Geopolitics

Highlights Should the U.S. 10-year T-bond yield approach 3% it would be a red flag, and a trigger to downgrade equities. Equity investors should stay overweight defensive-heavy Switzerland and Denmark. Contrary to what the consensus is expecting, global growth will lose steam in the first half of 2018. EUR/USD will continue to trend higher through 2018 as long-term interest rate differentials converge further. The multi-year prognosis for GBP/USD is higher. U.K. parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. Feature A happy and prosperous 2018 to you all! In this first report of the year, we describe some investment outcomes in 2017 that at first glance seemed odd or unexpected; but that on deeper reflection provide valuable insights for 2018. Some of these insights deviate substantially from the BCA house view. Bonds Became More Risky Than Equities The first oddity of 2017 concerns the 'drawdowns' suffered by bonds and equities. A drawdown is defined as an investment's peak to trough decline. In 2017, the odd thing was that the drawdowns suffered by government bonds - a supposedly safe asset-class - were equal to or worse than those suffered by equities - a supposedly risky asset-class (Chart of the Week, Chart I-2 and Chart I-3). Chart of the WeekBonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-2Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Chart I-3Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Bonds Suffered Worse Drawdowns Than Equities Contrary to classical theory, empirical evidence now proves that investors do not define an investment's risk in terms of its volatility, the fluctuations of its return around a mean. Instead, investors define risk as the ratio of large and sudden drawdowns versus potential gains. This unattractive asymmetry in an investment's return is technically known as negative skew. And it is as compensation for this negative skew that investors demand an excess return, the so-called 'risk premium'. Significantly, at low bond yields, the mathematics of bond returns necessarily means that their negative skew increases. The risk of large and sudden drawdowns rises while the prospect for price gains diminishes. But if bond risk becomes 'equity-like', it follows that equities' prospective long-term return should become 'bond-like'. Meaning, equities should no longer offer a meaningful risk premium over bonds. Is this the case? According to my colleague Martin Barnes, BCA Chief Economist, the answer appears to be yes - at least in certain major markets. In BCA's Outlook 2018, Martin projects that from current valuations U.S. equities are set to deliver a total nominal return of 2.6% a year to 2028 - almost indistinguishable from the 2.5% a year that a U.S. 10-year T-bond will deliver over the same period. But the mathematics of bond pricing tells us that the negative skew on bond returns fully disappears when a yield approaches 3%. At which point the risk of bonds once again declines to become 'bond-like', and the required return on equities should once again rise to become 'equity-like'. This higher required return would necessarily require today's equity prices to drop, perhaps substantially. Admittedly in Europe there is a bigger gap between the expected returns from equities and bonds than there is in the U.S. The trouble is that global capital markets move together and a chain is only as strong as its weakest link. Hence, one lesson for 2018 is that investors should downgrade equities to neutral should the U.S. 10-year T-bond yield approach 3%. In this event, investors should redeploy the funds into U.S. T-bonds, because any substantial adjustment in risk-asset prices would trigger supportive flows into haven bonds, reversing the spike in yields. Euro/Dollar Hit A 3-Year High EUR/USD ended 2017 touching 1.21, a 3-year high. At first glance, this might seem odd given that the ECB has committed to maintaining its zero and negative interest rate policy for at least another year while the Federal Reserve has already hiked interest rates five times. But EUR/USD is not tracking short-term rate differentials. It is tracking long-term rate differentials, and EUR/USD at a 3-year high is fully consistent with the 30-year T-bond/German bund yield spread converging to its narrowest for several years (Chart I-4). Chart I-4Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Further Convergence In Long-Term Interest Rate Differentials Will Support EUR/USD Where will this yield spread go from here? Let's consider both sides of the spread. On the ECB side, policy is at the realistic limit of ultra-looseness, so policy rate expectations cannot go significantly lower, but they can go higher. On the Federal Reserve side, long-term policy rate expectations are not far from our upper bound of the 'high 2s' at which risk-assets become vulnerable to a sell-off, perhaps substantial. So these interest rate expectations cannot go sustainably higher, but they can go lower. Considering this strong asymmetry, the most likely outcome is that the 30-year T-bond/German bund yield spread will continue to converge. The upshot is that EUR/USD will continue to trend higher through 2018. No Connection Between Economic Outperformance And Stock Market Outperformance Chart I-5The Eurostoxx50 Underperformed Even Though##br## The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed The Eurostoxx50 Underperformed Even Though The Euro Area Economy Outperformed 2017 proved that there is no positive correlation between relative economic performance and relative equity market performance. For example, the euro area was one of the best performing developed economies, yet the Eurostoxx50 was one of the worst performing stock market indexes (Chart I-5). This seems odd, until you realise that major stock market indexes are dominated by multinational rather than domestic stocks. And that when stock markets have vastly different sector weightings, the sector effect completely swamps the domestic economy effect. Therefore the first decision for international equity investors should never be which regions to own. The first decision should always be which sectors to own, and above all whether to tilt to cyclicals or defensives. The regional and country allocation then just drops out automatically. At the moment, our mini-cycle framework for global growth suggests tilting to defensives rather than to cyclicals. Global growth experiences remarkably consistent - and therefore predictable - 'mini-cycles', with half-cycle lengths averaging 8 months. As the current mini-upswing started last May we can infer that it is likely to end at some point in early 2018 (Chart I-6 and Chart I-7). So one surprise could be that global growth will lose steam in the first half of 2018 rather than in the second half - contrary to what the consensus is expecting. Chart I-6The Current Mini-Upswing##br## Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth The Current Mini-Upswing Is Long In The Tooth Chart I-7China Has Driven The Global 6-Month##br## Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher China Has Driven The Global 6-Month Credit Impulse Higher We will provide further ammunition for our mini-cycle thesis in next week's report. In the meantime, we will leave you with one ramification of paring back equity exposure to cyclicals and redeploying to defensives. Stay overweight defensive-heavy Switzerland and Denmark. Realpolitik Will Prevent A Hard Brexit For the FTSE100, the paradox is that its relative performance is negatively correlated with relative economic performance. When the U.K. economy outperforms, the FTSE100 underperforms. And vice-versa (Chart I-8). Chart I-8FTSE 100 Relative Performance Is The Inverse ##br##Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance FTSE 100 Relative Performance Is The Inverse Of U.K. Economic Relative Performance The simple explanation is that FTSE100 multinational sales and profits tend to be denominated in dollars and euros, whereas the FTSE100 index is denominated in pounds. The upshot is that an outperforming U.K. economy weighs on the U.K. stock market because a strengthening pound diminishes the FTSE100's multi-currency profits in pound terms. And vice-versa. Compared to a year ago, investors can be more optimistic about the long-term prospects for the U.K. economy and the pound (and therefore expect long-term underperformance from the FTSE100). This is because after the unexpectedly disastrous 2017 election for Theresa May, the parliamentary arithmetic simply does not support a hard Brexit. Furthermore, a hard Brexit would require either a North/South or East/West hard border in Ireland, which will be politically impossible to deliver. The constraints that come from this realpolitik means that Brexit's endpoint will retain much of the current trading relationship with the EU, albeit the journey to that eventual destination is likely to be a wild roller coaster ride. Therefore, the multi-year prognosis for GBP/USD is higher. But investors who want to optimize their timing into 'cable' can wait for one of the inevitable roller coaster dips in 2018. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* We are delighted to say that three of our recent trades quickly hit their profit targets: short bitcoin 29%, long silver 4.5% and long NZD/USD 3%. Against this, short Nikkei/long Eurostoxx50 hit its 3% stop-loss. This week's trade recommendation is to go short palladium. Set a profit target of 6% with a symmetrical stop-loss. This leaves us with three open trades. Chart I-9 Short Palladium Short Palladium 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. * 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 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal The New Normal The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? January 2018 January 2018 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship January 2018 January 2018 This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others January 2018 January 2018 China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility January 2018 January 2018 "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense January 2018 January 2018 In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Chart II-14Chinese Public Grievances January 2018 January 2018 Chart II-15Anti-Corruption Is Popular January 2018 January 2018 Chart II-16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... January 2018 January 2018 Chart II-17B...But There's A Long Way To Go January 2018 January 2018 Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind January 2018 January 2018 Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time January 2018 January 2018 Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power.

2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart 1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart 2).2 Chart 1The New Normal The New Normal The New Normal Chart 2Will China Get Caught In The Middle-Income Trap? A Long View Of China A Long View Of China Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart 3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart 4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart 3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart 4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart 5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart 6). Chart 5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Chart 6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship A Long View Of China A Long View Of China This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart 7). China is approaching this point and will eventually face similar challenges. The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart 8)! Chart 7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Chart 8Chinese People Not Less Fond Of Democracy Than Others A Long View Of China A Long View Of China China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart 9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart 10). Chart 9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China Chart 10China An Outlier In Inequality And Social Immobility A Long View Of China A Long View Of China "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart 11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart 12). Chart 11Chinese Social ##br##Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart 12China Spends More On ##br##Domestic Security Than Defense A Long View Of China A Long View Of China In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But it is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. The Governance And Reform Agenda Chart 13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart 13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart 14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart 3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart 15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart 16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart 14Chinese Public Grievances A Long View Of China A Long View Of China Chart 15Anti-Corruption Is Popular A Long View Of China A Long View Of China Chart 16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart 17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart 17AAnti-Corruption Campaign Is A Plus... A Long View Of China A Long View Of China Chart 17B...But There's A Long Way To Go A Long View Of China A Long View Of China Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart 18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart 18Reforms Cut Steel Capacity,##br## Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart 19China's Governance Still Falls Far Behind A Long View Of China A Long View Of China Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart 19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart 20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart 20China's Leaders Becoming More 'Communist' Over Time A Long View Of China A Long View Of China Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart 21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart 21Market Not Too Worried About ##br##Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org. 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org. 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power.

Highlights Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. It could be more, depending on the impact on animal spirits in the business sector and any fresh infrastructure spending. The good news on global growth continue to roll in. Real GDP growth is accelerating in the major advanced economies, driven in part by a surge in capital spending. Nonetheless, record low volatility and a flat yield curve in the U.S. highlight our major theme for 2018; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. We expect inflation to finally begin moving higher in the U.S. and some of the other advanced economies. This will challenge the consensus view that "inflation is dead forever", and that central banks will respond quickly to any turbulence in financial markets with an easier policy stance. The S&P 500 would suffer only a 3-5% correction if the VIX were to simply mean-revert. But the pain would likely be more intense if there is a complete unwinding of 'low-vol' trading strategies. We will be watching inflation expectations and our S&P Scorecard for signs to de-risk. Government yield curves should bear steepen, before flattening again later in 2018. Stay below benchmark in duration for now and favor bonds in Japan, Italy, the U.K. and Australia versus the U.S. and Canada (currency hedged). Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. The intensity of forthcoming Chinese reforms will have to be monitored carefully for signs they have reached an economic 'pain threshold'. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex. Bitcoin is not a systemic threat to global financial markets. Feature Chart I-1Policy Collision Course? Policy Collision Course? Policy Collision Course? Global bourses celebrated solid earnings growth and the passage of U.S. tax cuts heading into year-end. Ominously, though, a flatter U.S. yield curve and extraordinarily low measures of volatility hover like dark clouds over the equity bull market (Chart I-1). The flatter curve could be a sign that the Fed is at risk of tightening too far, which seems incompatible with depressed asset market volatility. This combination underscores the major theme of the BCA Outlook 2018 that was sent to clients in November; policy is on a collision course with risk assets because output gaps are closing and monetary policy is moving away from "pedal to the metal" stimulus. Analysts are debating how much of the decline in volatility is due to technical factors and how much can be pinned on the macro backdrop. For us, they are two sides of the same coin. Betting that volatility will remain depressed has reportedly become a yield play, via technical trading strategies and ETFs. Trading models encourage more risk taking as volatility declines, such that lower volatility enters a self-reinforcing feedback loop. The danger is that this virtuous circle turns vicious. On the macro front, many investors appear to believe that the structure of the advanced economies has changed in a fundamental and permanent way. Deflationary forces, such as Uber, Amazon and robotics are so strong that inflation cannot rise even if labor becomes very scarce. If true, this implies that central banks will proceed slowly in tightening, and that the peak in rates is not far away. Moreover, below-target inflation allows central banks to respond to any economic weakness or unwanted tightening in financial conditions by adopting a more accommodative policy stance. In other words, investors appear to believe in the "Fed Put". Implied volatility is a mean-reverting series. It can remain at depressed levels for extended periods, especially when global growth is robust and synchronized. Nonetheless, we believe that the "outdated Phillips curve" and the "Fed Put" consensus views will be challenged later in 2018, leading to an unwinding of low-vol yield plays. For now, though, it is too early to scale back on risk assets. Global Growth Shifts Up A Gear... The good news on global growth continue to roll in. Easy financial conditions and the end of fiscal austerity provide a supportive growth backdrop. A measure of fiscal thrust for the G20 advanced economies shifted from a headwind to a slight tailwind in 2016 (Chart I-2). Our short-term models for real GDP growth in the major countries continue to rise, in line with extremely elevated purchasing managers' survey data (Chart I-3). The major exception is the U.K., where our GDP growth model is rolling over as the Brexit negotiations take a toll. Chart I-2Fiscal Austerity Is Over Fiscal Austerity Is Over Fiscal Austerity Is Over Chart I-3GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat GDP Growth Models Are Upbeat Much of the