally in USD/CHF should subside, at least in the short term. Not only has the swissie reached technical overbought levels, but the continued tightening in EM financial conditions caused by the rising dollar increased the probability of a risk off period where the CHF would rally. EUR/CHF on the other hand is likely to have limited downside from here on. Since August 2015, this cross had traded within a tight range of 1.075 to 1.110, breaking down only after the Brexit vote, when all risk-off assets rallied. However it has recently broken down again, an unwelcomed development for the SNB, who will likely intervene in the currency market in order to keep a rising franc from adding additional deflationary pressures to the Swiss economy. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The Krone was another victim of Trump's election, with USD/NOK rising by 4%. Although we expect that the dollar bull market will ultimately weigh on the krone, we remain positive on the outlook for this currency compared to its commodity peers. Inflation is currently at 3.7%, significantly above the Norges Bank target. Additionally house prices are rising at almost 20%, while household debt as a percentage of disposable income has surpassed the 200% mark. The Norges Bank has not overlooked this developments, as their rhetoric has recently become more hawkish. All these factors along with rebalancing energy markets, should provide strong tailwinds for the NOK, particularly against its crosses. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy looks strong according to recent data: Manufacturing PMI ticked up last month from 54.9 to 58.4. Industrial production increased in September by 1.5% annually. Inflation in October came in at 1.2% yoy. Inflation in the near future also looks quite upbeat, as per the uptick in 1-, 2-, and 5-year Prospera inflation expectation numbers to 1.4%, 1.7%, and 1.9% respectively. The Riksbank has therefore lifted their easing bias, which is also reflected by an increase in the 12-month market expectations of the repo rate to -0.4%. All is not perfect though. New orders decreased by 16.4% annually, indicating possible fragility in the manufacturing sector. Additional medium-term risk to the SEK will be dictated by bullish moves in the USD, as SEK remains one of the currencies with the highest sensitivity to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following Chart I-10Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 1-13 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights EM risk assets will continue to plunge as U.S. bond yields and the U.S. dollar have more upside. Asset allocators should maintain an underweight allocation to EM within global equity and credit portfolios. Upgrade Russian stocks from neutral to overweight within an EM equity portfolio. Reinstate the long Russia ruble / short Malaysian ringgit trade. Feature The rout in emerging markets (EM) risk assets will persist, regardless of the direction of the U.S. equity market. While president-elect Donald Trump's potential fiscal stimulus will boost U.S. growth, it will not be sufficient to offset the negative impact on EM from rising U.S. Treasury yields and a stronger U.S. dollar. On a broader scale, risks of protectionist measures from the incoming U.S. administration are non-trivial, which will make investors even more jittery on EM. Notably, from a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter's domestic fundamentals were poor and commodities prices were falling. For example, EM in general and emerging Asia in particular collapsed in 1997- '98 when U.S. real GDP growth was averaging 4.5%, and European real GDP growth was 3.5%. In particular, U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia (Chart I-1). Importantly, U.S. bond yields were falling during the 1997-'98 period. Chart I-1Strong U.S. Growth Is No Panacea For EM Stocks It is hard to expect similar U.S. growth nowadays, even with Trump's potential fiscal impetus. Meanwhile, any fiscal boost in Europe so far remains a forecast. Besides, back in the 1990s, the U.S. and Europe were dominant sources of global demand - and China was not at all an economic power. Since the late 1990s, the significance of China and the rest of EM has grown enormously, while the importance of the U.S. and Europe with respect to global demand in general and EM in particular has fallen. In short, the outlook for stronger growth in the U.S. is not a reason to turn bullish on EM because the latter's fundamentals are poor. The U.S. dollar rally will persist. The greenback is close to being fairly valued, or only slightly expensive (Chart I-2). Typically, major cycles run until a market becomes considerably expensive or very cheap. It is not often that markets bottom or peak at their fair value. Odds are that the U.S. dollar will become more expensive before this bull market is over. In effect, the U.S. dollar rally is reflective of America sucking in capital. This will leave EM current account deficit countries exposed. As the currencies of these countries plummet and their local bond yields rise, their share prices will plunge and credit spreads will widen. Importantly, Trump's trade protectionist rhetoric could accelerate the depreciation in the Chinese RMB. If and when America imposes import tariffs on China, the latter will compensate via further yuan depreciation. In fact, Chinese residents will "assist" the People's Bank of China in devaluing the currency by converting their RMBs into U.S. dollars. As the RMB weakens further, probably at a faster speed, other Asian currencies will plummet (Chart I-3). In fact, odds are high that EM financial markets will once again become sensitive to the RMB. Chart I-2The U.S. Dollar Is Not Expensive Chart I-3RMB And Emerging Asian Currencies Apart from shorting the RMB versus the U.S. dollar, on October 19 we recommended shorting the KRW against the THB because the Korean won was one of most vulnerable EM currencies to continued RMB depreciation and renewed JPY weakness. We reiterate this trade today. Consistent with U.S. dollar appreciation, commodities prices will drop. One unsustainable post-U.S. presidential election move has been the rally in industrial metals in general, and copper in particular. Traders have bid up copper prices as the metal had lagged the rally in risk assets since February (Chart I-4). Nevertheless, expectations that U.S. infrastructure spending will considerably boost world demand for industrial metals are misplaced. The U.S. accounts for a very small portion of global industrial metals demand, including copper. Chart I-5 demonstrates that U.S. demand for copper is seven times smaller than that of China. On average, China accounts for about 50% of global demand for industrial metals, while the U.S. accounts for slightly less than 10%. Chart I-4The Rally In Copper ##br##Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China Hence, any reasonable rise in U.S. demand will not be sufficient to offset a single-digit percentage drop in China's intake of industrial metals, which we expect to occur in 2017. Finally, the Chilean mining firm Codelco - the largest copper producer in the world - in recent weeks has cut its premiums on copper shipped to Asia and Europe.1 This is a move to reduce prices - and a sign that demand is weak relative to supply. This leads us to believe that a rally driven by financial investors at a