acceleration in our GDP models is driven by the capital spending components. Animal spirits appear to be taking off and it is a theme across most of the advanced economies. G3 capital goods orders pulled back a bit in late 2017, but this is more likely due to noise in the data than to a peak in the capex cycle (Chart I-4). Industrial production, the PMI diffusion index and advanced-economy capital goods imports confirm strong underlying momentum in investment spending. Chart I-4Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth Capital Spending Helping To Drive Growth In the U.S., tax cuts will give business outlays and overall U.S. GDP growth a modest lift in 2018. The House and Senate hammered out a compromise on tax cuts that is similar to the original Senate version. The new legislation will cut individual taxes by about $680 billion over ten years, trim small business taxes by just under $400 billion, and reduce corporate taxes by roughly the same amount (including the offsetting tax on currently untaxed foreign profits). The direct effect of the tax cuts will likely boost U.S. real GDP growth in 2018 by 0.2 to 0.3 percentage points. However, much depends on the ability that the tax changes and immediate capital expensing to further lift animal spirits in the business sector and bring forward investment spending. Any infrastructure program would also augment the fiscal stimulus. The total impact is difficult to estimate given the lack of details, but it is clearly growth-positive. ...But The U.S. Yield Curve Flattens... Bond investors are unimpressed so far with the upbeat global economic data. It appears that long-term yields are almost impervious as long as inflation is stuck at low levels. In the U.S., a rising 2-year yield and a range-trading 10-year yield have resulted in a substantial flattening of the 2/10 yield slope (although some of the flattening has unwound as we go to press). Investors view a flattening yield curve with trepidation because it smells of a Fed policy mistake. It appears that the bond market is discounting that the Fed can only deliver another few rate hikes before the economy starts to struggle, at which point inflation will still be below target according to market expectations. We would not be as dismissive of an inverted yield curve as Fed Chair Yellen was during her December press conference. There are indeed reasons for the curve to be structurally flatter today than in the past, suggesting that it will invert more easily. Nonetheless, the fact that the yield curve has called all of the last seven recessions is impressive (with one false positive). The good news is that, in the seven episodes in which the curve correctly called a recession, the signal was confirmed by warning signs from our Global Leading Economic Indicator and our monetary conditions index. At the moment, these confirming indicators are not even flashing yellow.1 Our fixed-income strategists believe that the curve is more likely to steepen than invert over the next six months. If inflation edges higher as we expect, then long-term yields will finally break out to the upside and the curve will steepen until the Fed's tightening cycle is further advanced. If we are wrong and inflation remains stuck near current levels or declines, then the FOMC will have to revise the 'dot plot' lower and the curve will bull-steepen. In other words, we do not think the FOMC will make a policy mistake by sticking to the dot plot if inflation remains quiescent. Rising inflation is a larger risk for stocks and bonds than a policy mistake. A clear uptrend in inflation would shake investors' confidence in the "Fed Put" and thereby trigger an unwinding of the low-vol investment strategies. A sharp selloff at the long end of the curve in the major markets would send a chill through the investment world because it would suggest that the Phillips curve is not dead, and that central banks might have fallen behind the curve. ...As Inflation Languishes For now there is little evidence of building inflation pressure in either the CPI or the Fed's preferred measure, the core PCE price index. The latter edged up a little in October to 1.4% year-over-year, but the November core CPI rate slipped slightly to 1.7%. For perspective, core CPI inflation of 2.4-2.5% is consistent with the Fed's 2% target for the core PCE index. The Fed has made no progress in returning inflation to target since the FOMC started the tightening cycle. A risk to our view is that the expected inflation upturn takes longer to materialize. The annual core CPI inflation rate fell from 2.3 in January 2017 to 1.7 in November, a total decline of 0.55 percentage points. The drop was mostly accounted for by negative contributions from rent of shelter (-0.31), medical care services (-0.13) and wireless telephone services (-0.1). These categories are not closely related to the amount of slack in the economy, and thus might continue to depress the headline inflation rate in the coming months even as the labor market tightens further. Recent regulatory changes, for example, suggest that there is more downside potential in health care services inflation. We have highlighted in past research that it is not unusual for inflation to respond to a tight labor market with an extended lag, especially at the end of extremely long expansion phases. Chart I-5 updates the four indicators that heralded inflection points in inflation at the end of the 1980s and 1990s. All four leading inflation indicators are on the rise, as is the New York Fed's Underlying Inflation Indicator (not shown). Importantly, economic slack is disappearing at the global level. The OECD as a group will be operating above potential in 2018 for the first time since the Great Recession (Chart I-6). Finally, oil prices have further upside potential. Higher energy prices will add to headline inflation and boost inflation expectations in the U.S. and the other major economies. Chart I-5U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up U.S. Inflation: Indicators Point Up Chart I-6Vanishing Economic Slack Vanishing Economic Slack Vanishing Economic Slack The bottom line is that we are sticking with the view that U.S. inflation will grind higher in the coming months, allowing the FOMC to deliver the three rate hikes implied by the 'dot plot' for 2018. In December, the FOMC revised up its economic growth forecast to 2.5% in 2018, up from 2.1%. The projections for 2019 and 2020 were also revised higher. Growth is seen remaining above the 1.8% trend rate for the next three years. The FOMC expects that the jobless rate will dip to 3.9% in 2018 and 2019, before ticking up to 4.0% in 2020. With the estimate for long-run unemployment unchanged at 4.6%, this means that the labor market is expected to shift even further into 'excess demand' territory. If anything, these forecasts look too conservative. It is unreasonable to expect the unemployment rate to stabilize in 2019 and tick up in 2020 if the economy is growing above-trend. This forecast highlights the risk that the FOMC will suddenly feel 'behind the curve' if inflation re-bounds more quickly than expected, at a time when the labor market is so deep in 'excess demand' territory. The consensus among investors would also be caught off guard in this scenario, resulting in a rise in bond volatility from rock-bottom levels. How Vulnerable Are Stocks? How large a correction in risk assets should we expect? One way to gauge this risk is to estimate the historical 'beta' of risk asset prices to mean-reversions in the VIX. The VIX is currently a long way below its median. Major spikes to well above the median are associated with recessions and/or financial crises. However, as a starting point, we are interested in the downside potential for risk asset prices if the VIX simply moves back to the median. Table I-1 presents data corresponding to periods since 1990 when the VIX mean-reverted from a low level over a short period of time. We chose periods in which the VIX surged at least to its median level (17.2) from a starting point that was below 13. The choice of 13 as the lower threshold is arbitrary, but this level filters out insignificant noise in the data and still provides a reasonable number of episodes to analyze.2 Table I-1Episodes Of VIX 'Mean Reversion' January 2018 January 2018 The episodes are presented in ascending order with respect to the starting point for the 12-month forward P/E ratio. This was done to see whether the valuation starting point matters for the size of the equity correction. The "VIX Beta" column shows the ratio of the percent decline in the S&P 500 to the change in the VIX. The average beta over the 15 episodes suggests that stocks fall by almost a half of a percent for every one percent increase in the VIX. Today, the VIX would have to rise by about 7½% to reach the median value, implying that the S&P 500 would correct by roughly 3½%. Investment- and speculative-grade corporate bonds would underperform Treasurys by 22 and 46 basis points, respectively, in this scenario. Interestingly, the equity market reaction to a given jump in the VIX does not appear to intensify when stocks are expensive heading into the shock. The implication is that a shock that simply returns the VIX to "normal" would not be devastating for risk assets. The shock would have to be worse. Chart I-7Market Reaction To 1994 Fed Shock Market Reaction To 1994 Fed Stock Market Reaction To 1994 Fed Stock The episodes of VIX "mean reversion" shown in Table I-1 are a mixture of those caused by financial crises and by monetary tightening (and sometimes both). The U.S. 1994 bond market blood bath is a good example of a pure monetary policy shock. It was partly responsible for the "tequila crisis", but that did not occur until late that year. Chart I-7 highlights that the U.S. equity market reacted more violently to Fed rate hikes in 1994 than the average VIX beta would suggest. The VIX jumped by about 14% early in the year, coinciding with a 9% correction in the S&P 500. Investors had misread the Fed's intension in late 1993, expecting little in the way of rate hikes over the subsequent year. A dramatic re-rating of the Fed outlook caused a violent bond selloff that unnerved equity investors. We are not expecting a replay of the 1994 bond market turmoil because the Fed is far more transparent today. Nonetheless, the equity correction could be quite painful to the extent that the VIX overshoots the median as the large volume of low-volatility trades are unwound. A 10% equity correction in the U.S. this year would not be a surprise given the late stage of the bull market and current market positioning. Yield Curves To Bear Steepen Upward pressure on inflation, bond yields and volatility will not only come from the U.S. We expect inflation to edge higher in the Eurozone, Canada, and even Japan, given tight labor markets and diminished levels of global spare capacity. The European economy has been a star performer this year and this should continue through 2018. Even the periphery countries are participating. The key driving factors include the end of the fiscal squeeze in the periphery and the recapitalization of troubled banks. The latter has opened the door to bank lending, the weakness of which has been a major growth headwind in this expansion. Taken at face value, recent survey data are consistent with about 3% GDP growth (Chart I-3). We would dis-count that a bit, but even continued 2.0-2.5% GDP growth in the euro area would compare well to the 1% potential growth rate. This means that the output gap is shrinking and the labor market will continue tightening. Despite impressive economic momentum, the ECB is sticking to the policy path it laid out in October. Starting in January, asset purchases will continue at a reduced rate of €30bn per month until September 2018 or beyond. Meanwhile, interest rates will remain steady "for an extended period of time, and well past the horizon of the net asset purchases." If asset purchases come to an end next September, then the first rate hike may not come until 2019 Q1 at the earliest. Thus, rate hikes are a long way off, but the deceleration of growth in the Eurozone monetary base will likely place upward pressure on the long end of the bund curve (shown inverted in Chart I-8). Chart I-8ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish ECB Tapering Will Be Bond-Bearish Canada is another economy with ultra-low interest rates and rapidly diminishing labor market slack. The Bank of Canada will be forced to follow the Fed in hiking rates in the coming quarters. In Japan, strong PMI and capital goods orders are hopeful signs that domestic capital spending is picking up, consistent with our upbeat real GDP model (Chart I-3). Recent data on industrial production and retail sales were weak, but this was likely due to heavy storm activity; we expect those readings to bounce back. Nonetheless, it is still not clear that the Japanese economy has moved away from a complete dependency on the global growth engine. We would like to see stronger wage gains to signal that the economy is finally transitioning to a more self-reinforcing stage. It is hopeful that various measures of core inflation are slightly positive, but this is tentative at best. That said, the BoJ may be forced to alter its current "yield curve control" strategy by modestly lifting the target on longer-term JGB yields later in 2018, in response to pressures from robust growth and rising global bond yields. Thus, the pressure for higher bond yields should rotate away from the U.S. in the latter half of 2018 towards Europe, Canada and possibly Japan. This could eventually see the U.S. dollar head lower, but we still foresee a window in the first half of 2018 in which the dollar will appreciate on the back of widening interest rate differentials. We are less bullish than we were in mid-2017, expecting only about a 5% dollar appreciation. China: Long-Term Gain Or Short-Term Pain? The Chinese cyclical outlook remains a key risk to our upbeat view on risk assets. Significant structural reforms are on the way, now that President Xi has amassed significant political support for his reform agenda. These include deleveraging in the financial sector, a more intense anti-corruption campaign focused on the shadow-banking sector, and an ongoing restructuring in the industrial sector. The reforms will likely be positive for long-term growth, but only to the extent that they are accompanied by economic reforms. This month's Special Report, beginning on page 19, highlights that 2018 will be pivotal for China's long-term investment outlook. In the short term, reforms could be a net negative for growth depending on how deftly the authorities handle the monetary and fiscal policy dials. We witnessed this tension between growth and reform in the early years of President Xi's term, when the drive to curtail excessive credit growth and overcapacity caused an abrupt slowdown in 2015. Managing the tradeoff means that China's economy will evolve in a series of growth mini cycles. China is in the down-phase of a mini cycle at the moment, as highlighted by the Li Keqiang Index (LKI; Chart I-9). The LKI is a good proxy for the business cycle. BCA's China Strategy service recently combined the data with the best leading properties for the LKI into a single indicator.3 This indicator suggests that the LKI will end up retracing about 50% of its late 2015 to early 2017 rise before the current slowdown is complete. The good news is that broad money growth, which is a part of the LKI leading indicator, has re-accelerated in recent months. This suggests that the current economic slowdown phase will not be protracted, consistent with our 'soft landing' view. The intensity of forthcoming reforms will have to be monitored carefully for signs they have reached an economic pain threshold. We will be watching our LKI leading indicator and a basket of relevant equity sectors for warning signs. We do not view China as a risk to DM risk assets, but even a soft landing scenario could be painful for base metals and the EM complex (Chart I-10). Chart I-9China: Where Is The Bottom? China: Where Is the Bottom? China: Where Is the Bottom? Chart I-10Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Metals At Risk Of China Soft Landing Equity Country Allocation For now we continue to recommend overweight positions in stocks versus bonds and cash within balanced portfolios. We also still prefer Japanese stocks to the U.S., reflecting our expectation for rising bond yields in the latter and an earnings outlook that favors the former. Chart I-11 updates our earnings-per-share growth forecast for the U.S., Japan and the Eurozone. We expect U.S. EPS growth to decelerate more quickly in 2018 than in Japan, since the U.S. is further ahead in the earning cycle and is more exposed to wage and margin pressure. European earnings growth will also be solid in 2018, but this year's euro appreciation will be a headwind for Q4 2017 and Q1 2018 earnings. European and Japanese stocks are also a little on the cheap side versus the U.S., although not by enough to justify overweight positions on valuation grounds alone. We have extended our valuation work to a broader range of countries, shown in Chart I-12. All are expressed relative to the U.S. market. These metric exclude the Financials sector, and adjust for both differing sector weights and structural shifts in relative valuation. Mexico is the only one that is more than one standard deviation cheap relative to the U.S. Nonetheless, our EM team is reluctant to recommend this market given uncertainty regarding the NAFTA negotiations. Russia is not as cheap, but is in the early stages of recovery. Our EM team is overweight. Chart I-11Top-Down EPS Projection Top-Down EPS Projection Top-Down EPS Projection Chart I-12Valuation Ranking Of Nonfinancial Equity Markets Relative To The U.S. January 2018 January 2018 A Note On Bitcoin Finally, we have received a lot of client questions regarding bitcoin. The incredible surge in the price of the cryptocurrency dwarfs previous asset price bubbles by a wide margin (Chart I-13). As is usually the case with bubble, supporters argue that "this time is different." We doubt it. Chart I-13Bitcoin Bubble Dwarfs All The Rest January 2018 January 2018 BCA's Technology Sector Strategy weighed into this debate in a recent Special Report.4 In theory, blockchain technology, including cyber currencies, can be used as a highly secure, low cost, means of transfer value from one person to the next without an intermediary. However, the report highlights that bitcoin is highly subject to fraud and manipulation because it is unregulated. Liquidity and accurate market quotes are questionable on the "fly by night" exchanges. Its use as a medium of exchange is very limited, and governments are bound to regulate it because cryptocurrencies are a tool for money laundering, tax evasion and other criminal activities. Another fact to keep in mind is that, although the supply of new bitcoins is restricted, the creation of other cryptocurrencies is unlimited. Would the bursting of the bitcoin bubble represent a risk to the economy? The market cap of all cryptocurrencies is estimated to be roughly US$400 billion (US$250 billion for bitcoin alone). This is tiny compared to global GDP or the market cap of the main asset classes such as stocks and bonds. The amount of leverage associated with bitcoin is unknown, but it is hard to see that it would be large enough to generate a significant wealth effect on spending and/or a marked impact on overall credit conditions. The links to other financial markets appear limited. Investment Conclusions Our recommended asset allocation is "steady as she goes" as we move into 2018. The policy and corporate earnings backdrop will remain supportive of risk assets at least for the first half of the year. In the U.S., the recently passed tax reform package will boost after-tax corporate cash flows by roughly 3-5%. Cyclical stocks should outperform defensives in the near term. Nonetheless, we expect 2018 to be a transition year. Stretched valuations and extremely low volatility imply that risk assets are vulnerable to the consensus macro view that central banks will not be able to reach their inflation targets even in the long term. The consensus could be in for a rude awakening. We expect equity markets to begin discounting the next U.S. recession sometime in early 2019, but markets will be vulnerable in 2018 to a bond bear phase and escalating uncertainty regarding the economic outlook. If risk assets have indeed entered the late innings, then we must watch closely for signs to de-risk. One item to watch is the 10-year U.S. CPI swap rate; a shift above 2.3% would be consistent with the Fed's 2% target for the PCE measure of inflation. This would be a signal that the FOMC will have to step-up the pace of rate hikes and aggressively slow economic growth. We will also use our S&P Scorecard Indicator to help time the exit from our overweight equity position (Chart I-14). The Scorecard is based on seven indicators that have a good track record of heralding equity bear markets.5 These include measures of monetary conditions, financial conditions, value, momentum, and economic activity. The more of these indicators in "bullish" territory, the higher the score. Currently, four of the indicators are flashing a bullish signal (financial conditions, U.S. unemployment claims, ISM new orders minus inventories, and momentum). We demonstrated in previous research that a Scorecard reading of three or above was historically associated with positive equity total returns in the subsequent months. A drop below three this year would signal the time to de-risk. Our thoughts on the risks facing equities carry over to the corporate bonds space. Our Global Fixed Income Strategy service notes that uncertainty about future growth has the potential to increase interest rate volatility that can also push corporate credit spreads wider (Chart I-15).6 Elevated leverage in the corporate sector adds to the risk of a re-rating of implied volatility. For now, however, investors should continue to favor corporate bonds relative to governments for the (albeit modest) yield pickup. Chart I-14Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Watch Our Scorecard To Time The Exit Chart I-15Higher Uncertainty & ##br##Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Higher Uncertainty & Vol To Hit Corporate Bonds Overall bond portfolio duration should be kept short of benchmark. We may recommend taking profits and switching to benchmark duration after global yields have increased and are beginning to negatively affect risk assets. While yields are rising, investors should favor bonds in Japan, Italy, the U.K. and Australia within fixed-income portfolios (on a currency-hedged basis). Underweight the U.S. and Canada. German and French bonds should be close to benchmark. Yield curves should steepen, before flattening later in the year. Interest rate differentials in the first half of the year should modestly benefit the U.S. dollar versus the other major currencies. Finally, investors should remain exposed to oil and related assets, and bet on rising inflation expectations in the major bond markets. Mark McClellan Senior Vice President The Bank Credit Analyst December 28, 2017 Next Report: January 25, 2018 1 Please see BCA Global ETF Strategy service, "A Guide to Spotting And Weathering Bear Markets," August 16, 2017, available at etf.bcaresearch.com 2 Note that we are not saying that a rise in the VIX "causes" stocks to correct. Rather, we are assuming that a shock occurs that causes stocks to correct and the VIX to rise simultaneously. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," November 30, 2017, available at cis.bcaresearch.com 4 Please see BCA Technology Sector Strategy Special Report, "Cyber Currencies: Actual Currencies Or Just Speculative Assets?" December 12, 2017, available at tech.bcaresearch.com 5 Market Timing: Holy Grail Or Fool's Gold? The Bank Credit Analyst, May 26, 2016. 6 Please see BCA Global Fixed Income Strategy service, "Our Model Bond Portfolio Allocation In 2018: A Tail Of Two Halves," December 19, 2017, available at gfis.bcaresearch.com II. A Long View Of China 2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal The New Normal The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? January 2018 January 2018 Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign China's Slowdown So Far Benign China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Urban Income Targets At Risk Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship January 2018 January 2018 This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others January 2018 January 2018 China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Inequality: A Severe Problem In China Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility January 2018 January 2018 "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense January 2018 January 2018 In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. Chart II-14Chinese Public Grievances January 2018 January 2018 Chart II-15Anti-Corruption Is Popular January 2018 January 2018 Chart II-16Productivity Requires Institutional Change Productivity Requires Institutional Change Productivity Requires Institutional Change On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... January 2018 January 2018 Chart II-17B...But There's A Long Way To Go January 2018 January 2018 Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap Reforms Cut Steel Capacity, Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind January 2018 January 2018 Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time January 2018 January 2018 Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Market Not Too Worried About Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power. III. Indicators And Reference Charts Global equity indexes remained on a tear heading into year-end on the back of robust earnings growth in the major countries and U.S. tax cuts. There are some dark clouds hanging over this rally, as discussed in the Overview section. The technicals are stretched, but none of our fundamental indicators are warning of a market top. Implied equity volatility is very low, which can be interpreted in a contrary fashion. Investor sentiment is frothy and our Speculation Indicator is very elevated. Moreover, our equity valuation indicator has finally reached one standard deviation, which is our threshold of overvaluation. Valuation does not tell us anything about timing, but it does highlight the downside risks. Our monetary indicator also deteriorated a little more in December, although not by enough on its own to justify downgrading risk assets. On a positive note, earnings surprises and the net revisions ratio are not sending any warning signs for profit growth (although net revisions have edged lower recently). Moreover, our new Revealed Preference Indicator (RPI) continued on its bullish equity signal in November for the fifth consecutive month. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Our Willingness-to-Pay (WTP) indicators are also bullish on stocks in the U.S., Europe and Japan. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The small dip in the Japanese WTP in December is a little worrying, but we need to see more weakness to confirm that flows no longer favor Japanese equities. In contrast, Europe's WTP rose sharply in December, suggesting that investors are allocating more to their European equity holdings. We are overweight both Europe and (especially) Japan relative to the U.S. (currency hedged). U.S. Treasury valuation is still very close to neutral, even following December's backup in yields. There is plenty of upside potential for yields before they hit "inexpensive" territory. Similarly, our technical bond indicator suggests that technical factors will not be headwind to a further bond selloff in 2018. Little has change for the dollar. The technicals are neutral. Value is expensive based on PPP, but less so by other valuation metrics. We see modest upside for the greenback in 2018. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And ##br##Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart II-9U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart II-10U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart II-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart II-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart II-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart II-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart II-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart II-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart II-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart II-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart II-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart II-20Euro Technicals Euro Technicals Euro Technicals Chart II-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart II-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart II-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart II-24Commodity Prices Commodity Prices Commodity Prices Chart II-25Commodity Prices Commodity Prices Commodity Prices Chart II-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart II-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart II-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart II-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart II-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart II-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart II-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart II-33U.S. Consumption U.S. Consumption U.S. Consumption Chart II-34U.S. Housing U.S. Housing U.S. Housing Chart II-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart II-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart II-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart II-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Dear Client, This is our last report of 2017. We will be back on January 4, 2018, with our customary recap of recommendations made this year. We wish you and your loved ones the very best this lovely season has to offer. Sincerely, Robert P. Ryan, Chief Commodity Strategist Commodity & Energy Strategy Highlights With GDP growth accelerating in ~ 75% of countries monitored by the IMF, we expect commodity demand - particularly for crude oil and refined products - to remain strong in 2018. On the supply side, OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - will maintain its production discipline, which will force commercial oil inventories lower in 2018. As a result, we expect oil markets to continue to tighten in 2018, keeping upside risk to prices from unplanned production outages acute. This was clearly demonstrated in separate incidents in the U.S. and North Sea in the past two months, which removed more than 400k b/d from markets since November. Geopolitical risk will remain elevated, particularly in Venezuela, where operations at the state oil company were paralyzed after senior military officers assumed leadership positions there. Beyond 2018, we believe OPEC 2.0 will endure as a coalition. It will manage production and provide forward guidance consistent with a strategy to keep WTI and Brent forward curves backwardated. This will provide a supportive backdrop for the Saudi Aramco IPO, expected toward the end of next year, and will limit the volume of hedging U.S. shale-oil producers are able to effect. In turn, this will limit the number of rigs U.S. E&Ps can profitably deploy. Energy: Overweight. Our Brent and WTI call spreads in 2018 - long $55/bbl calls vs. short $60/bbl calls - are up an average 53.8%. We will retain these exposures into 2018. Base Metals: Neutral. We expect base metals to be supported through 1Q18, after which reform measures in China could crimp supply and demand, as we discuss below. Precious Metals: Neutral. We remain long gold as a strategic portfolio hedge against inflation and geopolitical risk, even though inflation remains quiescent (see below). Ags/Softs: Underweight. Fed policy will be critical to ag markets in 2018. We expect as many as four rate hikes next year, as the Fed continues with rates normalization (see below). Feature Our updated balances model indicates global oil markets will continue to tighten in 2018, as demand growth accelerates and OPEC 2.0 - the producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia - maintains production discipline (Chart of the Week). Earlier this week, IMF noted improving employment conditions globally, which will continue to support aggregate demand and the synchronized global expansion in manufacturing and trade (Chart 2 and Chart 3).1 This acceleration of GDP growth rates globally will continue to support income growth and commodity demand generally. Oil-exporters have not participated in the global economic expansion to the extent of other economies, according to the Fund, which can be seen in the trade data (Chart 3). However, imports by Middle East and African countries are moving higher, and look set to post year-on-year (yoy) growth in the near future. Chart of the WeekOil Balances Will Continue to Tighten In 2018 Oil Balances Will Continue to Tighten In 2018 Oil Balances Will Continue to Tighten In 2018 Chart 2Global Upturn Boosts Manufacturing, ##br##Commodity Demand... Global Upturn Boosts Manufacturing, Commodity Demand... Global Upturn Boosts Manufacturing, Commodity Demand... The combination of continued production discipline from OPEC 2.0 and expanding incomes boosting demand will force crude and product inventories lower, particularly those in the OECD, which are the primary target of the producer coalition (Chart 4). Chart 3...And Global Trade ...And Global Trade ...And Global Trade Chart 4OECD Inventories Will Fall Below 5-year ##br##Average In BCA's Supply-Demand Assessment OECD Inventories Will Fall Below 5-year Average In BCA's Supply-Demand Assessment OECD Inventories Will Fall Below 5-year Average In BCA's Supply-Demand Assessment Unplanned Outages Mounting; Risk Remains Acute Unlike many forecasters, we continue to expect inventories to draw in 1Q18. This expectation is the direct result of our supply-demand modelling, and also is supported by our expectation that the risk of unplanned outages is increasing. This already has been demonstrated in the U.S. and U.K. North Sea, where more than 400k b/d of pipeline flows in November and December were lost. Of far greater moment, however, is the potential for unplanned outages in Venezuela. We believe the state-owned oil company there is one systemic malfunction away from shutting down exports entirely - e.g., a breakdown in pumping stations - as happened in 2002. Reuters reports the government of Nicolas Maduro appears to be consolidating power via an "anti-corruption" campaign, and is installing senior military officials with little or no industry experience in leadership roles inside PDVSA.2 Reuters notes, "The ongoing purge, in which prosecutors have arrested at least 67 executives including two recently ousted oil ministers, now threatens to further harm operations for the OPEC country, which is already producing at 30-year-lows and struggling to run PDVSA units including Citgo Petroleum, its U.S. refiner." The news service goes on to report, "Executives that remain, meanwhile, are so rattled by the arrests that they are loathe to act, scared they will later be accused of wrongdoing." We have Venezuela output at just under 1.90mm b/d, and expect it to decline to a little more than 1.70mm b/d by the end of 2018. Brent Expected To Average $67/bbl In 2018 We continue to forecast average Brent prices of $67/bbl and WTI at $63/bbl next year, given our assessment of global supply-demand balances, which drive our fundamental price forecasts: We expect global crude and liquids supply to average 100.23mm b/d in 2018, vs 100.01mm b/d expected by the U.S. EIA, while we have global demand coming in at 100.29mm b/d on average next year, vs the 99.97mm b/d expected by EIA (Chart 5 and Chart 6). Chart 5BCA's Expected Crude Oil Supply Vs. EIA's BCA's Expected Crude Oil Supply Vs. EIA's BCA's Expected Crude Oil Supply Vs. EIA's Chart 6BCA's Expected Demand Exceeds EIA's In 2018 BCA's Expected Demand Exceeds EIA's In 2018 BCA's Expected Demand Exceeds EIA's In 2018 Our expectations translate into a 2.55mm b/d increase in supply next year, vs a 1.67mm b/d increase in demand yoy (Table 1). Running the EIA's supply-demand assessments through our fundamental pricing models produces average Brent and WTI prices of $49/bbl and $47/bbl, respectively. EIA is expecting a 2.04mm b/d increase in supply next year, vs a 1.63mm b/d increase in demand. Table 1BCA Global Oil Supply - Demand Balances (mm b/d) Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 In line with our House view, we are expecting some USD strengthening on the back of as many as four interest-rate hikes by the Federal Reserve in the U.S. (Chart 7). As we've noted in the past, we expect these effects to be felt more in 2H18. Along with higher U.S. shale-oil production driven by higher prices - we expect shale output to go up 0.97mm b/d next year to 6.64mm b/d - a stronger USD will keep Brent and WTI prices below $70/bbl next year. Oil Beyond 2018: OPEC 2.0 Endures OPEC 2.0 will remain an enduring feature of the oil market going forward, in our view. Allowing the coalition to fade away, and returning the global oil market to a production free-for-all once again serves neither KSA's nor Russia's interests. Following the IPO of Saudi Aramco toward the end of 2018, KSA will, we believe, want to maintain stability in the market, by demonstrating to capital markets that OPEC 2.0 can manage crude-oil supplies in a way that is not disruptive to its new-found investors. It is important to remember the Aramco