time of inferior demand-supply balance will prove short-lived. Investors should consider shorting copper on any further price strength. The selloff in U.S. and global bonds will likely persist well into December, which in turn will unravel the turmoil in bond proxies and high-multiples stocks (Chart I-6). In our July 13 Weekly Report,2 we argued that U.S. bond yields had bottomed and a selloff would prove painful as lower yields increases their duration. As a result, even a small rise in yields would lead to considerable bond price declines. Since then, while G7 bond yields initially grinded higher, they have surged over the past week. U.S. 10-year and 30-year bond yields have risen by 40 and 36 basis points, respectively since November 1. This translates into a 3.5% and 7.5% price decline for 10-year and 30-year bonds, accordingly. A similar scenario has also played out with EM bonds - both U.S. dollar and local-currency denominated. Accumulating considerable losses will force further bond liquidation. Our feeling is that many bond proxies and markets that benefited from lower yields will be seriously damaged in the coming weeks. Consistently, EM carry trades are at risk of further unraveling. Interestingly, Chart I-7 demonstrates that many high-yielding EM local bond markets are at a critical technical juncture. Odds are that their yields are heading considerably higher after troughing at their long-term moving averages. Chart I-6U.S. Bond Yields ##br##And Bond Proxies Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels Bottom Line: EM risk assets will continue to plunge. Stay put and remain defensive. Asset allocators should maintain an underweight allocation to EM within both global equity and credit portfolios. Currency traders who are not already short should consider shorting a basket of the following EM currencies: BRL, CLP, ZAR, TRY, IDR and MYR. In addition, we recommend maintaining our short RMB versus USD trade, as well as our short KRW / long THB position. Today, we are also reinstating the long RUB / short MYR trade (see section on Russia below). For more details on other currency, fixed-income, credit and equity positions, please refer to our Open Position Tables on pages 12-13. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please see: Codelco cuts 2017 China copper premium by 27% to $72/t.- sources (2016, November 14). Retrieved from https://www.metalbulletin.com/Article/3601613/Latest-news/Codelco-cuts-2017-China-copper-premium-by-27-to-72-sources.html 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 14. Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade Chart II-1Overweight Russian Stocks ##br##Versus The EM Equity Benchmark Russia stands out as one of the few EM countries that will likely benefit from Trump's presidency. As such, we recommend dedicated EM investors overweight Russia within both EM equity and credit portfolios. The energy and financial equity sectors together account for 75% of the Russian MSCI equity index, and we think they will continue to outperform their EM peers for the following reasons: With the ruble serving as a shock absorber, Russia's oil and gas sector has been able to weather the volatility in energy prices. If it wasn't for the ruble's massive devaluation in 2014-15, Russian energy companies would have struggled to stay solvent. While we expect oil prices to drop toward $35 per barrell, Russian energy stocks will still perform better than their EM counterparts. Furthermore, going forward, oil prices will outpace industrial metals prices. This should help Russian stocks, credit, and the currency outperform their EM peers (Chart II-1). As we argued above (please refer to page 3), the latest rally in industrial metals prices - based on expectations of U.S. infrastructure spending - does not make sense to us. In fact, the U.S. is a much more important consumer of oil than industrial metals in total world aggregate demand. Hence, strong U.S. growth and weaker Chinese growth (our baseline assumption) should be associated with oil prices outperforming base metals prices. Russia is much more advanced in its deleveraging cycle than most other EM economies. This will help banks and consumer stocks outperform their EM peers. In March 2016 we highlighted our preference for Russia's banking system relative to Malaysia's, and initiated a relative equity trade: long Russian stocks / short Malaysian stocks. This trade has already returned 30% and we believe it still has further to go. Today, we extend this positive view on Russia's banking system vis-à-vis Malaysia, to one versus the entire EM bank universe. In contrast to other emerging markets, Russian banks have been recognizing NPLs and have increased their provisions significantly (Chart II-2). Russia has now been in recession for two years and its banks have increased their NPL provisions and their credit growth has already slowed down significantly. This stands in stark contrast to other emerging markets, where banks are failing to realize NPLs and increase provisions adequately, despite substantially slower economic growth and elevated debt levels. In fact, Russia's domestic credit impulse is already starting to head into positive territory (Chart II-3), while the same indicator for the overall EM aggregate will be negative over the next 12 months or so. Russia's financial market outperformance will be aided by orthodox macro policies. This stands in contrast to unorthodox measures in many other developing countries. In terms of monetary policy, the Central Bank of Russia has refrained from injecting excess liquidity into the system or intervening in the foreign exchange market. Moreover, the central bank has been canceling the licenses of smaller banks. This is bullish for listed banks, as their market share will increase (Chart II-4). Chart II-2Russian Banks Have Recognized ##br##NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks With respect to fiscal policy, although the government has exceeded its planned budget deficit of 3% of GDP for 2016, we believe this is not an issue given that Russia's total government debt is very low at only 16.5% of GDP. Lastly, our bias is that the recent victory of President-elect Trump will be marginally positive for the Russian economy relative to other EM. While the U.S. is not a major importer of Russian exports, investors will begin to price in sanction relief. European sanctions are particularly important for Russia and a substantive improvement in U.S.