IPO is only the beginning of the process of transforming KSA from a crude resource exporter into a vertically integrated global refining and marketing colossus. To eclipse Exxon as the world's largest refiner, Aramco would benefit from continued access to capital markets throughout the following decades, as well reliable cash flows to lower its cost of capital, service debt, and maintain whatever dividends it envisions. This cannot occur if oil markets are continually at risk of collapsing because production cannot be managed in a business-like manner. While Russia has not embarked on the same sort of transformation of its resource industry as KSA, it still has a very strong interest in maintaining stability in the crude oil markets, given its dependence on hydrocarbon exports. The Russian rouble moves in near-lock-step with Brent prices - since 2010, Brent prices explain ~80% of the movement in the rouble (Chart 8). It is obvious a collapse in global crude oil prices would, once again, have devastating effects on Russia's economy, as it did in 2009 and 2014. Such a collapse would trigger inflation domestically, as the cost of imports skyrockets, and threaten civil unrest as incomes and GDP are hobbled and foreign reserves evaporate. Chart 7Stronger USD Limits Oil-Price Appreciation In 2018 Stronger USD Limits Oil-Price Appreciation In 2018 Stronger USD Limits Oil-Price Appreciation In 2018 Chart 8Russia Cannot Afford An Oil Price Collapse Russia Cannot Afford An Oil Price Collapse Russia Cannot Afford An Oil Price Collapse Both KSA and Russia have a deep interest in maintaining oil's pre-eminent position as a transportation fuel for as long as possible. For this reason, neither wants to encourage prices that are too high - $100/bbl+ prices greatly encouraged the development of shale technology in the U.S. - nor too low, given the dire consequences such an outcome would have for both their economies. The common goals of KSA and Russia cannot be achieved by allowing OPEC 2.0 to dissolve, leaving member states to produce at will in the sort of production free-for-all that characterized the OPEC market-share war of 2014 - 15. To the extent possible, OPEC 2.0 must continue to manage member states' production in a manner that does not permit inventories to once again fill to the point where the only way to moderate over-production is to push prices through cash costs, so that enough output is shut in to clear the market. The most obvious way for these goals to be accomplished is by keeping markets relatively tight. This can be done by keeping commercial oil inventories worldwide low enough to keep Brent and WTI forward curves backwardated - particularly in highly visible OECD and U.S. storage facilities. A backwardated forward curve means the average price over a typical 2- or 3-year hedge horizon is lower than the spot price received by OPEC 2.0 producers. The deeper the backwardation, the lower the average price a U.S. shale producer can lock in by hedging. This limits the number of rigs that can be deployed by shale producers. This will require continual communication with markets to assure them sufficient spare capacity and easily developed production can be brought to market to alleviate any temporary shortage. In the meantime, OPEC 2.0 members with flexible storage will need to communicate these barrels will be readily available to the market. This management and forward-guidance should be easier for OPEC 2.0 to execute on, following its recent success in keeping some 1.0mm b/d of production off the market - largely in KSA and Russia - and member states' existing spare capacity and storage. We continue to expect the daily working dialogue of the OPEC 2.0 member states - most especially KSA and Russia - to deepen as time goes by, and for tactics and strategy to evolve as each gains comfort operating with the other. Whether OPEC 2.0 can pull this off remains to be seen. However, given the success of the coalition over the past two years, we are inclined to believe they will continue to develop a durable modus operandi supporting this outcome. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com Opposing Forces: Stay Neutral Metals In 2018 Chart 9Strong Global Demand Will Neutralize ##br##Impact of China Slowdown Strong Global Demand Will Neutralize Impact of China Slowdown Strong Global Demand Will Neutralize Impact of China Slowdown While we expect more upside to metal prices in the first half of 2018, slowing growth in China and a stronger USD will prevent a repeat of this year's stellar performance. While a deceleration in China is - ceteris paribus - most definitely a headwind to metal prices, we believe the impact may pan out differently this time around. The silver lining comes from the Communist Party's commitment to environmental reforms, which, in many cases, will manifest themselves in the form of less supply of the refined product, or demand for the ores. Either way, this alone is a positive for metals. China's Environmental Reforms Will Dominate in 1Q18 China's commitment to cleaning its air is currently shaping up in the form of winter cuts in major steel- and aluminum-producing provinces. While policies are hard to predict, we will keep monitoring the development and implementation of reforms from within China to assess how they will impact the markets. Outcomes from the Annual National People's Congress in March will give us a clearer indication of what to expect in terms of policy. For now, we see these reforms putting a floor under metal prices, at least in the beginning of 2018. Robust Global Demand Offsets Stronger USD & Slower Chinese Growth Xi's reforms will turn into a headwind for metal prices as they begin to impact the real economy in 2H18. Signs of weakness have already emerged in measures of industrial activity such as the Li Keqiang and Chinese PMI (Chart 9). In addition, the real estate sector has been showing some weakness since the beginning of the year. Annual growth rates in real estate investment and floor-space started are decelerating - a worrisome sign. Nonetheless, domestic demand remains robust, and policymakers in Beijing are approaching economic reforms gradually and with caution. Consequently we do not expect a major policy mistake to derail the Chinese economy. While Chinese growth will likely slow from above trend levels, a hard landing is most probably not in the cards. Another bearish risk comes from a stronger USD. We see the Fed as more committed to interest-rate normalization than markets expect, and consequently would not be surprised to see up to four rate hikes next year. Inverting the yield curve is a policy mistake incoming Chair Jerome Powell will try to avoid; however, we expect inflation to bottom in the first half of next year, giving the Fed room to accelerate its path of rate hikes. This will result in a stronger USD, which is bearish for commodities priced in U.S. dollars. In any case, these bearish factors will likely be offset by strong global growth, supported by a robust U.S. economy. Bottom Line: Xi's reforms will dominate metal markets in 2018 as bullish supply side environmental reforms duel against bearish demand-side economic reforms. Robust global growth will neutralize the impact of downside pressures. Stay neutral, but beware of modest USD strength. Low Inflation Retards Gold's Advance Once again, reality confounded theory: Inflation failed to emerge this year, even as systematically important central banks remained massively accommodative, and some 70% of the economies tracked by the OECD reported jobless rates below the commonly used estimate of the natural rate of unemployment (Chart 10). Chart 10Massive Monetary Accommodation Failed ##br##To Spur Inflation In The U.S. Massive Monetary Accommodation Failed To Spur Inflation In The U.S. Massive Monetary Accommodation Failed To Spur Inflation In The U.S. These fundamentals should be inflationary and supportive of gold. To date, they haven't been. We Expect Inflation To Revive The global economy has endured decades of low inflation going back at least to the 1990s. This has been driven by numerous factors. First, the expansion of the global value chain (GVC) over the past three decades has synchronized inflation rates worldwide, as our research and that of the BIS has found. As a result, U.S. wages and goods' inflation are now more dependent on global spare capacity. With the global output gap now almost closed, this disinflationary force will dissipate.3 Second, most measures of labor-market slack are now pointing toward tighter conditions, which, we expect, will strengthen the Phillips curve trade-off between inflation and unemployment next year. Inflation is a lagging indicator: Wage inflation lags the unemployment rate, and CPI inflation lags wage inflation. Investors should expect inflation to show up in 2018.4 Lastly, one-off technical factors, which depressed inflation last year - e.g. drop in cellphone data charges and prescription drug prices - also will fade. Once these big one-offs are no longer in annual percent-change calculations, inflation rates will rise. The Fed's Choppy Waters Against this backdrop, the Fed is embarking on a rates-normalization policy, which we believe will result in U.S. central bank's policy rate being increased up to four times next year. The risk of a policy error is high. Should the Fed proceed with its rate hikes while inflation remains quiescent, real interest rates will increase. This would depress gold prices, and, at the limit, threaten the current economic expansion by tightening monetary conditions well beyond current levels, potentially lifting unemployment levels. If, on the other hand, the Fed deliberately keeps rate hikes below the rate of growth in prices - i.e., it stays "behind the curve" - it risks being forced to implement steeper rate hikes later in 2018 or in 2019 to get stronger inflation under control. This could tighten monetary conditions suddenly, and threaten the expansion, pushing the U.S. economy into recession. There's a lot riding on how the Fed navigates these difficult conditions. Geopolitical Risks Will Support Gold On the geopolitical side, the risks we've identified in our October 12, 2017 publication - i.e. (1) U.S.-North Korea tensions, (2) trade protectionism of the Trump administration, and (3) ongoing conflicts in the Middle East-- will add a geopolitical risk premium to gold prices, supporting the metal's role as a safe haven.5 Bottom Line: We remain neutral precious metals, but still recommend investors allocate to gold as a strategic portfolio hedge against inflation and geopolitical risk. U.S. Policies Will Weigh On Ags In 2018 U.S. monetary and trade policy will dominate ags next year. Our modelling reveals that U.S. financial factors - real rates and the USD - are significant in explaining ag price behavior (Chart 11).6 Given that we expect the Fed to hike interest rates more aggressively than what the market is currently pricing in, we see grains as vulnerable to the downside. In addition, the risk that NAFTA is abrogated by the U.S. would weigh on ag markets, as Canada and Mexico are among the U.S.'s top three ag export destinations. Chart 11Bearish U.S. Monetary And Trade Policies ##br##Amid Healthy Inventories Will Weigh On Ags Bearish U.S. Monetary And Trade Policies Amid Healthy Inventories Will Weigh On Ags Bearish U.S. Monetary And Trade Policies Amid Healthy Inventories Will Weigh On Ags We expect ag markets will remain well supplied next year, and inventories will moderate the impact of supply-side shocks - most notably in the form of a La Nina event. The probability of a La Nina currently stands above 80%, and is expected to last until mid-to-late spring. U.S. Monetary Policy Is Relevant With U.S. inflation rates still subdued, there has been much talk about how soon the Fed will be able embark on its tightening cycle. A weaker-than-expected USD has been favorable for ag markets this year, and thus kept U.S. ag exports competitive. However, if and when the economy reaches the kink in the Philipps Curve, and inflation begins its ascent, the Fed will be able to proceed with its rate-hiking cycle. With the New York Fed's Underlying Inflation Gauge at a cycle high, we expect this scenario to unfold in the first half of 2018. This would give incoming Fed Chairman Jerome Powell ample room to hike rates which would - ceteris paribus - bear down on ag prices. FX Developments In Other Major Exporters Will Also Be Bearish The effects of higher U.S. interest rates are translated to ag markets via the exchange-rate channel. Commodities are priced in USD, thus a stronger USD vis-à-vis the currency of a major ag exporter will, all else equal, increase the profitability of farmers competing against U.S. exporters in international markets. Among the ag-relevant currencies, we highlight the Brazilian Real, EUR, Russian Rouble, and Australian Dollar as most likely to depreciate vis-à-vis the USD in 2018. Termination Of NAFTA Is A Risk For American Farmers U.S. farmers are keeping a close eye on NAFTA renegotiations, and rightly so. Canada and Mexico are the U.S.'s second and third largest agricultural export markets - accounting for 15% and 13% of U.S. agricultural exports in 2016, respectively. In fact, corn, rice, and wheat exports to Mexico accounted for 26%, 15%, and 11% share of U.S. exports of those commodities, respectively. However, as BCA Research's Geopolitical Strategy service points out, the long-run impact depends on the underlying reason for the termination of the trade agreement. If Trump is merely a "pluto-populist" - as they expect - NAFTA will simply be replaced by bilateral trade agreements, with no lasting economic disturbance. The risk is that Trump is a genuine populist. If this turns out to be the case, tariffs and a rejection of the WTO would make U.S. exports less competitive, and would become a bearish force in ag markets.7 The risk of a collapse in the NAFTA trade deal would be devastating for U.S. farmers. In fact, in a bid to reduce reliance on the U.S., Mexican Economic Minister Ildefonso Guajardo recently announced that they are working on a Mexico-European Union trade deal.8 In addition, Mexico signed the world's largest free trade agreement with Japan, and is currently exploring the opportunity to join Mercosur. Bottom Line: Weather-induced volatility is possible in the near term, as a La Nina event threatens to reduce yields. Nevertheless, U.S. financial conditions and trade policy will dominate ag markets in 2018. With markets underestimating the Fed's resolve regarding interest rate hikes, we see some upside to the USD. This will keep a lid on ag prices next year. 1 Please see "The year in Review: Global Economy in 5 Charts," published on the IMF Blog December 18, 2017. https://blogs.imf.org/2017/12/17/the-year-in-review-global-economy-in-5-charts/ 2 Please see "Paralysis at PDVSA: Venezuela's oil purge cripples company," published by reuters.com December 15, 2017. 3 The IMF estimates the median output gap for 20 advanced economies reached -0.1% in 2017 and will rise to +0.3% in 2018. Please see BIS https://www.bis.org/publ/work602.htm. The Bank for International Settlements in Basel describes the GVC as "cross-border trade in intermediate goods and services." 4 The U.S. unemployment has been under its estimated NAIRU for 9 consecutive months now. 5 Please see Commodity and Energy Strategy Weekly Report titled "Balance Of Risks Favors Holding Gold," dated October 12, 2017, available at ces.bcaresearch.com. 6 Our modelling indicates that U.S. financial factors are important determinants of agriculture commodity price developments. More specifically, a 1% move in the USD TWI and a 1pp change in 5 year real rates are associated with a 1.4%, and an 18% change in the CCI Grains & Oilseed Index, in the opposite direction. 7 Please see Global Investment Strategy Special Report titled "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 8 Please see "Mexico sees possible EU trade deal as NAFTA talks drag on," dated December 13, 2017, available at reuters.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q17 Oil Fundamentals Remain Bullish Heading Into 2018 Oil Fundamentals Remain Bullish Heading Into 2018 Trades Closed in Summary of Trades Closed in

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Feature It has been a Geopolitical Strategy tradition, since our launch in 2012, to include our best and worst forecasts of the year in our end-of-year Strategic Outlook monthly reports.1 Since we have switched over to a weekly publication schedule, we are making this section of our Outlook an individual report.2 It will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 10, when we return to our regular publication schedule. The Worst Calls Of 2017 A forecasting mistake is wasted if one learns nothing from the error. Alternatively, it is an opportunity to arm oneself with wisdom for the next fight. This is why we take our mistakes seriously and why we begin this report card with the zingers. Overall, we are satisfied with our performance in 2017, as the successes below will testify. However, we made one serious error and two ancillary ones. Short Emerging Markets Continuing to recommend an overweight DM / underweight EM stance was the major failure this year (Chart 1). More specifically, we penned several bearish reports on the politics of Brazil, South Africa, and Turkey throughout the year to support our view.3 What did we learn from our mistake? The main driving forces behind EM risk assets in 2017 have been U.S. TIPS yields and the greenback (Chart 2). Weak inflation data and policy disappointments as the pro-growth, populist economic policy of the Trump Administration stalled mid-year supported the EM carry trade throughout the year. The post-election dollar rally dissipated, while Chinese fiscal and credit stimulus carried over into 2017 and buoyed demand for EM exports. Chart 1The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM The Worst Call Of 2017: Long DM / Short EM Chart 2How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? How Long Can The EM Carry Trade Survive? Our bearish call was based on EM macroeconomic and political fundamentals. On one hand, our fundamental analysis was genuinely wrong. Emerging markets were buoyed by Chinese stimulus and a broad-based DM recovery. On the other hand, our fundamental analysis was irrelevant, as the global "search-for-yield" overwhelmed all other factors. Chart 3The Dollar Ought ##br##To Rebound The Dollar Ought To Rebound The Dollar Ought To Rebound Chart 4Chinese Monetary Conditions Point##br## To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Chinese Monetary Conditions Point To Slowing Industrial Activity Going forward, it is difficult to see this combination of factors emerge anew. First, the U.S. economy is set to outperform the rest of the world in 2018, particularly with the stimulative tax cut finally on the books, which should be dollar bullish (Chart 3). Second, downside risks to the Chinese economy are multiplying (Chart 4) as policymakers crack down on the shadow financial sector and real estate (Chart 5). BCA's Foreign Exchange Strategy has shown that EM currencies are already flagging risks to global growth. Their "carry canary indicator" - EM currencies vs. the JPY - is forecasting a sharp deceleration in global growth within the next two quarters (Chart 6). Chart 5Chinese Growth ##br##Slowing Down? Chinese Growth Slowing Down? Chinese Growth Slowing Down? Chart 6After Carry Trades Lose Momentum,##br## Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens After Carry Trades Lose Momentum, Global IP Weakens That said, we have learned our lesson. We are closing all of our short EM positions and awaiting January credit numbers from China. If our view on Chinese financial sector reforms is correct, these figures should disappoint. If they do not, the EM party can continue. "Trump, Day One: Let The Trade War Begin" In our defense, the title of our first Weekly Report of the year belied the nuanced analysis within.4 We argued that the Trump administration would begin its relationship with China with a "symbolic punitive measure," but that it would then "seek high-level negotiations toward a framework for the administration's relations with China over the next four years." This was largely the script followed by the White House. We also warned clients that it would be the "lead up to the 2018 or 2020 elections" that truly revealed President Trump's protectionist side. Nonetheless, we were overly bearish about trade protectionism throughout 2017. First, President Trump did not name China a currency manipulator. Second, the border adjustment tax (BAT), which we thought had a 55% chance of being included in tax reform, really was dead-on-arrival. Third, the "Mar-A-Lago Summit" consensus lasted through the summer, buoying companies with relative exposure to China relative to the S&P 500 (Chart 7).5 Chart 7Second Worst Call Of 2017:##br## Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Second Worst Call Of 2017: Alarmism On Protectionism Why did we get the Trump White House wrong on protectionism? There are three possibilities: Constraints error: We strayed too far from our constraints-based model by focusing too much on preferences of the Trump Administration. While we are correct that the White House lacks constraints when it comes to trade, tensions with North Korea this year - which we forecast correctly - were a constraint on an overly punitive trade policy against China. Preferences error: We got the Trump administration preferences wrong. Trade protectionism is the wool that Candidate Trump pulled over his voters' eyes. He is in fact an establishment Republican - a pluto-populist - with no intention of actually enacting protectionist policies. Timing error: We were too early. Year 2018 will see fireworks. Unfortunately for our clients, we have no idea which error we committed. But Trump's national security speech on Dec. 18 maintained the protectionist threat, and there are several key deadlines coming up that should reveal which way the winds are blowing: New Year: Trump will have to decide on January 12 and February 3 whether to impose tariffs on solar panels and washing machines, respectively, under Section 201 of the U.S. Trade Act of 1974. This ruling will have implications for other trade items. End of Q1: NAFTA negotiations have been extended through the end of Q1 2018. As we recently posited, the abrogation of NAFTA by the White House is a 50-50 probability.6 The question is whether the Trump administration follows this up with separate bilateral talks with Canada and Mexico, or whether it moves beyond NAFTA to clash directly with the WTO instead.7 The U.K. Election (Although We Got Brexit Right!) Our forecasting record of U.K. elections is abysmal. We predicted that Theresa May would preserve her majority in the House of Commons, although in our defense we also noted that the risks were clearly skewed to the downside given the movement of the U.K. median voter to the left.8 We are now 0 for 2, having also incorrectly called the 2015 general election (we expected the Tories to fail to reach the majority in that election).9 On the other hand, we correctly sounded the alarm on Brexit, noting that the probability was much closer to 50% than what the market was pricing at the time.10 What gives? The mix of U.K.'s first-past-the-post system and the country's unique party distribution makes forecasting elections difficult. Because the Tories are essentially the only right-of-center party in England, they tend to outperform their polls and win constituencies with a low-plurality of votes. As such, in 2017, we ignored the strong Labour momentum in the polls, expecting that it would stall. It did not (Chart 8). That said, our job is not to call elections, but to generate alpha by focusing on the difference between what the market is pricing in and what we believe will happen. If elections are a catalyst for market performance - as was the case with the French one this year - we track them closely in a series of publications and adjust our probabilities as new data comes in. For U.K. assets this year, by contrast, getting the Brexit process right was far more relevant than the general election. Our high conviction view that the EU would not be punitive, that the U.K. would accept all conditions, and that the May administration would essentially stick to the "hard Brexit" strategy it defined in January ended up being correct.11 This allowed us to call the GBP bottom versus the USD in January (Chart 9). Chart 8Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Third Worst Call Of 2018: The U.K. Election Chart 9But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right But We Got Brexit - And Cable! - Right What did we learn from our final error? Stop trying to forecast U.K. elections! The Best Calls Of 2017 The best overall call in 2017 was to tell clients to buy the S&P 500 in April and never look back. Our "Buy In May And Enjoy Your Day!" missive on April 26 was preceded by our analysis of global geopolitical risks and opportunities.12 In these, we concluded that "Political Risks Are Overstated In 2017" and "Understated In 2018."13 As such, the combination of strong risk asset performance and low volatility did not surprise us. It was our forecast (Chart 10). U.S. Politics: Tax Cuts & Impeachment Not only did we forecast that President Trump would manage to successfully pass tax reform in 2017, but we also correctly called the GOP's fiscal profligacy.14 We get little recognition for the latter in conversations with clients and colleagues, but it was a highly contentious call, especially after seven years of austere rhetoric from the fiscal conservatives supposedly running the Republican Party. We were also correct that impeachment fears and the ongoing Mueller Investigation would have little impact on U.S. assets.15 Chart 11 shows that the U.S. dollar and S&P 500 barely moved with each Trump-related scandal (Table 1). Chart 10The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right The Best Call Of 2017: Getting The Market Right Chart 11No Real Impact From Trump Imbroglio BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card By correctly identifying the ongoing "Trump Put" in the market, we were able to remain bullish on U.S. equities throughout the year and avoid calling any pullbacks. Table 1An Eventful Year 1 Of The Trump Presidency BCA Geopolitical Strategy 2017 Report Card BCA Geopolitical Strategy 2017 Report Card Europe (All Of It) Our performance forecasting European politics and markets has been stellar this year. Instead of reviewing each call, the list below simply summarizes each report: "After Brexit, N-Exit?" - Although technically a call made in 2016, our view that Brexit would cause a surge in support for the EU was a view for 2017.16 Several anti-establishment populists failed to perform in line with their 2015-2016 polling, particularly Geert Wilders in the Netherlands. "Will Marine Le Pen Win?" - We definitely answered this question in the negative, going back to November 2016.17 This allowed us to recommend clients go long the euro vs. the U.S. dollar (Chart 12). Moreover, we argued that regardless of who won the election, the next French government would embark on structural reforms.18 As a play on our bullish view of France, we recommended that clients overweight French industrials vs. German ones (Chart 13). "Europe's Divine Comedy: Italy In Purgatorio" - We correctly assessed that Italian Euroskpetics would migrate towards the center on the question of the euro. However, we missed recommending the epic rally in Italian equities and bonds that should have naturally flowed from our political view.19 "Fade Catalan Risks" - Based on our 2014 net assessment, we concluded that the Catalan independence drive would be largely irrelevant for the markets.20 This proved to be correct this year. "Can Turkey Restart The Immigration Crisis?" - Earlier in the year, clients became nervous about a potential diplomatic breakdown between the EU and Turkey leading to a renewal of the immigration crisis.21 We reiterated our long-held view that the immigration crisis did not end because of Turkish intervention, but because of tighter European enforcement. Throughout the year, we were proven right, with Europeans becoming more and more focused on interdiction. Chart 12Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Second Best Call Of 2017: The Euro... Chart 13...And France In Particular ...And France In Particular ...And France In Particular China: Policy-Induced Financial Tightening Throughout 2016-17, in the lead-up to China's nineteenth National Party Congress, we argued that the stability imperative would ensure an accommodative-but-not-too-accommodative policy stance.22 In particular, we highlighted the ongoing impetus for anti-pollution controls.23 This forecast broadly proved to be correct, as the government maintained stimulus yet simultaneously surprised the markets with financial and environmental regulatory crackdowns throughout the year. Once these regulatory campaigns took off, we argued that they would remain tentative, since the truly tough policies would have to wait until after the party congress. At that point, Xi Jinping could re-launch his structural reform agenda, primarily by intensifying financial sector tightening.24 Over the course of the year, this political analysis began to be revealed in the data, with broad money (M3) figures suggesting that money growth decelerated sharply in 2017 (Chart 14). In addition, we correctly called several moves by President Xi Jinping at the party congress.25 Chart 14Third Best Call Of 2017:##br## Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Third Best Call Of 2017: Chinese Reforms? (We Will See In 2018!) Our view that Chinese policymakers will restart reforms after the party congress is now becoming more widely accepted, given Xi's party congress speech Oct. 18 and the news from the December Politburo meeting.26 Where we differ from the market is in arguing that Beijing's bite will be worse than its bark. We are concerned that there is considerable risk to the downside and that stimulus will come much later than investors think this time around. Our China view was largely correct in 2017, but the real market significance will be felt in 2018. There are still several questions outstanding, including whether the crackdown on the financial sector will be as growth-constraining as we think. As such, this is a key view that will carry over into 2018. Thankfully, we should know whether we are right or wrong by the March National People's Congress session and the data releases shortly thereafter. North Korea - Both A Tail Risk And An Overstated Risk We correctly identified North Korea as a key 2017 geopolitical risk in our Strategic Outlook and began signaling that it was no longer a "red herring" as early as April 2016.27 In April 2017, we told clients to prepare for safe haven flows due to the likelihood that tensions would increase as the U.S. established a "credible threat" of war, a playbook that the Obama administration most recently used against Iran.28 While we flagged North Korea as a risk that would move the markets, we also signaled precisely when the risk became overstated. In September, we told clients that U.S. Treasury yields would rise from their lows that month as investors realized that the North Korean regime was constrained by its paltry military capability.29 At the same time, we gave President Trump an A+ for his performance establishing a credible threat, a bet that worked not only on Pyongyang, but also on Beijing. Since this summer, China has begun to ratchet up economic pressure against North Korea (Chart 15). Chart 15Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Fourth Best Call Of 2017: North Korea Middle East And Oil Prices BCA Research scored a big win this year with our energy call. It would be unfair for us to take credit for that view. Our Commodity & Energy Strategy as well as our Energy Sector Strategy deserve all the credit.30 Nonetheless, we helped our commodity teams make the right calls by: Correctly forecasting that Saudi-Iranian and Russo-Turkish tensions would de-escalate, allowing OPEC and Russia to maintain the production-cut agreement;31 Emphasizing risks to Iraqi production as tensions shifted from the Islamic State to the Kurdish Regional Government; Highlighting the likely continued decline, but not sharp cut-off, of Venezuelan production, due to the regime's ability to cling to power even as the conditions of production worsened.32 In addition, we were correct to fade various concerns regarding renewed tensions in Qatar, Yemen, and Lebanon throughout the year. Despite the media narrative that the Middle East has become a cauldron of instability anew, our long-held view that all the players involved are constrained by domestic and material constraints has remained cogent. In particular, our view that Saudi Arabia would engage in serious social reforms bore fruit in 2017, with several moves by the ruling regime to evolve the country away from feudal monarchy.33 Going forward, a major risk to our view is the Trump administration policy towards Iran, our top Black Swan risk for 2018. Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com Jesse Anak Kuri, Research Analyst jesse.kuri@bcaresearch.com Ekaterina Shtrevensky, Research Assistant ekaterinas@bcaresearch.com 1 Due to the high volume of footnotes in this report, we have decided to include them at the end of the document. For a review of our past Strategic Outlooks, please visit gps.bcaresearch.com. 2 For the rest of our 2018 Outlook, please see BCA Geopolitical Strategy Special Report, "Five Black Swans In 2018," dated December 6, 2017, and "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy, "Turkey: Military Adventurism And Capital Controls," dated December 7, 2016, "South Africa: Back To Reality," dated April 5, 2017, "Brazil: Politics Giveth And Politics Taketh Away," dated May 24, 2017, "South Africa: Crisis Of Expectations," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Weekly Report, "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Weekly Report, "G19," dated July 12, 2017, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gps.bcaresearch.com. 7 The outcome at the WTO Buenos Aires summit last week offered a possible way out of confrontation between the Trump administration and the WTO. It featured Europe and Japan taking a tougher line on trade violations, namely China, to respond to the Trump administration grievances that, unaddressed, could escalate into a full-fledged Trump-WTO clash. 8 Please see BCA Geopolitical Strategy Weekly Report, "How Long Can The 'Trump Put' Last?" dated June 14, 2017 and "U.K. Election: The Median Voter Has Spoken," dated June 9, 2017, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "U.K. Election Preview," dated February 26, 2015, available at gps.bcaresearch.com. 10 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me?' World?" dated January 25, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Weekly Report, "Buy In May And Enjoy Your Day!" dated April 26, 2017, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Overstated In 2017," dated April 5, 2017 and "Political Risks Are Understated In 2017," dated April 12, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 16 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 17 Please see BCA Geopolitical Strategy Special Report, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Special Report, "The French Revolution," dated February 3, 2017 and "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy Part II: Italy In Purgatorio," dated June 21, 2017, available at gps.bcaresearch.com. 20 Please see BCA Geopolitical Strategy and European Investment Strategy Special Report, "Secession In Europe: Scotland And Catalonia," dated May 14, 2014 and "Why So Serious?" dated October 11, 2017, available at gps.bcaresearch.com. 21 Please see BCA Geopolitical Strategy Weekly Report, "Five Questions On Europe," dated March 22, 2017, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Monthly Report, "Throwing The Baby (Globalization) Out With The Bath Water (Deflation)," dated July 13, 2016, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy We," dated June 28, 2017, "Update On Emerging Markets: Malaysia, Mexico, And The United States Of America," dated August 9, 2017, available at gps.bcaresearch.com. 25 We argued in our 2017 Strategic Outlook that while Xi's faction would gain a majority on the Politburo Standing Committee, he would maintain a reasonable balance and refrain from excluding opposing factions from power. We expected that factional struggle would flare back up into the open (as with the ouster of Sun Zhengcai), and that Xi would retire anti-corruption chief Wang Qishan, but not that Xi would avoid promoting a successor for 2022 to the Politburo Standing Committee. 26 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy "North Korea: A Red Herring No More?" in Monthly Report, "Partem Mirabilis," dated April 13, 2016 and "Strategic Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "North Korea: Beyond Satire," dated April 19, 2017, available at gps.bcaresearch.com. 29 Please see BCA Geopolitical Strategy Weekly Report, "Can Equities And Bonds Continue To Rally?" dated September 20, 2017, available at gps.bcaresearch.com. 30 If you are an investor with even a passing interest in commodities and oil, you must review the work of our colleagues Robert Ryan and Matt Conlan. 31 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Forget About The Middle East?" dated January 13, 2017, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 33 Please see BCA Geopolitical Strategy Special Report, "The Middle East: Separating The Signal From The Noise," dated November 15, 2017, available at gps.bcaresearch.com.

Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... 2018 Will See Risks Dominate... 2018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Three Questions For 2018 Three Questions For 2018 Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Three Questions For 2018 Three Questions For 2018 Chart 6Party Identifications##BR##Are Shrinking Party Identifications Are Shrinking Party Identifications Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Three Questions For 2018 Three Questions For 2018 Chart 8Trump Is Not A U.S. Dollar Paradigm Shift Three Questions For 2018 Three Questions For 2018 If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America A Changing America A Changing America Chart 10No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem Excess Investment Is A Real Problem Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Property Tightening Continues Property Tightening Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? Three Questions For 2018 Three Questions For 2018 What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist Three Questions For 2018 Three Questions For 2018 By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Three Questions For 2018 Three Questions For 2018 Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach Three Questions For 2018 Three Questions For 2018 BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Three Questions For 2018 Three Questions For 2018 Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Buy Energy, Short Metals Buy Energy, Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Highlights Investors should expect little policy initiative out of the U.S. Congress after tax cuts; Polarization is likely to rise substantively in 2018, gridlocking Congress; Chinese policymakers are experimenting with growth-constraining reforms; Global growth has peaked; underweight emerging markets in 2018; Go long energy stocks relative to metal and mining equities. Feature Last week we published Part I of our 2018 Key Views.1 In it, we presented our five "Black Swans" for 2018: Lame Duck Trump: President Trump realizes his time in the White House is going to be short and seeks relevance abroad. He finds it in jingoism towards Iran - throwing the Middle East into chaos - and protectionism against China. A Coup In North Korea: Chinese economic pressure overshoots its mark and throws Pyongyang into a crisis. Kim Jong-un is replaced, but markets struggle to ascertain whether the successor is a moderate or a hawk. Prime Minister Jeremy Corbyn: Markets cheer the higher probability of "Bremain" and then remember that Corbyn is a genuine socialist. Italian Election Troubles: Markets are fully pricing in the sanguine scenario of "much ado about nothing," which is our view as well. But is there really anything to cheer in Italy? If not, then why is the Italian market the best performing in all of DM? Bloodbath In Latin America: Emerging markets stall next year as Chinese policymakers tighten financial regulations. As the tide pulls back, Mexico and Brazil are caught swimming naked. These are not our core views. As black swans, they are low-probability events that may disturb markets in 2018. Our core view remains that geopolitical risks were overstated in 2017 and will be understated in 2018 (Charts 1 & 2). Most importantly, U.S. politics will be a tailwind to global growth while Chinese politics will be a headwind to global growth. While the overall effect may be neutral, the combination will be bullish for the U.S. dollar and bearish for emerging markets.2 Chart 12018 Will See Risks Dominate... 2018 Will See Risks Dominate... 2018 Will See Risks Dominate... Chart 2...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge ...As Global Growth Concerns Reemerge This week, we turn to the three questions that we believe will define the year for investors: Is A Civil War Coming To America? Is The Ghost Of Deng Xiaoping Haunting China? Will Geopolitical Risk Shift To The Middle East? Is A Civil War Coming To America? On a recent visit to Boston and New York we were caught off guard by how alarmed several large institutional clients were about the risk of severe social unrest in the U.S. We share this concern about the level of polarization in the U.S. and expect social instability to rise over the coming years (Chart 3).3 When roughly 40% of both Democrats and Republicans believe that their political competitors pose a "threat to the nation's well-being," we have entered a new paradigm (Chart 4). Chart 3Inequality Fuels Political Polarization Inequality Fuels Political Polarization Inequality Fuels Political Polarization Chart 4"A Threat To The Nation's Well-Being?" Really?! Three Questions For 2018 Three Questions For 2018 Where we differ from some of our clients is in assessing the likely trigger for the unrest and its investment implications over the next 12 months. If the Democrats take the House of Representatives in the November 6 midterm election, as is our low-conviction view at this early point, then we would expect them eventually to impeach President Trump in 2019.4 Even then, it is not clear that the Senate would have the necessary 67 votes to convict Trump of the articles of impeachment (whatever they prove to be) and hence remove him from power. Republicans are likely to increase their majority in the Senate, even if they lose the House, because more Democratic senators are up for re-election in 2018. Therefore well over a dozen Republican senators would have to vote to remove a Republican president from power. For that to happen, Trump's popularity with Republican voters would have to go into a free fall, diving well below 60% (Chart 5). Meanwhile, we do not buy the argument that hordes of gun-wielding "deplorables" would descend upon the liberal coasts in case of impeachment. There may well be significant acts of domestic terrorism, particularly in the wake of any removal of Trump from office, but they would likely be isolated and unable to galvanize broader support. Our clients should remember, however, that ultra-right-wing militant groups are not the only perpetrators of domestic terrorism.5 Any acts of violence or social unrest are likely to draw press coverage and analytical hyperbole. But our left-leaning clients in the Northeast are likely overstating the sincerity of support for President Trump. President Trump won 44.9% of the Republican primary votes, but he averaged only 35% of the vote in the early days when the races were the most competitive. Given that only 25% of Americans identify as Republicans (Chart 6), it is fair to say that only about a third of that figure - 8%-10% of all U.S. voters - are Trump loyalists. Many conservative voters simply wanted change and were willing to give an outsider a chance (much as their liberal counterparts did in 2008!). Of that small percentage of genuine Trump fans, it is highly unlikely that a large share would seriously contemplate taking arms against the state in order to keep their leader in power against the constitutional impeachment process. Especially given that President Trump would be replaced by a genuine conservative, Vice President Mike Pence.6 Chart 5We Are A Long Way Away##BR##From Trump's Demise Three Questions For 2018 Three Questions For 2018 Chart 6Party Identifications##BR##Are Shrinking Party Identifications Are Shrinking Party Identifications Are Shrinking As such, we believe that it is premature to speak of a total breakdown of social order in America. It is notable that such a conversation is taking place, but other forms of polarization and social unrest are far more likely to be relevant at the moment. In terms of policy, we would expect gridlock in Congress if Democrats take the House and begin focusing on impeachment. In fact, gridlock may already be upon us, as we see little agreement between the Trump administration, its loyalists in Congress, and establishment Republican Senators like Dan Sullivan (R, Alaska), Cory Gardner (R, Colorado), Joni Ernst (R, Iowa), Susan Collins (R, Maine), Ben Sasse (R, Nebraska), and Thom Tillis (R, North Carolina). These six Senators are all facing reelection in 2020 and are likely to evolve into Democrats-in-all-but-name. If President Trump's overall popularity continues to decline, we would not be surprised if one or two (starting with Collins) even take the dramatic step of leaving the Republican Party for the 2020 election. Essentially, establishment Republicans will become effective Democrats ahead of the midterms. Post-midterm election, with Democrats potentially taking over the House, the legislative process will grind to a complete halt. Government shutdowns, debt ceiling fights, failure of proactive policymaking to deal with crises and natural disasters, will all rise in probability. As President Trump faces greater constraints in Congress, we can see him becoming increasingly reliant on his executive authority to create policy. He would not be unique in this way, as President Obama did the same. While Trump's executive policy will be pro-business, unlike Obama's, uncertainty will rise regardless. The business community will not be able to take White House policies seriously amidst impeachment and a potential Democratic wave-election in 2020. Whatever executive orders Trump signs into power over the next three years, chances are that they will be immediately reversed in 2020. What about the markets? The Mueller investigation and heightened level of polarization could create drawdowns in equity markets throughout the year. However, impeachment proceedings are not likely to begin in 2018 and have never carried more weight with investors than market fundamentals (Chart 7).7 True, the Watergate scandal under President Richard Nixon triggered a spike in volatility and a fall in equities. However, the scandal alone did not cause the correction, rather it was a combination of factors, including the second devaluation of the dollar, rapid increases in price inflation, massive insurance fraud, recession, and a global oil shock.8 Chart 7AFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets Chart 7BFundamentals, Not Impeachment,##BR##Drive Markets Fundamentals, Not Impeachment, Drive Markets Fundamentals, Not Impeachment, Drive Markets What about the impact on the U.S. dollar? Does Trump-related political instability threaten the dollar's status as the chief global reserve currency and a major financial safe haven? The data suggest not. We put together a list of events in 2017 that could be categorized as "unorthodox, Trump-related, political risk" (Table 1). We specifically left out geopolitical events, such as the North Korean nuclear crisis, so as not to dilute our dataset's focus on domestic intrigue. As Chart 8 illustrates, the U.S. dollar rose slightly, on average, a week after each event relative to its average weekly return prior to the crisis. While this may not be a resounding vote of confidence for the greenback (gold performed better), there is no evidence that investors are betting on a paradigm shift away from the dollar as the global reserve currency. Table 1An Eventful Year 1 Of Trump Presidency Three Questions For 2018 Three Questions For 2018 Chart 8Trump Is Not A U.S. Dollar Paradigm Shift Three Questions For 2018 Three Questions For 2018 If investors should not worry about investment-relevant social strife in the U.S. in 2018, then when should they worry? Well, if Trump is actually removed from office, a first in U.S. history, at a time of extreme polarization, and in a country with easy access to arms and at least a strain of domestic terrorism, then 2019-20 will at least be a time for concern. Even without Trump's removal, we worry about unrest beyond 2018. We expect the ideological pendulum to shift to the left by the 2020 election. If our sister service - BCA's Global Investment Strategy - is correct, then a recession is likely to begin in late 2019.9 A combination of low popularity, market turbulence, and economic recession would doom Trump's chances of returning to the White House. But they would also be toxic for the candidacy of a moderate Democrat and would possibly propel a left-wing candidate to the presidency. Four years under a left-wing, socially progressive firebrand may be too much for many far-right voters to tolerate. Given America's demographic trends (Chart 9), these voters will realize that the writing is on the wall, that the window of opportunity to lock in their preferred policies has been firmly shut. The international context teaches us that disenchanted groups contemplate "exit" when the strategy of "voice" no longer works. How this will look in the U.S. is unclear at this point. Bottom Line: Investors should continue to fade impeachment-related, and Mueller investigation-related, pullbacks in the markets or the U.S. dollar in 2018. Our fears of U.S. social instability are mostly for the medium and long term. Fundamentals drive the markets and U.S. fundamentals remain solid for now. As our colleague Peter Berezin has pointed out, there is no imminent risk of a U.S. recession (Chart 10) and the cyclical picture remains bright (Chart 11).10 Chart 9A Changing America A Changing America A Changing America Chart 10No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession No Imminent Risk Of A U.S. Recession Chart 11U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright U.S. Cyclical Picture Is Bright Where BCA's Geopolitical Strategy diverges from the BCA House View, however, is in terms of the global growth picture. While we recognize that there are no imminent risks of a global recession, we do believe that the policy trajectory in China is being obfuscated by positive global economic projections. To this risk we now turn. Is The Ghost Of Deng Xiaoping Haunting China? Our view that Chinese President Xi Jinping would reboot his reform agenda after the nineteenth National Party Congress this October is beginning to bear fruit. Investors are starting to realize that the policy tightening of 2017 was not a one-off event but a harbinger of what to expect in 2018. China's economic activity is slowing down and the policy outlook is getting less accommodative (Chart 12).11 To be clear, we never bought into the 2013 Third Plenum "reform" hype, which sought to resurrect the ghost of Deng Xiaoping and his decision to open China's economy at the Third Plenum in 1978.12 Nor will we buy into any similar hype around the upcoming Third Plenum in 2018. Instead, we focus on policymaker constraints. And it seems to us that the constraints to reform in China have fallen since 2013. The severity of China's financial and economic imbalances, the positive external economic backdrop, the desire to avoid confrontation with Trump, and the Xi administration's advantageous moment in the Chinese domestic political cycle, all suggest to us that Xi will be driven to accelerate his agenda in 2018. Broadly, this agenda consists of revitalizing the Communist Party regime at home and elevating China's national power and prestige abroad. More specifically it entails: Re-centralizing power after a perceived lack of leadership from roughly 2004-12; Improving governance, to rebuild the legitimacy and popular support of the single-party state, namely by fighting corruption; Restructuring the economy to phase out the existing growth model, which relies excessively on resource-intensive investment while suppressing private consumption (Chart 13). Chart 12China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming China's Economic Prospects Are Dimming Chart 13Excess Investment Is A Real Problem Excess Investment Is A Real Problem Excess Investment Is A Real Problem The October party congress showed that this framework remains intact.13 First, Xi was elevated to Mao Zedong's status in the party constitution, which makes it much riskier for vested interests to flout his policies. Second, he declared the creation of a "National Supervision Commission," which will expand the anti-corruption campaign from the Communist Party to the administrative bureaucracy at all levels. Third, he recommitted to his economic agenda of improving the quality of economic growth at the expense of its pace and capital intensity. What does this mean for the economy in 2018? We expect government policy to become a headwind, after having been a tailwind in 2016-17. As Xi and the top-decision-making Politburo officially stated on December 9, the coming year will be a "crucial year" for advancing the most difficult aspects of the agenda: Financial risk: Financial regulation will continue to tighten, not only on banks and shadow lenders but also on the property sector, which Chinese officials claim will see a new "long-term regulatory mechanism" begin to be enacted (perhaps a nationwide property tax) (Chart 14). Local governments will face greater central discipline over bad investments, excessive debt, and corruption. The new leadership of the People's Bank of China, and of the just-created "Financial Stability and Development Commission," will attempt to establish their credibility in the face of banks that will be clamoring for less readily available liquidity.14 Green industrial restructuring: State-owned enterprises (SOEs) will continue to face stricter environmental regulations and cuts to overcapacity. This is in addition to tighter financial conditions, SOE restructuring initiatives, and an anti-corruption campaign that puts top managers under the microscope. SOEs that have not been identified as national champions, or otherwise as leading firms, will get squeezed.15 What are the market implications? First and foremost, the status quo in China is shifting, which is at least marginally negative for