-Russia relations could lead some relatively pro-Russia European governments (Italy, Hungary, Greece, etc.) to demand that EU sanctions be either rolled back fully or significantly modified. Therefore, since Russia does not export as many goods to the U.S. compared to other emerging markets and sanctions may be easing soon, the nation is much more insulated from potential U.S. protectionist measures than many other EM countries. Investment Recommendations The Russian economy is further along its necessary adjustment path compared to the rest of the EM world, and there is less downside at the moment. Furthermore, Russian monetary and fiscal policymakers have undertaken orthodox policy measures in the face of an economic crisis - which cannot be said of many other EM countries. As such, we recommend dedicated EM investors upgrade Russia from neutral to overweight within an EM equity portfolio. We reiterate an overweight stance on Russian sovereign and corporate credit and recommend holding the following trades: Short Russian CDS / long South African CDS Long Russian and Chilean corporate credit / Short Chinese offshore corporate credit. We also recommend currency traders reinstate the long RUB / short MYR trade (Chart II-5). The two currencies are sensitive to energy prices, but the Russian economy is likely to recover soon, while the Malaysian economy has much more downside ahead. Excessive liquidity injections in Malaysia relative to somewhat tighter monetary conditions in Russia will lead to ringgit depreciation versus the ruble (Chart II-6). Lastly, the ruble offers a higher carry than the ringgit. Consistent with the currency trade, we are maintaining our long Russian / short Malaysian equity trade. Chart II-5Reinstate Long RUB / ##br##Short MYR Trade Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trump's Win: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. Trump Stimulus & The Yield Curve: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Feature Chart of the WeekTrump Turmoil For Bonds America has been treated to a pair of major shocking events over the past couple of weeks. The Chicago Cubs won baseball's World Series for the first time in 108 years. And now, Donald Trump - real estate tycoon, reality TV star, Twitter addict - has become the 45th President of the United States. In the aftermath of that stunning election victory, investors are being treated to one more shocker that seemed impossible even just a few months ago - rapidly rising bond yields. Trump's victory has not only changed the political power structure in the U.S., but has seemingly altered many of the familiar financial market narratives as well. The idea of "deficit spending" by the government to boost growth has not been heard for many years in Washington, but Trump has made it clear that a big fiscal stimulus is coming soon to America. He has laid out a combination of large tax cuts and infrastructure spending that could result in both a surge in U.S. Treasury issuance in the coming years and a more structural rise in inflation - again, developments that have not been seen in the U.S. in quite a while. The prospect of fiscal easing amid still-accommodative monetary conditions in the U.S., with the economy running at full employment, has sent Treasury yields surging back to pre-Brexit levels, wiping out six months of positive bond returns in the process (Chart of the Week). While many details are still to be worked out with regards to Trump's proposed fiscal policy shift, the markets have taken its pro-business tilt as a bullish sign for growth and a bearish sign for bonds. There is more scope for yields to rise in the near term, in the U.S. and elsewhere, with the Fed likely to deliver another rate hike next month and the global economy now in a cyclical upswing. Duration risk remains the biggest immediate threat for bond investors, and we continue to recommend a below-benchmark portfolio duration stance. A New Sheriff In Washington Chart 2Markets Cheer Trump 'Bigly' The consensus opinion among investors going into the U.S. election was that a Trump victory would result in considerable market turmoil. This was a reasonable argument, as Trump ran a disruptive, anti-status-quo campaign that, by definition, would be expected to generate far more changes and uncertainty than a victory by Hillary Clinton. Yet outside of a few shaky moments in the wee hours of Election Night as markets began to realize that Trump would win, the big bond-bullish/equity-bearish risk-off moment never arrived. Perhaps Trump's more conciliatory tone in his victory speech helped to calm investors' fears that his caustic campaign demeanor would continue in the White House. More likely, investors saw the results in the U.S. Congressional elections and realized that the Republican Party had won a clean sweep in D.C. that would allow Trump to implement many of his campaign promises. Markets have been rapidly pricing the potential implications of a Trump presidency into many financial assets (Chart 2), from bank stocks (which would gain from Trump's proposed rollback of the Dodd-Frank regulations on bank activities and, more importantly, from the impact of higher bond yields and a steeper yield curve on profitability) to the U.S. dollar (which would benefit from Trump's protectionist trade agenda through narrower U.S. trade deficits and stronger U.S. growth that would raise the future trajectory of U.S. interest rates). Higher-quality USD-denominated credit spreads have been surprisingly well behaved, given the moves higher in U.S. yields and the USD itself. This may reflect an optimistic belief that Trump's pro-business, pro-growth policies can offset the negative impact on corporate profits from higher yields and a stronger USD. Markets are right to assume that Trump can actually deliver on his economic agenda. A detailed analysis of the implications of the Trump victory was laid in a Special Report sent last week to all BCA clients by our colleagues at BCA Geopolitical Strategy.1 One of their main conclusions was that Trump's ability to enact his plans will not be hindered much by the U.S. Congress. Republicans now control both the House of Representatives and Senate after last week's elections and Trump has been strongly supported even by the small government fiscal conservatives in Congress. After delivering such a stunning victory for the Republicans, Trump shouldn't face much serious resistance to his economic initiatives. Investors are starting to price in the potential inflationary implications of a President Trump, with the 5-year inflation breakeven, 5-years forward from the U.S. TIPS market now sitting at 1.84%. This is still well below the Fed's 2% inflation target (after adjusting for the usual historical difference between the CPI used to price TIPS and the Fed's preferred inflation gauge, the PCE deflator, which is around 0.4-0.5%). This measure can keep moving higher over the medium-term, given the timing of Trump's proposed fiscal stimulus. Bottom Line: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. The 1980s Called - They Want Their Economic Policy Back The U.S. economy is now showing few internal imbalances that would require wider government deficits as a counter-cyclical policy measure. The private sector savings/investment balance is close to zero, as the post-crisis household deleveraging phase has ended and corporate sector borrowing has skyrocketed in recent years (Chart 3, top panel). Also, measures of spare capacity in the U.S. economy like the output gap or the unemployment gap are also near zero (bottom panel), suggesting that any pickup in aggregate demand from current levels could trigger a rise in wage inflation and domestically-focused core inflation. Chart 3Deficit Spending At Full Employment: Back To The Future? The last time that such a combination of fiscal stimulus and full employment occurred was in the mid-1980s during the presidency of Ronald Reagan. Trump's plans for aggressive tax cuts and sharp increases in discretionary government spending do echo the policies of Reagan, who presided over one of the nation's largest peacetime run-ups in discretionary government budget deficits and debt (Chart 4). Perhaps there was a kernel of truth in the Trump/Reagan comparisons made during the election campaign! Chart 4Less Fiscal Space Than In The 1980s Clearly, a sharp run-up in federal budget deficits could have a much greater impact on longer-term interest rates and the shape of the yield curve, given the much higher starting point for federal debt/GDP now (74%) compared to the beginning of the Reagan presidency (26%). Especially given the potentially large budget deficits implied by Trump's campaign promises. Back in June, Moody's undertook an economic analysis of Trump's economic policies based on publically available information (i.e. Trump's campaign website) and their own assumptions based on Trump's campaign speeches.2 Moody's ran policies through its own U.S. economic model, which is similar to the forecasting and policy analysis models used by the Fed and the U.S. Congressional Budget Office. This model allows feedback from fiscal policy changes to the expected swings in growth and inflation and the likely shifts in monetary policy. The Moody's analysts used a variety of scenarios, ranging from full implementation of Trump's proposals3 to a heavily watered-down version if he faced a hostile Congress (which is clearly not the case now). We show the Moody's model forecasts for the U.S. Federal budget deficit as a percentage of GDP in Chart 5, along with the slope of the very long end of the U.S. Treasury curve. We also show the 10-year/30-year slope versus a measure of the Fed's policy stance, the real fed funds rate. According to Moody's, a full implementation of the Trump platform would push the U.S. budget deficit to double-digit levels by 2020, and would add nearly $7 trillion in debt over that time, pushing the federal debt/GDP ratio to 100%. The less extreme scenarios show smaller increases in deficits and debt, but the main point is that even if Trump implements only some fraction of his policies, the U.S. budget deficit will go up significantly during his first term in office. Looking at the historic relationship between the deficit and the slope of the Treasury yield curve, this implies that Trump's policies should put steepening pressures on the long-end of the curve as the bond market prices in greater Treasury issuance and higher future inflation rates. Of course, the bottom panel of Chart 5 shows that Fed policy also matters for the shape of the curve, and this is where the current debate over the Fed's next moves comes into play. Chart 5Trump's Deficits Will Steepen The Curve (Fed Permitting) The market is currently discounting a 70% probability that the Fed will hike at the December FOMC meeting, which has been our call for the past few months. The Fed has been projecting an increase next month and another 50bps of hikes in 2017, but these were forecasts made in the BT (Before Trump) era. The pricing from the Overnight Index Swap (OIS) curve shows that the market's expectations have started to shift upward towards the Fed's forecasts, in contrast to the BT dynamic where the Fed was having to cut its forecasts down towards the lower levels implied by the market (Chart 6). Will the Fed now look at the fiscal stimulus proposed by Trump as a reason to hike rates higher, or faster, than their latest set of projections? A big fiscal stimulus at full employment would certainly give the FOMC cover to raise its forecasts for growth and inflation, which would require a shift upwards in its interest rate projections. We do not expect that outcome at next month's FOMC meeting, as the Fed would likely want to see more specific budget details from the Trump administration in the New Year. More importantly, the Fed will want to avoid any additional strength in the U.S. dollar by moving to a more hawkish stance too soon, which would turn the dollar once again into a drag on U.S. growth, inflation and corporate profits, potentially disrupting financial markets. With the Fed unlikely to become more hawkish in the near term, the Treasury market will remain focused on the fiscal implications of Trump, placing bear-steepening pressures on the Treasury curve. For that reason, we are exiting our current Treasury curve flattener positions (2-year vs 10-year, 10-year vs 30-year) this week and moving to a neutral curve posture. We continue to maintain a below-benchmark stance on overall portfolio duration, as well as an underweight bias toward U.S. Treasuries within the developed market bond universe (on a currency-hedged basis). Treasuries are still not cheap, despite the recent run-up in yields, according to our global PMI model which incorporates variables for growth, U.S. dollar sentiment and policy uncertainty (Chart 7). Fair value has risen to 2.25% on the back of improving global growth and reduced uncertainty post-Brexit, with rising dollar bullishness providing a downward offset. Chart 6Markets Moving UP To The Fed Forecasts Chart 7USTs Not Yet Cheap If the Fed were to move too quickly to a more hawkish stance, dollar bullishness would increase and limit the cyclical rise in yields. At the same time, greater policy uncertainty under a new President could also limit yield increases although, as we have laid out above, the nature of the Trump uncertainty is not bond-bullish if it results in rising levels of government debt. For now, it is best to maintain a cautious investment stance until there is greater clarity on the U.S. policy front, while being aware that Treasuries are no longer as sharply undervalued as they were just a week ago. Looking ahead, this bond bear phase could end if the ECB announces an extension of its bond-buying program beyond the March 2017 deadline. As we discussed in a recent Weekly Report, the ECB will not be able to credibly declare that European inflation will soon return to the 2% target.4 This will force the ECB to extend the bond buying for at least another six months, with some changes to the rules of the program to allow for smoother implementation of future purchases. If, however, the ECB does indeed announce a tapering of bond purchases starting in March, bond yields will reprice higher within the main developed bond markets, led by rising term premiums (Chart 8). Given the global bond market's current worries about the inflationary implications of a switch away from extremely accommodative monetary policy to greater fiscal stimulus, a spike in yields related to a less-accommodative ECB could turn nasty fairly quickly. Chart 8A Dovish ECB Will Prevent A Deeper Global Bond Rout Bottom Line: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: More Growth, Fewer Defaults In recent discussions with clients, many have asked whether the implications of Trump's pro-growth policies, coming at a time of a cyclical upturn in the U.S. economy and inflation, should provide a boost to corporate profits that will, by extension, reduce the default risk in U.S. high-yield bonds. Chart 9Higher Nominal Growth Is Good For Junk (During Expansions) Chart 10High-Yield Valuations Have Improved Slightly It is a valid question to ask, as the excess returns on U.S. junk bonds have been historically been higher during expansions when nominal GDP growth (currently 2.8%) has been 4% or greater (Chart 9).5 With real U.S. GDP growth likely to expand by at least 2.5% in 2017, with moderately higher inflation, nominal growth should accelerate to a pace that has historically been friendlier for junk returns. Chart 11Corporate Balance Sheets Are Still A Problem Of course, the state of the corporate leverage cycle matters too, and that remains the biggest problem for high-yield. We have been maintaining an extremely cautious stance on U.S. junk bonds over the past few months, as a combination of highly-levered balance sheets and unattractive valuations led us to expect an underwhelming return performance from junk, especially with a volatility-inducing Fed rate hike likely to occur by year-end. That has not been case, however, as junk spreads declined steadily as the summer turned to autumn and have been relatively stable during the U.S. election uncertainty. Our colleagues at our sister publication, BCA U.S. Bond Strategy, recently introduced a simple model to predict junk bond excess returns as a function of lagged junk spreads and realized default losses.6 That model had been predicting excess returns over the next year of close to zero, but at today's spread levels the expected excess return over duration-matched U.S. Treasuries during the next year is closer to 157bps (Chart 10). While this is not the usual return that investors expect from an allocation to high-yield, it is better than the previous model prediction. Given this slightly more attractive level of spreads, a bond market now more prepared for a Fed rate hike, and with the default risks potentially narrowing somewhat on the back of a better nominal growth outlook for 2017, we no longer see the case for a maximum underweight position in high-yield. We still have our concerns about the state of the corporate credit cycle, and the valuations have not improved enough to justify a move back to neutral (Chart 11). Thus, we are only moving our U.S. high-yield allocation to below-benchmark (2 of 5) from maximum underweight (1 of 5). We are maintaining our below-benchmark stance on Euro Area and Emerging Market high-yield within our model portfolio, in line with our stance on U.S. junk. Bottom Line: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com. 2 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf 3 Aggressive income tax cuts, no changes to entitlement spending, increased defense outlays, and even the more controversial protectionist promises such as a 46% tariff on Chinese imports and the deportation of 11 million undocumented immigrant workers. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com. 5 Excess returns are the highest during low growth or recession periods, as this is when credit spreads are at their widest and companies are deleveraging and actively acting to reduce default risks. That is not the case at the moment. 6 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. TIPS: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Yield Curve: An upward re-rating of the market's assessment of the equilibrium level of monetary conditions is necessary for the curve to steepen further from current levels. Spread Product: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Conversely, the sharp rise in yields turns us more cautious on MBS. Municipal Bonds: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Feature We had expected any flight to quality related to a Donald Trump victory to be brief, but would never have anticipated how brief it actually was. Treasury yields declined for about four hours as the results came in on election night, but since midnight EST last Tuesday the bond bear market has been supercharged. BCA's fixed income publications have maintained a below benchmark duration stance since July 19 with a year-end target of 1.95-2% for the 10-year Treasury yield. The 10-year yield is now above our year-end target, as Trump's surprise victory caused investors to question many long-held assumptions. Chief among them is the thesis of secular stagnation - the idea that a chronic imbalance between savings and investment has resulted in an extremely depressed equilibrium interest rate. The secular stagnation theory has ruled the day in U.S. bond markets, but even Larry Summers, who popularized the theory in recent years, has admitted that "an expansionary fiscal policy by the U.S. government can help overcome the secular stagnation problem and get growth back on track." 1 The market has been quick to take on board President Trump's promises of massive debt-financed infrastructure spending, and is now questioning the idea of permanently low interest rates. While much uncertainty about President Trump still abounds, one thing for certain is that the path of Treasury yields next year and beyond will be determined by whether Trumponomics can successfully tackle secular stagnation. As of now, we are cautious optimists. Last week BCA sent a Special Report2 to all clients that describes the likely outcomes of a Trump presidency. One of those outcomes is that a sizeable fiscal stimulus will be enacted next year. In this week's report we explore its potential impact on bond markets and re-assess our U.S. bond portfolio in light of this surprise change in the economic landscape. Duration The expected path of future rate hikes has moved sharply higher during the past week (Chart 1). If we assume that U.S. monetary conditions reach our estimate of equilibrium3 by the end of 2019, then the shaded region in Chart 1 shows a range of possible outcomes for the federal funds rate based on different scenarios for the U.S. dollar. The upper-bound of the shaded region corresponds to the path of the fed funds rate assuming the dollar depreciates by 2% per year, while the lower-bound assumes the dollar appreciates by 2% per year. The market's expected fed funds rate path has shifted into the upper-half of the shaded region, which assumes the U.S. dollar will depreciate. The thick black line corresponds to the assumption of a flat dollar. Chart 1The Market's Rate Hike Expectations: Pre- And Post-Election Since the U.S. dollar is very likely to appreciate in the event that a Trump administration enacts growth-enhancing fiscal stimulus, it would appear as though the market's expected interest rate path is already too high. However, we must consider the possibility that large-scale government investment could shift the savings/investment balance in the economy and lead to a higher equilibrium level of monetary conditions or that the U.S. economy reaches monetary equilibrium more quickly under President Trump. In that event, Treasury yields still have room to rise. Chart 2Not Much Gap Between Market & Fed Similarly, 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 2). The 5-year/5-year forward overnight index swap rate is now 2.05%, only about 80bps below the Fed's median estimate of the equilibrium fed funds rate. Meanwhile, our 12-month discounter - the market's expected change in the fed funds rate during the next 12 months - is already at 44bps. If there are no revisions to the Fed's interest rate forecasts at next month's meeting, then a level of 50bps on our discounter will be consistent with the Fed's expectations. This would be the first time the market and dots were lined up since 2014. The key point is that the balance of risks in the Treasury market has shifted. Prior to the election, Treasury yields had been under-estimating the potential for fiscal stimulus in 2017. Now, for Treasury yields to continue their move higher, we need to transition from a world where the Fed is continuously revising its interest rate forecasts lower to one where it is making upward revisions. To be clear, we do expect this transition to occur in 2017 but probably not during the next few months. Now that the Treasury market has reacted to the promise of fiscal stimulus, the next step is that it will demand to see some results. On that note, while Trump's infrastructure spending plan is assumed to be huge, at this point details are scarce. Further, our U.S. Investment Strategy service4 has pointed out that the effectiveness of fiscal stimulus depends critically on how well fiscal multipliers are working, and that estimates of fiscal multipliers can vary widely (Table 1). Table 1Ranges For U.S. Fiscal Multipliers Another risk to the bond bear market comes from a rapid increase in the U.S. dollar. Our modeling work shows that Treasury yields tend to rise alongside improvements in global growth (as proxied by the global manufacturing PMI), but that the impact of improving global growth on Treasury yields is dampened if bullish sentiment toward the U.S. dollar is also increasing (Chart 3). At present, the 10-year Treasury yield is very close to the fair value reading from our model, but the worry is that continued upward pressure on the dollar will cause the model's fair value to roll over in the months ahead. Another risk is the impact of a stronger dollar on emerging markets. A rebound in emerging market growth has contributed significantly to the strength in the overall global PMI since early this year (Chart 4). A strengthening dollar correlates with a weaker emerging market PMI (Chart 4, panel 2), and weakness on this front will weigh on the global growth component of our Treasury model. The possibility that President Trump will classify China as a "currency manipulator" once he takes office only exacerbates the risk from emerging markets. Chart 3Global PMI Model Chart 4EM Could Derail The Bond Bear Bottom Line: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. We therefore take this opportunity to book +35bps of profits on our tactical short December 2017 Eurodollar trade. Longer run, we expect Donald Trump will be able to deliver a sizeable fiscal stimulus package and that Treasury yields will be higher at the end of 2017. TIPS Chart 5TIPS Breakevens Still Depressed Our overweight recommendation on TIPS versus nominal Treasuries has also benefitted from Trump's win. The 10-year breakeven rate has increased +15bps since last Tuesday, but still has a long way to go before reaching levels that are consistent with the Fed hitting its inflation target (Chart 5). Trump's main economic policies - increased fiscal spending and more protectionist trade relationships - are both inflationary. The most likely candidate to derail the widening trend in breakevens would be a quicker pace of Fed rate hikes that offsets the inflationary fiscal impulse. We think a much more hawkish Fed policy is unlikely in the near term. With TIPS breakevens still so low the Fed will want to nurture their recovery toward pre-crisis levels. It is only once TIPS breakevens are much more firmly anchored at pre-crisis levels that the Fed will be enticed to significantly quicken the pace of hikes. Bottom Line: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Remain overweight TIPS versus nominal Treasuries. Yield Curve We had been positioned in Treasury curve flatteners on the view that the curve would flatten in advance of a December Fed rate hike, much as it did last year. Trump's surprise win has steepened the curve dramatically, and today we close both our curve trades taking losses of -86bps on our 2/10 flattener and -42bps on our 10/30 flattener. The best determinant of the slope of the yield curve in the long run is the deviation from equilibrium of our monetary conditions index (MCI). The curve tends to flatten as monetary conditions are being tightened toward equilibrium and steepen when monetary conditions are easing away from equilibrium. Chart 6 shows a model of the 2/10 Treasury slope versus the deviation from equilibrium of our MCI. The model works well over both pre- and post-crisis time intervals, and the trailing 52-week beta between the slope of the curve and the MCI's deviation from equilibrium is in line with the beta estimated for the entire post-1990 time interval (Chart 6, bottom panel). Chart 6The Yield Curve & Monetary Conditions The curve had appeared too flat relative to fair value prior to last week's steepening, but now appears slightly too steep (Chart 6, panel 3). Since the dollar is unlikely to depreciate substantially and the fed funds rate is unlikely to be cut, the only way that the curve can continue steepening from current levels is if the market starts to revise up its assessment of the equilibrium level of monetary conditions. This is consistent with the dynamic we observed with the level of Treasury yields. Given the rapid moves we've seen in the past week, to be confident that further curve steepening is in store we need to forecast that Trump's fiscal measures will conquer secular stagnation and that the Fed will start revising up its assessment of the equilibrium rate. Much like with the level of Treasury yields, we are reluctant to bet on further steepening in the near term, before we have seen some action on Trump's fiscal policies. However, the steepening trade has gathered enough momentum at this juncture that betting on flatteners equally does not seem wise. Bottom Line: We advocate a laddered position across the Treasury curve at the moment, while we await clarity on President Trump's fiscal proposals. The Treasury curve has room to steepen further if sizeable fiscal stimulus is implemented next year. Spread Product In recent weeks we have advocated a maximum underweight (1 out of 5) allocation to high-yield and a neutral allocation (3 out of 5) to investment grade corporates, while also avoiding the Baa credit tier. This cautious stance on corporate debt was in place for two reasons. First, the junk spread had tightened in recent months despite a slight increase in the VIX and there was a sizeable risk that a Fed rate hike in December could prompt a spike in implied volatility, with a knock-on effect on spreads. Junk spreads have since widened to be more in-line with the VIX (Chart 7), and the much steeper Treasury curve tells us that the market is now less likely to consider a Fed rate hike in December - which we still expect - a policy mistake. Consequently, we are marginally less worried about a large spike in the VIX index that would translate into wider high-yield spreads. Second, high-yield spreads were simply too low relative to our forecast for default losses in 2017 (Chart 8). A model consisting of lagged junk spreads and realized default losses explains more than 50% of the variation in excess junk returns over 12-month periods.5 Previously, this model had predicted excess junk returns of close to zero, but today's spread levels are consistent with excess junk returns of +157bps during the next 12 months. Not inspiring by any means, but still better than nothing. Given the slightly better entry level for spreads and less near-term risk of a Fed-driven volatility event, we upgrade our allocation to high-yield from maximum underweight (1 out of 5) to underweight (2 out of 5). We maintain our neutral (3 out of 5) recommendation on investment grade corporates, but remove the recommendation to avoid the Baa credit tier. The past week's large increase in Treasury yields also leads us to downgrade our allocation to MBS from overweight (4 out of 5) to underweight (2 out of 5). The low level of option-adjusted spreads makes the long-term outlook for MBS uninspiring, but we had expected that the option cost component of spreads would tighten as Treasury yields moved higher (Chart 9). Now that Treasury yields have risen sharply and the option cost has tightened, we take the opportunity to adopt a more cautious outlook on the sector. Chart 7Spreads Re-Converge With VIX Chart 8Expect Low But Positive Excess Returns Chart 9Allocate Away From MBS Bottom Line: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Now that the MBS option cost has tightened in response to higher Treasury yields, the outlook for the sector is less inspiring. Municipal Bonds A Donald Trump presidency is full-stop negative for the municipal bond market. Further, as we highlighted in a recent Special Report,6 no matter the election result the outlook for state & local government health is likely to turn more negative in the second half of next year. Trump's tax cuts de-value the tax advantage of municipal debt and will drive flows out of the sector leading to wider Municipal / Treasury (M/T) yield ratios. We had been overweight municipal bonds since August 9, anticipating that a Clinton victory might provide us with a very attractive level from which to downgrade the sector heading into 2017. It was not to be, but municipal bond yields have still not quite kept pace with the sharp increase in Treasury yields, so we are able to downgrade today with M/T ratios not far off the low-end of their post-crisis range (Chart 10). In addition to tax cuts, Trump's infrastructure plan could also be a large negative for the muni market depending on how much of it is financed at the state & local government level. While the specifics of Trump's plan are not yet known, historically, most public infrastructure spending is financed at the level of state & local government (Chart 11). Another potential risk is that if large scale tax reform is on the table in 2017, then there is always the possibility that municipal bonds will lose their tax exemption altogether. At the moment it is difficult to assign odds to such an outcome. Chart 10Municipal / Treasury ##br##Yield Ratios Chart 11State & Local Government ##br##Drives Public Investment Bottom Line: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/ 2 Please see BCA Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 3 For further details on how we estimate the equilibrium level of monetary conditions please see U.S. Bond Strategy Special Report, "Peak Policy Divergence And What It Means For Treasury Valuation", dated February 9, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, 2016, available at usis.bcaresearch.com 5 For further details on this modeling framework please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Trump's election victory means that there is potential for policy settings to flip from "easy money, tight fiscal" to "tight money, easy fiscal" The market implications of that shift are dollar bullish, bond bearish and equity mixed. The major risk is that violent currency and bond market moves rekindle emerging market stress and/or choke off the recovery before fiscal spending kicks in. Trump's trade reform risks being a tax on growth. Businesses may opt to automate instead of hire. A variety of factors now make small caps appealing relative to large caps. Feature Contrary to the pre-election consensus, Donald Trump's election victory has prompted a risk-on rally, based on the notion that Trump's vision of fiscal largesse will be realized (Chart 1). Ultimately, it will only become clear what policy changes are on the table once Trump takes office in January. The consensus at BCA is that Trump will be "unbound" in his first two years as President. Thus, if Trump lives up to his campaign promises, fiscal stimulus and trade restriction will be tabled early in 2017. Chart 1Trump Moves As we argue below, trade restrictions should be viewed as a tax on growth. We have doubts about the link between job creation and tariffs. If anything, imposing tariffs on imports could incite a more intense wave of automation. After all, the cost of capital is still attractive relative to labor costs. Meanwhile, fiscal spending - if delivered even close to the size and scope that Trump has hinted at in his pre-election speeches - will boost GDP growth well above trend in 2017. If that occurs, the dynamic that has existed since 2010, i.e. "tight fiscal, exceptionally easy money policy" will rapidly flip to "easy fiscal, tight money". For the bond market and the U.S. dollar, the investment implications are clear: Treasuries are likely to head higher, and the pressure will be for the U.S. dollar to rise. Implications for equities are less certain. If the U.S. dollar rises, it might rekindle emerging world financial stress and undermine U.S. corporate profits. The rapid rise in yields may not easily be digested by the equity market and it is notable that corporate spreads have not rallied along with other risk assets in recent days. We are comfortable maintaining a defensive stance. Donald Trump said a lot of things to a lot of people during the campaign process. He can't possibly deliver on all of his promises, but earlier this week, BCA sent out a Special Report to all clients, outlining the implications of the election results and what we expect he can accomplish.1 We believe there are three that are especially important for investors to monitor: the potential for trade restrictions, gauging fiscal stimulus and monetary policy settings in this possibly new environment. Stagflation? Trump has repeatedly signaled his intention to restrict American openness to international trade and the U.S. president can revoke international treaties solely on their own authority. Trump can also impose tariffs. All of this is of course inflationary, and it's the nasty kind. We have repeatedly written in this publication that, historically, the U.S. economy only falls into recessions for two reasons. The first is growth-restrictive monetary policy and the second is an adverse supply shock that acts like a tax on growth, e.g. an oil price spike. Tariffs are akin to the latter. Chart 2 shows that as import penetration rose over the past 30 years, tradeable goods price inflation steadily fell. A simple read of the chart suggests that with barriers in place and as import penetration recedes, the process of the past 30 years will reverse and consumer goods prices will rise. This can easily be absorbed if it is accompanied by rising wages via the "onshoring" of jobs. But that is not a foregone conclusion. Instead of bringing manufacturing jobs back to the U.S., a more logical decision might be for businesses to further automate production. After all, earlier studies have already concluded that nearly half of all existing jobs are at high risk of being automated over the next decade or so.2 As Chart 3 shows, with the price of capital equipment and software still falling and the cost of capital so low relative to the cost of labor, the incentive to automate instead of hire is high. Chart 2Trade And Inflation Chart 3Tariffs May Lead To Robots, Not Jobs The bottom line is that increased tariffs will increase prices in the near term. But it is hardly clear that this will improve the lives of voters or create a more virtuous economic recovery. Opening The Fiscal Taps... In last week's report, we explored the potential for fiscal spending to turbocharge the U.S. economy. We warned that fiscal multipliers are probably not overly high in the current environment and the effectiveness of fiscal spending is highly dependent on the type of fiscal stimulus. Trump has called for significantly lowering both income and corporate taxes, although his main pitch has been infrastructure spending. The latter tends to have the highest multiplier effects, but can often take a long time to get underway. However, one important point is that Trump will face little political restraint, at least in his first two years in office. Gridlock will not be a problem given that all three Houses are now in GOP hands. And 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. Over the past 28 years, each new president has generally succeeded in passing their signature items. Moreover, the GOP has historically not been that fiscally conservative. Overall, a Trump government will more than make up for the drag from weak state and local spending that we wrote about last week. Exactly how big of an impulse will only become clear once Trump takes office. ...And Tightening The Money Supply? Forecasts about the impact of fiscal spending on 2017 GDP growth are premature, since it is impossible to decipher an action plan from campaign rhetoric. And the severity of stagflation due to trade restrictions will be highly dependent on the form and scope of trade reform. Ergo, it is too early to make bold new assumptions about the path of Fed rate hikes. An aggressive fiscal plan that boosts GDP well above trend growth would force policymakers to revise their expected path of rate hikes higher. That would be a sea change from the past four years, when policymakers have consistently revised the neutral rate down. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked Janet Yellen and current monetary policy settings. A review of the Fed may happen at some point, but we assert that investigating the Fed will not be a priority early in Trump's mandate. Market Action The bond market has already priced in more inflation and more growth for 2017 since Trump's victory. 10-year Treasury yields have surged to 2.15% and momentum selling could lift the 10-year Treasury yield even further into oversold territory. But that is not a case to become aggressively underweight duration. Dollar strength and rising bond yields have already tightened financial conditions significantly over the past several weeks. The risk is that these trends go too far in the near term, inflicting economic damage before fiscal spending kicks in. Given the easy monetary stance of central banks around the world, lack of significant fiscal stimulus elsewhere, economic growth outperformance in the U.S. and rising interest rates, the dollar should rise in the medium term. We remain dollar bulls. We have been surprised by the equity market action since November 8. Although we repeatedly wrote that a Trump victory was unlikely to have meaningful negative consequences for risk asset prices, we did not anticipate a rally. As for equities, our cautiousness toward risk assets in 2016 has been primarily focused on the ongoing headwinds for profits in a demand-deficient economy, especially while margins are falling and valuations are elevated (Chart 4). Greater fiscal spending would surely help to alleviate our concern, although that conclusion seems premature given the lack of contour to Trump's plans so far. Perhaps the greatest downside risk is a reaction from China. After all, Trump's anti-trade rhetoric has been pointed (mostly) at China and Asia. Recall that in August, 2015, the RMB was devalued just weeks ahead of an expected rate hike from the Fed. That devaluation sent shock waves through financial markets and ultimately delayed the Fed rate hike until the end of the year (Chart 5). A similar proactive policy move from Chinese policymakers should be on investors' radars. Overall, we remain comfortable with our cautious equity stance, albeit recent market action has created an entry point in favor of small relative to large cap stocks. Chart 4Equity Fundamentals Still Poor Chart 5China: Global Stability Risk? Enter Small Cap Bias We upgraded small caps relative to large caps to neutral in August. We now recommend investors make the full switch to a small cap bias relative to large caps. Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets; we believe this provides a good entry point to a cyclical uptrend in small cap performance (Chart 6). True, at first glance, advocating for small cap exposure appears inconsistent with our overall defensive equity strategy. After all, small cap outperformance tends to be associated with risk-on phases. However, small cap stocks have a variety of other characteristics that currently make them appealing relative to larger caps. Chart 6(Part I) Favor Small/Large Caps Chart 7(Part II) Favor Small/Large Caps Small cap companies tend to be more domestically focused. We expect that U.S. growth will continue to outpace growth overseas. And particularly important, small cap companies, with their domestic focus, are better insulated from dollar strength (Chart 7). Small cap weightings are no longer geared toward cyclical sectors. As part of our cautious strategy, we remain focused on defensive vs. cyclical sectors. There are no major differences between large and small cap defensive and cyclical sector weightings (Table 1). Trump corporate tax reform, if implemented, will favor small, domestic firms. Because major corporations already have low effective tax rates, any lowering of the marginal rate will benefit small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then this would diminish their current tax advantage vis-à-vis smaller companies. Table 1Similar Weightings For Small And Large Cap Cyclicals And Defensives Bottom Line: Small cap outperformance is typically associated with risk-on equity phases. However, valuations now favor small caps. Importantly, small caps are better insulated from dollar strength and are one way to play the domestic vs. global theme. Additionally, smaller firms will be the relative winners from corporate tax reform. Small caps are set to outperform large caps. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Geopolitical Strategy Special Report "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com 2 "The Future Of Employment: How Susceptible Are Jobs To Computerisation?" Carl Frey and Michael Osborne, September 2013. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process Chart 8. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical component of the equity model still has a "buy" signal, the breadth indicator has moved into less favorable territory relative to the momentum indicator. The monetary component has also slightly weakened but retains its positive bias for equities. The earnings-driven component continues to warrant caution as expectations for the outlook of corporate profits would need to be bolstered through stronger economic stronger growth over the medium term. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. Even so, despite that the "buy signals" of the cyclical and technical components of the bond model still persist, the preference for Treasuries has diminished to some extent. Nevertheless, the valuation component continues trending towards expensive territory and a "buy signal" remains in place Chart 9. Chart 8Portfolio Total Returns Chart 9Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.