China's GDP growth, fixed investment, capital spending, import volumes, and resource-intensity. Real GDP should fall to around 6%, if not below, rather than today's 7%, while the Li Keqiang index should fall beneath the 2013-14 average rate of 7.3%. Second, a smooth and seamless conclusion of the 2016-17 upcycle cannot be assumed. The government's heightened effectiveness in economic policy will stem in part from an increase in political risk: the expansion of the anti-corruption campaign and Xi Jinping's personal power.16 The linking of anti-corruption probes with general policy enforcement means that any lack of compliance could result in top officials being ostracized, imprisoned, or even executed. Xi's measures will have sharper teeth than the market currently expects. Local economic actors (small banks, shadow lenders, local governments, provincial SOEs) will behave more cautiously. This will create negative growth surprises not currently being predicted by leading economic indicators (Chart 15). Chart 14Property Tightening##BR##Continues Property Tightening Continues Property Tightening Continues Chart 15Our Composite LKI Indicator Suggests##BR##A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Our Composite LKI Indicator Suggests A Benign Slowdown In Growth Chinese economic policy uncertainty, credit default swaps, and equity volatility should trend upward, as investors become accustomed to sectors disrupted by government scrutiny and a government with a higher tolerance for economic pain (Chart 16). How should investors play this scenario? Despite the volatility, we still expect Chinese equities, particularly H-shares, to outperform the EM benchmark, assuming the economy does not spiral out of control and cause a global rout. Reforms will improve China's long-term potential even as they weigh on EM exports, currencies, corporate profits and share prices. On a sectoral basis, BCA's China Investment Strategy has shown that China's health care, tech, and consumer staples sectors (and arguably energy) all outperformed China's other sectors in the wake of the party congress, as one would expect of a reinvigorated reform agenda (Chart 17). These sectors should continue to outperform. Going long the MSCI Environmental, Social, and Governance (ESG) Leaders index, relative to the broad market, is one way to bet on more sustainable growth.17 Chart 16Stability Continues##BR##After Party Congress? Stability Continues After Party Congress? Stability Continues After Party Congress? Chart 17China's Reforms Will Create##BR##Some Winners And Losers China's Reforms Will Create Some Winners And Losers China's Reforms Will Create Some Winners And Losers More broadly, investors should prefer DM over EM equities, since emerging markets (especially Latin America) will suffer from a slower-growing and less commodity-hungry China (Chart 18). Within the commodities complex, investors should expect crosswinds, with energy diverging upward from base metals that are weighed down by China.18 Chart 18Who Is Exposed To China? Three Questions For 2018 Three Questions For 2018 What are the risks to this view? How and when will we find out if we are wrong? Chart 19All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead All Signs Pointing To Headwinds Ahead First, the best leading indicators of China's economy are indicators of money and credit, as BCA's Emerging Markets Strategy and China Investment Strategy have shown.19 The credit and broad money (M3) impulses have finally begun to tick back up after a deep dip, suggesting that in six-to-nine months the economy, which has only just begun to slow, will receive some necessary relief (Chart 19). The question is how much relief? Strong spikes in these impulses, or in the monetary conditions index or housing prices, would indicate that stimulus is still taking precedence over reform. Second, our checklist for a reform reboot, which we have maintained since April and is so far on track, offers some critical political signposts for H1 2018 (Table 2).20 For instance, if China is serious about deleveraging, then authorities will restrain bank lending at the beginning of the year. A sharp increase in credit growth in Q1 would greatly undermine our thesis (while likely encouraging exuberance globally).21 Also, in March, the National People's Congress (NPC), China's rubber-stamp parliament, will hold its annual meeting. NPC sessions can serve to launch new reform initiatives (as in 1998 and 2008) or new stimulus efforts (as in 2009 and 2016). This year's legislative session is more important than usual because it will formally launch Xi Jinping's second term. The event should provide more detail on at least a few concrete reform initiatives. If the only solid takeaways are short-term growth measures and more infrastructure investment, then the status quo will prevail. Table 2China Reform Checklist Three Questions For 2018 Three Questions For 2018 By the end of May, an assessment of the concrete NPC initiatives and the post-NPC economic data should indicate whether China's threshold for economic pain has truly gone up. If not, then any reforms that the Xi administration takes will have limited effect. It is important to note that our view does not hinge on China's refraining from stimulus altogether. We do not expect Beijing to self-impose a recession. Rather, we expect stimulus to be of a smaller magnitude than in 2015-16. We also expect the complexion of fiscal spending to continue to become less capital intensive as it is directed toward building a social safety net (Chart 20). Massive old-style stimulus should only return if the economy starts to collapse, or closer to the sensitive 2020-21 economic targets timed to coincide with the anniversary of the Communist Party.22 Chart 20China's Fiscal Spending Is Becoming Less Capital Intensive Three Questions For 2018 Three Questions For 2018 Bottom Line: The Xi administration has identified financial instability, environmental degradation, and poverty as persistent threats to the regime and is moving to address them. The consequences are, on the whole, likely to be negative for growth in the short term but positive in the long term. We expect China to see greater volatility but to benefit from better long-term prospects. Meanwhile China-exposed, commodity-reliant EMs will suffer negative side-effects. Will Geopolitical Risk Shift To The Middle East? The U.S. geopolitical "pivot to Asia" has been a central theme of our service since its launch in 2012.23 The decision to geopolitically deleverage from the Middle East and shift to Asia was undertaken by the Obama administration (Chart 21). Not because President Obama was a dove with no stomach to fight it out in the Middle East, but because the U.S. defense and intelligence establishment sees containing China as America's premier twenty-first century challenge. Chart 21U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East U.S. Has Deleveraged From The Middle East The grand strategy of containing China has underpinned several crucial decisions by the U.S. since 2011. First, the U.S. has become a lot more aggressive about challenging China's military expansion in the South China Sea. Second, the U.S. has begun to reposition military hardware into East Asia. Third, Washington concluded a nuclear deal with Tehran in 2015 - referred to as the Joint Comprehensive Plan of Action (JCPA) - in order to extricate itself from the Middle East and focus on China.24 President Trump, however, while maintaining the pivot, has re-focused his rhetoric back on the Middle East. The decision to move the U.S. embassy to Jerusalem, while largely accepting a fait accompli, is an unorthodox move that suggests that this administration's threshold for accepting chaos in the Middle East is a lot lower. Our concern is that the Trump administration may set its sights on Iran next. President Trump appears to believe that the U.S. can contain China, coerce North Korea into nuclear negotiations, and reverse Iranian gains in the Middle East at the same time. In our view, he cannot. The U.S. military is stretched, public war weariness remains a political constraint, regional allies are weak, and without ground-troop commitments to the Middle East Trump is unlikely to change the balance of power against Iran. All that the abrogation of the JCPA would do is provoke Iran, which could lash out across the Middle East, particularly in Iraq where Tehran-supported Shia militias remain entrenched. Investors should carefully watch whether Trump approves another six-month waiver for the Iran Freedom and Counter-Proliferation Act (IFCA) of 2012. This act imposes sanctions against all entities - whether U.S., Iranian, or others - doing business with the country (Table 3). In essence, IFCA is the congressional act that imposed sanctions against Iran. The original 2015 nuclear deal did not abrogate IFCA. Instead, Obama simply waived its provisions every six months, as provided under the original act. Table 3U.S. Sanctions Have Global Reach Three Questions For 2018 Three Questions For 2018 BCA's Commodity & Energy Strategy remains overweight oil. As our energy strategists point out, the last two years have been remarkably benign regarding unplanned production outages. Iran, Libya, and Nigeria all returned production to near-full potential, adding over 1.5 million b/d of supply back to the world markets (Chart 22). This supply increase is unlikely to repeat itself in 2018, particularly as geopolitical risks are likely to return in Iraq, Libya, and Nigeria, and already have in Venezuela (Chart 23). Chart 22Unplanned Production Outages Are At The Lowest Level In Years Three Questions For 2018 Three Questions For 2018 Nigeria is on the map once again with the Niger Delta Avengers vowing to renew hostilities with the government. Nigeria's production has been recovering since pipeline saboteurs knocked it down to 1.4 million b/d in the period from May 2016 to June 2017, but rising tensions could threaten output anew. And Venezuela remains in a state of near-collapse.25 Iraq is key, and three risks loom large. First, as we have pointed out since early 2016, the destruction of the Islamic State is exposing fault lines between the Kurds - who have benefited the most from the vacuum created by the Islamic State's defeat - and their Arab neighbors.26 Second, remnants of the Islamic State may turn into saboteurs since their dream of controlling a Caliphate is dead. Third, investors need to watch renewed tensions between the U.S. and Iran. Shia-Sunni tensions could reignite if Tehran decides to retaliate against any re-imposition of economic sanctions by Washington. Not only could Tehran retaliate against Sunnis in Iraq, throwing the country into another civil war, but it could even go back to its favorite tactic from 2011: threatening to close the Straits of Hormuz. Another critical issue to consider is how the rest of the world would respond to the re-imposition of sanctions against Iran. Under IFCA, the Trump administration would be able to sanction any bank, shipping, or energy company that does business with the country, including companies belonging to European and Asian allies. If the administration pursued such policy, however, we would expect a major break between the U.S. and Europe. It took Obama four years of cajoling, threatening, and strategizing to convince Europe, China, India, Russia, and Asian allies to impose sanctions against Iran. For many economies this was a tough decision given reliance on Iran for energy supplies. A move by the U.S. to re-open the front against Iran, with no evidence that Tehran has failed to uphold the nuclear deal itself, would throw U.S. alliances into a flux. The implications of such a decision could therefore go beyond merely increasing the geopolitical risk premium. Chart 23Iraq, Libya, And Venezuela Are##BR##At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Iraq, Libya, And Venezuela Are At Risk Of Production Disruptions In 2018 Chart 24Buy Energy,##BR##Short Metals Buy Energy, Short Metals Buy Energy, Short Metals Bottom Line: BCA's Commodity & Energy Strategy has set the average oil price forecast at $67 per barrel for 2018.27 We believe that the upside risk to this view is considerable. As a way to parlay our relatively bearish view on the Chinese economy with the bullish oil view of our commodity colleagues, we would recommend that our clients go long global energy stocks relative to metal and mining equities (Chart 24). Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Associate Vice President Geopolitical Strategy mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "2018 Key Views, Part I: Five Black Swans," dated December 6, 2017, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 5 On June 14, James Hodkinson, a left-wing activist, attacked Republican members of Congress while practicing baseball for the annual Congressional Baseball Game for Charity. 6 A very sophisticated client in New York asked us whether we believed that National Guard units, who are staffed from the neighborhoods they would have to pacify in case of unrest, would remain loyal to the federal government in case of impeachment-related unrest. Our high-conviction view is that they would. First, the U.S. has a highly professionalized military with a strong history of robust civil-military relations. Second, if the Alabama National Guard remained loyal to President Kennedy in the 1963 University of Alabama integration protests - the so-called "Stand in the Schoolhouse Door" incident - then we certainly would expect "Red State" National Guard units to remain loyal to their chain-of-command in 2017. That said, the very fact that we do not consider the premise of the question to be ludicrous suggests that we are in a genuine paradigm shift. 7 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. 8 The "Saturday Night Massacre," which escalated the crisis in the White House, occurred in October, the same month that OPEC launched an oil embargo and caused the oil shock. The U.S. economy was already sliding into recession, which technically began in November. 9 Please see BCA Global Investment Strategy Weekly Report, "The Timing Of The Next Recession," dated June 16, 2017, available at gis.bcaresearch.com. 10 Please see BCA Global Investment Strategy Weekly Report, "When To Get Out," dated December 8, 2017, available at gis.bcaresearch.com. 11 Please see BCA Geopolitical Strategy Weekly Report, "Northeast Asia: Moonshine, Militarism, And Markets," dated May 24, 2017, and Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Reflections On China's Reforms," in "The Great Risk Rotation - December 2013," dated December 11, 2013, and Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "China: Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Weekly Report, "The Wrath Of Cohn," dated July 26, 2017, available at gps.bcaresearch.com. 15 Please see BCA Geopolitical Strategy Special Report, "Xi Jinping: Chairman Of Everything," dated October 25, 2017, available at gps.bcaresearch.com. 16 For instance, the decision to stack the country's chief bank regulator (the CBRC) with some of the country's toughest anti-corruption officials is significant and will bode ill not only for corrupt regulators but also for banks that have benefited from cozy relationships with them. This is not a neutral development with regard to bank lending. Please see BCA Geopolitical Strategy Weekly Report, "Geopolitics - From Overstated To Understated Risks," dated November 22, 2017, available at gps.bcaresearch.com. 17 Please see BCA China Investment Strategy Weekly Report, "Messages From The Market, Post-Party Congress," dated November 16, 2017, available at cis.bcaresearch.com. 18 Note that these eco-reforms will reduce supply, which could offset - at least in part - the lower demand from within China. Please see BCA Commodity & Energy Strategy Weekly Report, "Shifting Gears In China: The Impact On Base Metals," dated November 9, 2017, available at ces.bcaresearch.com. The status of China's supply-side reforms suggests that steel, coking coal, and iron ore prices are most likely to decline from current levels; please see BCA Emerging Markets Strategy Special Report, "China's 'De-Capacity' Reforms: Where Steel & Coal Prices Are Headed," dated November 22, 2017, available at ems.bcaresearch.com. 19 Please see BCA Emerging Markets Strategy Special Report, "Ms. Mea Challenges The EMS View," dated October 19, 2017, available at ems.bcaresearch.com, and China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle," dated November 30, 2017, available at cis.bcaresearch.com. 20 Please see BCA Geopolitical Strategy Weekly Report, "Political Risks Are Understated In 2018," dated April 12, 2017, available at gps.bcaresearch.com. 21 It is primarily credit excesses that a reform-oriented government would seek to rein in, while fiscal spending may have to increase to try to compensate for slower credit growth. 22 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 23 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, and "Brewing Tensions In The South China Sea: Implications," dated June 13, 2012, available at gps.bcaresearch.com. 24 Please see BCA Geopolitical Strategy Special Report, "Out Of The Vault: Explaining The U.S.-Iran Détente," dated July 15, 2015, available at gps.bcaresearch.com. 25 Please see BCA Geopolitical Strategy and Energy Sector Strategy Special Report, "Venezuela: Oil Market Rebalance Is Too Little, Too Late," dated May 17, 2017, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Commodity & Energy Strategy, "Key Themes For Energy Markets In 2018," dated December 7, 2017, available at ces.bcaresearch.com.

Highlights Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This points to a major top in EM share prices. In Brazil, falling inflation has led to a relapse in nominal GDP growth. This has endangered the already-bad public debt dynamics. Without the social security reforms, the country needs to boost nominal growth to stabilize public debt dynamics. Currency depreciation will likely be required to achieve this. When the Brazilian currency sells off, the nation's financial markets perform poorly. Feature Deteriorating EM Equity Breadth Breadth within EM equity markets has been deteriorating, especially in relative terms, versus DM stock markets. This heralds a major downleg in EM versus DM relative share prices, at a minimum, and a relapse in EM share prices in absolute terms as well. Chart I-1 demonstrates that the relative performance of EM equal-weighted stock index versus the DM equal-weighted share price index has decoupled from the relative performance of EM versus DM market cap-weighted equity benchmarks. Such a gap has emerged for the first time since 1999, when MSCI's equal-weighted equity data became available. Chart I-1EM Equity Outperformance Narrowly Based Versus DM... EM Equity Outperformance Narrowly Based Versus DM... EM Equity Outperformance Narrowly Based Versus DM... Each stock has the same weight in the equal-weighted index, while the regular indexes are market-cap weighted. Hence, an equal-weighted index reflects performance of an average stock while the market cap-weighted ones are skewed by the performances of large-cap stocks. This confirms what many investors already know: that in 2017, EM outperformance versus DM has been largely due to the surge in four large-cap technology stocks in Asia. Comparing EM against the U.S. only on similar measures, the message is identical (Chart I-2). Chart I-3 illustrates the absolute performance of MSCI EM market cap-weighted and MSCI EM equal-weighted equity indexes. It appears that the EM equal-weighted stock index has failed to make new cyclical highs lately. Thereby, it has not confirmed the new high in the EM market-cap weighted equity benchmark (Chart I-3). Chart I-2...And U.S. ...And U.S. ...And U.S. Chart I-3EM Equal-Weighted Index Did Not ##br##Confirm EM Market-Cap Recent Highs EM Equal-Weighted Index Did Not Confirm EM Market-Cap Recent Highs EM Equal-Weighted Index Did Not Confirm EM Market-Cap Recent Highs Similarly, the rally in share prices of EM banks - an important macro-driven sector of the EM equity universe - has lately paused. As such, it has also not confirmed the new high in the overall EM equity benchmark (Chart I-4). Given EM tech stocks (29% of MSCI benchmark index) are extremely overbought, the EM equity rally can be sustained if leadership rotates to EM financials and commodities stocks, which account for 23% and 14% of market cap, respectively. The failure of both EM financials and commodities stocks to make new cyclical highs of late suggests the EM equity rally is wearing off. The advance-decline line for EM stocks has lately dropped below the 50 line (Chart I-5, top panel). By contrast, the DM measure is still above 50 (Chart I-5, bottom panel). This signals a major bout of EM underperformance versus DM, as well as downside risks to EM's absolute performance. Chart I-4EM Banks Also Did Not Confirm ##br##EM Market-Cap Recent Highs EM Banks Also Did Not Confirm EM Market-Cap Recent Highs EM Banks Also Did Not Confirm EM Market-Cap Recent Highs Chart I-5Poor Advance-Decline Line In EM Equities Poor Advance-Decline Line In EM Equities Poor Advance-Decline Line In EM Equities The weak technical profile for EM equities is consistent with our fundamental assessment that the main risks to global growth and share prices stem from EM/China rather than DM economies. Therefore, EM/China plays will be the first to roll over, while DM stocks will lag. Investors looking for signs of reversal in the rally in global risk assets should monitor EM/China plays. Finally, EM small cap stocks' relative performance against their DM counterparts has not confirmed the EM outperformance based on an aggregate index (Chart I-6). This is a negative signal as well, and heralds new lows in relative performance. This also corroborates that, outside those EM large-cap tech stocks that have gone exponential, the EM equity rally has been much less exuberant and vigorous. More importantly, the EM rally has recently shown signs of fatigue. Bottom Line: Breadth within EM equity markets has been deteriorating both in absolute terms and relative to DM equities. This implies that a major downturn in EM share prices as well as EM risk assets generally is approaching. Investors should stay put/underweight EM risk assets. Brazil: A Political Economy Dilemma The Nominal Impediment We are aware that the pace of economic activity in Brazil is presently gathering speed. Manufacturing, retail sales and hiring are all recovering (Chart I-7). Even capital spending that has been shrinking until recently is now starting to show signs of life. Chart I-6EM Small Caps Have Not Confirmed ##br##EM Large Cap Outperformance EM Small Caps Have Not Confirmed EM Large Cap Outperformance EM Small Caps Have Not Confirmed EM Large Cap Outperformance Chart I-7Brazil: Economic Activity Is Recovering Brazil: Economic Activity Is Recovering Brazil: Economic Activity Is Recovering Nevertheless, Brazil's public debt dynamics remain unsustainable. Nominal GDP growth has declined to its 2015 low - as falling inflation has more than offset the revival in real output (Chart I-8). Besides, real interest rates remain elevated and nominal GDP growth is well below the government's borrowing costs (Chart I-9). Chart I-8Brazil: Real Growth Is Recovering ##br##While Nominal Growth Is Relapsing Brazil: Real Growth Is Recovering While Nominal Growth Is Relapsing Brazil: Real Growth Is Recovering While Nominal Growth Is Relapsing Chart I-9Brazil: Borrowing Costs Are Still High Brazil: Borrowing Costs Are Still High Brazil: Borrowing Costs Are Still High Therefore, without full-fledged social security reforms and/or lowering ex-ante real interest rates substantially, the public debt trajectory will likely spin out of control. Interest rates in real terms are also elevated for the private sector. This suggests that credit stress among companies and households might not recede quickly, and high real interest rates might cap the recovery in loan growth (Chart I-10). Interestingly, Chart I-11 demonstrates that private banks' NPLs (non-performing loans) inversely correlate with nominal GDP growth (nominal GDP is inverted on the chart). This entails that the amelioration in Brazil's NPL cycle is at least due for a pause. Chart I-10Brazil: Bank Loan Growth Is Stabilizing Brazil: Bank Loan Growth Is Stabilizing Brazil: Bank Loan Growth Is Stabilizing Chart I-11Brazil: Nominal GDP & Bank NPLs Brazil: Nominal GDP & Bank NPLs Brazil: Nominal GDP & Bank NPLs In short, to stabilize public and private debt dynamics, higher nominal GDP growth and much lower borrowing costs in real terms are vital. The latter means an unexpected rise in inflation is required. Chart I-12Brazil In the Late 1990s Brazil In the Late 1990s Brazil In the Late 1990s To boost nominal growth considerably and finance government at lower real interest rates, a combination of quantitative easing (QE) and currency depreciation will be needed. This is not a forecast that the Brazilian central bank will certainly implement QE. Rather, our point is that without extensive social security reforms - which are politically unfeasible now (more on this below) - a meaningful currency depreciation and/or public debt monetization by the central bank will be necessary to stabilize public debt dynamics and put the economy on a sustainable expansion path. Remarkably, in the late 1990s, faced with low inflation and weak nominal growth, the Brazilian government opted for large currency devaluation, which boosted nominal GDP growth (Chart I-12). Notably, the currency was devalued despite the large share of public foreign currency debt. This ratio is now very low. Hence, currency depreciation will be less painful now than it was in 1998. A Political Economy Dilemma: Growth Versus Creditors Brazil's elected politicians (congressmen and senators) are facing a political economy dilemma: (a) Should they satisfy interests of government creditors (including foreign investors) - i.e., pursue painful fiscal reforms to make public debt sustainable? Or (b) Should they gratify the electorate - i.e., avoid austerity and stimulate the still-beleaguered economy? To put this in perspective, the economy is just exiting one of the worst recessions of the past century, and the unemployment rate is still at a decade high. Over the next several months, the government of President Michel Temer will try to pass a diluted version of the pension reform bill. The government is desperate to enact this bill to keep financial markets buoyant and preserve the ongoing economic recovery heading into the elections. Being already very unpopular, government officials realize this is the only way their candidate has a chance to get elected in the presidential elections next year. However, the diluted version will not be enough to ensure debt sustainability. Chart I-13Brazil's Median Voter Favors ##br##Anti-Government Candidates Brazil's Median Voter Favors Anti-Government Candidates Brazil's Median Voter Favors Anti-Government Candidates Moreover, many of the government's coalition partners have different incentives. Going into the general elections in October 2018, odds favor that the majority of congressmen and senators will likely vote for avoiding austerity. As a result, the pension reforms draft - even in its diluted form - will likely fail. The median voter in Brazil remains on the left. Chart I-13 reveals that according to the latest polls, 60% of voters support anti-market candidates. Hence, any politician who wants to be elected needs to heed to the electorate. Worsening Fiscal Dynamics Public debt sustainability has been worsening: The primary and overall deficits have lately widened to 2.9% and 9.3% of GDP, respectively (Chart I-14). Public debt sustainability necessitates that the primary fiscal balance swings into a surplus, and borrowing costs drop below nominal GDP. None of these requirements have been satisfied or are likely to be anytime soon. Meanwhile, central government total revenue growth has dwindled (Chart I-15, top panel). In turn, central government net revenue - i.e. excluding transfers to local governments - are mildly contracting due to the increase in revenue transfers to the latter (Chart I-15, bottom panel). Chart I-14Brazil: Fiscal Deficit Has Not Improved Brazil: Fiscal Deficit Has Not Improved Brazil: Fiscal Deficit Has Not Improved Chart I-15Central Government Revenues Are Very Weak Central Government Revenues Are Very Weak Central Government Revenues Are Very Weak Furthermore, the overall fiscal deficit excluding social security is at 6% of GDP and has widened over the past year (Chart I-14, bottom panel). Interest payments account for 32% of government spending and 6.4% of GDP. On the whole, without a large fiscal retrenchment and with real interest rates close to current levels, the gross public debt-to-GDP ratio will likely reach 85% by the end of 2018 and 92% in two years' time - even if nominal GDP growth recovers to 6-6.5%. This puts the impetus solely on the central bank to reflate nominal growth aggressively and/or bring down real interest rates. This can be achieved via currency depreciation or public debt monetization. The outcome of the latter will necessarily be a major drop in the currency's value. This, along with our negative view on commodities prices in general and iron ore prices in particular, prompts us to retain our bearish stance on the Brazilian real. Chart I-16 demonstrates that the currency is highly correlated with iron ore prices, and has no correlation with the level of and changes in the interest rate differential between Brazil and the U.S. Investment Implications The path of least resistance for the Brazilian real is down - it will depreciate more than 2% and 4% that are implied by 6- and 12-month forwards, respectively. Stay short. When the Brazilian currency sells off, the nation's financial markets perform poorly. In particular, Brazil's sovereign and corporate credit spreads are very narrow, and will widen as investors begin doubting public debt sustainability. In turn, currency depreciation will raise the cost of foreign currency debt for the private sector. Dedicated EM investors should underweight Brazilian sovereign and corporate credit relative to their benchmarks. The relapse in narrow money (M1) growth presages downside risk in share prices (Chart I-17). Chart I-16Driver Of BRL: Commodities Not Interest Rates Driver Of BRL: Commodities Not Interest Rates Driver Of BRL: Commodities Not Interest Rates Chart I-17Brazil: M1 Growth And Share Prices Brazil: M1 Growth And Share Prices Brazil: M1 Growth And Share Prices The broad stock market is not particularly cheap, given the magnitude of the rally that has considerably exceeded the EPS recovery. Finally, in the local fixed-income market we continue recommending a bet on yield curve flattening that typically happens when the currency sells off. Foreign investors should wait for currency depreciation to play out before going long local currency government bonds. Local investors should overweight local bonds versus stocks. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Andrija Vesic, Research Assistant andrijav@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations