Geopolitics

Highlights Will inflation return in Europe & Japan? Can Trumponomics successfully boost U.S. economic growth? Will global market volatility remain this low? Can China avert a crisis and still be the engine of global growth? Feature With a New Year now upon us, fixed income investors are trying to determine what the next move is for global bond yields after the rapid rise at the end of 2016. While much has been made of the impact of the 2016 U.S. election result on the global bond rout, many other important factors will drive fixed income markets this year (Chart of the Week). In our first Weekly Report of the New Year, we present our list of the most important questions for global bond markets in 2017. Chart 1The Big Questions For 2017 The Big Questions For 2017 The Big Questions For 2017 Chart 2Taper Tantrum 2.0? Taper Tantrum 2.0? Taper Tantrum 2.0? Will Inflation Return In Europe & Japan? Extremely low inflation in the Euro Area and Japan over the past few years has forced both the European Central Bank (ECB) and Bank of Japan (BoJ) to pursue exceptionally accommodative monetary policies like negative interest rates and large scale quantitative easing (QE) programs - the latter acting to depress bond term premia among the major developed markets. Much of this decline in headline inflation in both regions was due to the 2014/15 collapse in oil prices and the previous strength in both the euro and yen (Chart 2), but core inflation and wage growth have also been subdued. If headline inflation were to move higher in either Europe or Japan, it could call into question the central banks' commitment to continue hyper-easy monetary stimulus programs. This could raise the threat of another "taper tantrum" in developed bond markets later in 2017. The recovery in global energy prices in 2016, combined with significant currency depreciations related to ECB/BoJ QE, have boosted the annual growth in the local currency price of oil to 72% in the Euro Area and 63% in Japan. Already, headline inflation measures have begun to move higher in response and, judging by past relationships, a move up to 2% headline inflation in both regions by year-end is possible. In Chart 3 & Chart 4, we present simulations for headline inflation in both the Euro Area and Japan assuming the only changes come from movements in oil prices, the euro and the yen. We show two scenarios where the Brent oil price rises to $65/bbl (the high end of the range expected by our commodity strategists in 2017) and $75/bbl (an extreme scenario). In both simulations, the euro and yen continue to weaken versus the U.S. dollar until mid-2017 before recovering to near current levels by year-end. Chart 3Euro Area Inflation Simulation Euro Area Inflation Simulation Euro Area Inflation Simulation Chart 4Japan Inflation Simulation Japan Inflation Simulation Japan Inflation Simulation Our simulations show that headline inflation in both the Euro Area and Japan could rise to at least the 2% level, and perhaps even higher, if oil prices continue to climb and both the yen and Euro weaken towards 125 and parity versus the U.S. dollar, respectively. Given our views on the likely path of interest rates in the U.S. - higher, as the Fed continues hiking rates - the U.S. dollar is likely to strengthen more in 2017. The oil price moves incorporated in our simulations are somewhat more bullish than our base case expectation, but not extraordinarily so. If there are any upside surprises to global growth this year, oil prices could show surprising strength given the production cutbacks occurring in many of the major oil exporting nations. Higher inflation would be welcome by both the ECB and BoJ, especially if it were accompanied by a rise in inflation expectations. Both central banks have acknowledged the role played by low realized inflation in recent years in depressing expected inflation, but the latter could move up surprisingly fast if the markets believe that either central bank will be slow to respond to the rise in realized inflation. That seems like more of a risk in Japan, where the BoJ is aiming for an overshoot of its 2% inflation target and is promising to keep the Japanese government bond (JGB) curve at current levels until that point is reached. The ECB would be much more likely to make the decision to begin tapering their bond purchases if Euro Area inflation approaches 2%. We see this as the biggest potential threat to global bond markets in 2017 - even more than the expected Fed rate hikes, which are already largely priced into the U.S. yield curve. The ECB was able to successfully kick the tapering can down the road last month by choosing to extend its QE program to the end of 2017, but a decision to defer tapering again will be much harder to make if Euro Area inflation is closer to 2%. If the ECB were to announce a taper later in 2017, this would be very damaging for the long ends of yield curves in the developed markets as bond term premia would begin to normalize - perhaps very rapidly. There is more room for adjustment for term premia in core Euro Area government bonds relative to U.S. Treasuries. An ECB taper announcement, or even just expectations of it, would mark the peak in the spread between U.S. Treasuries and German Bunds which is now at the highest levels in a quarter century. Given the busy upcoming election calendar in the Euro Area, the ECB will not want to even mention the word "taper" until later in the year. Until then, owning inflation protection in Europe, and Japan as well, is the best way to position for upside surprises in inflation in those regions. Bottom Line: Rising inflation in the Euro Area and Japan in 2017 will prompt a rethink of the hyper-easy monetary policies of both the ECB and BoJ, but only the former is likely to consider a taper of its bond purchase program this year. That decision would push global bond yields higher via wider term premia and cause Euro Area government bond markets to underperform U.S. Treasuries, but not until later in the year. Can Trumponomics Successfully Boost U.S. Economic Growth? After a long and divisive U.S. election campaign, the curtain is about to officially be raised on the Trump era on January 20. In anticipation of a more pro-growth agenda from the new president, investors have already bid up the valuations of assets sensitive to U.S. economic growth, like equities and corporate bonds, while also driving up both U.S. Treasury yields and the U.S. dollar. Chart 5Time To Spruce Up U.S. Infrastructure Time To Spruce Up U.S. Infrastructure Time To Spruce Up U.S. Infrastructure Markets are now discounting a fairly rosy scenario for a solid "Trump bump" to U.S. economic growth in 2017. This is to be expected, given that the president-elect won the White House on a platform full of promises to, among other things, boost government infrastructure spending, cut corporate taxes, tear down excess regulations on U.S. companies and adopt a more protectionist U.S. trade policy. In terms of a direct impact to U.S. GDP growth, there are three obvious places where the economic plan of Candidate Trump could turn into stronger growth this year for President Trump: government fixed investment, net exports and private capital expenditure. Trump's infrastructure plans have received much of the attention from those bullish on U.S. growth in 2017; unsurprising given the proposed size of the proposals ($550 billion). This stimulus would appear to be a source of low-hanging fruit to boost U.S. economic growth, as years of underinvestment has left America with an aging government infrastructure in need of an upgrade (Chart 5). Yet the boost to growth from government investment spending has historically not been large, adding between 0.25% and 0.5%, at most, over the past 40 years (bottom panel). Trump's proposed figure of $550 billion would fit right in with that experience, as it would represent 0.3% of the current $18.6 trillion U.S. economy. That assumes that all the proposed infrastructure spending occurs in a single year. Given the usual long lead times for big government infrastructure projects, and the discussions between the White House and the U.S. Congress over the scope and funding of any major government spending initiative, it is highly unlikely that the direct effect of more infrastructure spending will provide much of a boost to U.S. growth in 2017. That impact is more likely to be seen in 2018. A boost to growth from trade is also possible given Trump's fiery protectionist election rhetoric and his decision to nominate China hawks for major cabinet positions. It is unclear if Trump is willing to risk entering a trade war with China (or even Mexico) by raising import tariffs soon after taking office. It is even more uncertain if this will provide much of an immediate lift to U.S. net exports, if tariffs merely raise the cost of imports without any material substitution to domestically produced goods and services. Even if it did, trade has rarely contributed positively to real U.S. GDP growth outside of recessions since 1960. That leaves private fixed investment as the biggest potential source of new growth in the U.S. in 2017. Trump is proposing a cut in the U.S. corporate tax rate from 35% to 15%, while the Republican plan already set out by House Speaker Paul Ryan is calling for a cut to 25%. Both sides also are in favor of a lower "repatriation tax" on corporate profits held abroad, at a rate of 10-15%. So with all parts of the U.S. government in agreement, a move to cut corporate taxes appears to be a near certainty. In the past, efforts to initiate comprehensive tax reform have been not been done quickly in Washington. Our colleagues at BCA Geopolitical Strategy, however, believe that a deal between the White House and Congress could happen in the first half of 2017. The details of the other major policy initiatives that Trump wants done early in his first term - repealing and replacing Obamacare, and the infrastructure spending program - will be much harder to iron out than a tax cut on which both Trump and the Republican Congress agree. Doing the tax reform first will be the easier choice for a new president.1 Cutting corporate taxes seems like a move that should help boost U.S. private investment spending, as it would raise the after-tax return on capital. However, investment spending has already been underperforming relative to after-tax cash flows since the 2008 Financial Crisis, and the effective tax rate paid by the U.S. corporate sector is already much lower than the 35% marginal tax rate (Chart 6). Something else besides tax levels has been weighing on U.S. corporate sentiment with regards to capital spending intentions. It may be that the burden of excess government regulations, which has soared during the years of the Obama administration (bottom panel), has dampened animal spirits in the U.S. corporate sector. On that front, Trump's proposals to slash regulations - none bigger than repealing Obamacare - could help boost business confidence and fuel an upturn in capital spending. Chart 6A Regulatory Burden, Not A Tax Burden A Regulatory Burden, Not A Tax Burden A Regulatory Burden, Not A Tax Burden Chart 7Making Corporate America Happy Again Making Corporate America Happy Again Making Corporate America Happy Again Some rebound in capex was likely to occur, Trump or no Trump, given the recent improvement in U.S. corporate profits (Chart 7, top panel). This is especially true in the Energy sector which generated the biggest drag on U.S. corporate investment spending after the collapse in oil prices in 2014/15. Since the election, however, there has been a noticeable improvement in confidence within the "C-suite" for American companies. The Duke University/CFO Magazine measure of optimism on the U.S. economy hit the highest level in over a decade (middle panel), while the Conference Board index of CEO optimism soared to the highest level in three years, at the end of 2016. Executive confidence at those levels would be consistent with a pace of capital spending that could add up to 1 full percentage point to U.S. real GDP growth, based on past relationships - (bottom panel). For both of these surveys, executives cited a more positive outlook on future growth after the U.S. election as a major reason for the increase in optimism. In sum, the biggest potential lift to U.S. economic growth in 2017 from Trumponomics will come from business investment and not government spending or exports, and likely by enough to boost overall U.S. GDP growth to an above-trend pace that will prompt the Fed to deliver at least 2-3 rate hikes by year-end. Bottom Line: A major boost to U.S. economic growth from government investment spending and net exports is unlikely in 2017. A pickup in corporate investment, however, seems far more likely given the boost to longer-term business confidence seen after the U.S. elections, coming at a time of improving global economic growth. Will Market Volatility Stay This Low? Given all the uncertainties over the latter half of 2016, from Brexit to Trump to Italy, it is surprising how low market volatility has been. Measures of implied volatility like the VIX index for U.S. equities have remained incredibly subdued, while even the uptick in MOVE index has been relatively modest considering the year-end carnage in the Treasury market (Chart 8). The fact that global risk assets can remain so relatively well-behaved, even after a surprising U.S election result and a Fed rate hike that has boosted the U.S. dollar, is a sign that the "Fed Policy Loop" - where a more hawkish U.S. monetary stance causes an unwanted surge in the U.S. dollar and a selloff in equity and credit markets - has been broken. As we discussed in our 2017 Outlook report, the Fed Policy Loop framework would not apply in an environment where non-U.S. economic growth was improving, as is the currently the case.2 This may be the most obvious explanation for why market volatilities are low, with developed market equities hitting cyclical highs and corporate credit spreads staying at cyclical lows. In other words, volatility is low because growth is accelerating and global central banks (most notably, the Fed) are not slamming on the brakes. Chart 8The Death Of The Fed Policy Loop? The Death Of The Fed Policy Loop? The Death Of The Fed Policy Loop? Chart 9U.S. Dollar Strength Will Persist In 2017 U.S. Dollar Strength Will Persist In 2017 U.S. Dollar Strength Will Persist In 2017 The strength of the U.S. dollar has been a function of the widening real interest rate differential between the U.S. and the rest of the world (Chart 9), which is likely to continue this year as the Fed delivers a few more rate hikes while U.S. inflation grinds slowly higher. We do not expect the Fed to be forced to shift to a more aggressive pace of tightening than currently implied by the FOMC forecasts. On the margin, this will help keep market volatility at subdued levels. A predictable Fed slowly tightening into an improving economy is not overly problematic for financial markets. That logic would be turned upside down if non-U.S. growth were to begin to slow sharply (not our base case) or if there were some non-U.S. source of uncertainty that could make markets jittery. Last year, political surprises ended up being the biggest shock for financial markets. Given the busy upcoming election schedule in Europe (Table 1), there is concern that a similar story could play out in 2017. Table 1Europe In 2017 Will Be A Headline Risk 4 Big Questions For Bond Markets In 2017 4 Big Questions For Bond Markets In 2017 The shock of Brexit and Trump have investors asking "where will the next populist uprising be?" France seems like the most obvious possibility, with the well-known right-wing (and anti-EU) populist Marine Le Pen running in this year's presidential election. French government debt has already priced in some modestly higher risk premium in recent months (Chart 10). Even in the bastion of stability, Germany, the rise of anti-immigration parties has some forecasting a difficult re-election campaign for Chancellor Angela Merkel later in the year. Our geopolitical strategists have long argued that there is not enough support for populist, anti-EU, anti-immigration parties in either Germany, France or the Netherlands (who also have an election this year) to win an election.3 The recent polling data strongly supports that view, with Le Pen's popularity on the decline for the past three years and with Merkel's popularity holding steady over the past year (Chart 11) - even as horrific terror incidents committed by "foreigners" have occurred on both French and German soil. Chart 10Not Worried About European Populism... Not Worried About European Populism... Not Worried About European Populism... Chart 11...For Good Reasons ...For Good Reasons ...For Good Reasons BCA's Chief Geopolitical Strategist, Marko Papic, believes that Italy remains the greatest political risk in Europe in 2017, with elections possible as early as the spring. With the Senate reforms defeated in the December referendum, the country needs to re-write its already complicated electoral laws. This will likely take time, pushing the potential election date to late spring or early summer. If an early election is not called, a new vote must be held by the expiry of the government's mandate in May 2018. Chart 12Italy Is The Biggest Political Risk In Europ Italy Is The Biggest Political Risk In Europ Italy Is The Biggest Political Risk In Europ Chart 13A Managed Renminbi Depreciation A Managed Renminbi Depreciation A Managed Renminbi Depreciation Given the lower support for the euro in Italy than the rest of the Euro Area (Chart 12), and given the strong showing in the polls for the anti-establishment, anti-EU Five Star Movement led by Beppe Grillo, an early Italian election could be the biggest potential political shock for markets in 2017. This likely will not be enough to cause a major flare-up of global market volatility, but it does suggest that investors should remain underweight Italian government debt. Bottom Line: Improving global growth will continue to support low market volatility during 2017, even with the Fed remaining in a tightening cycle. European political risk should not be a Brexit/Trump-type source of concern for investors outside of Italy. Can China Avert A Crisis And Still Be The Engine Of Global Growth? This is a question that we may be asking every year for the next decade, given China's high debt levels and decelerating potential economic growth. Periodic episodes of uncertainty over Chinese currency policy are always a threat to trigger capital outflows, as has occurred over the past year and half (Chart 13). The Chinese authorities have chosen to allow currency depreciation versus the U.S. dollar to help manage the pace of that outflow, particularly during the past year when interest rate differentials have moved in a more dollar-positive direction. With over US$3 trillion in foreign exchange reserves at the government's disposal, the odds remain low that a true economic crisis can unfold in China. Additional renminbi weakness versus the U.S. dollar is likely in 2017, but the recent actions to sharply raise offshore renminbi interest rates is an indication that Chinese authorities will not tolerate a rapidly weakening currency. The incoming Trump administration is obviously an unforecastable wild card here, and China could respond to a new trade war with the U.S. by allowing a more rapid pace of currency weakness versus the dollar. Having said that - if China-U.S. relations don't boil over, then the underlying story for China will be one of improving economic growth in 2017. The underlying growth indicators in our "China Checklist" unveiled late last year (Table 2) continue to improve (Chart 14), and we continue to see China as being a positive contributor to the global economic cycle in 2017 (Donald Trump and his band of China hawks notwithstanding). This is important, as the global upturn seen in 2016 began in China early in the year. This fed through into many other countries either directly via exports to China or indirectly through an improvement in the pricing power for commodity exporters that benefitted from faster Chinese demand. Table 2The GFIS China Checklist 4 Big Questions For Bond Markets In 2017 4 Big Questions For Bond Markets In 2017 Chart 14Chinese Growth Still Improving Chinese Growth Still Improving Chinese Growth Still Improving Bottom Line: China will likely remain a positive driver of the global economic upturn in 2017, with the biggest risk coming from increased tensions with the incoming Trump administration, not accelerating domestic capital outflows. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency", dated November 20th 2016, available at gps.bcaresearch.com 2 Please see BCA Global Fixed Income Strategy Special Report, "How To Think About Global Bond Investing In 2017", dated December 20th 2016, available at gfis.bcarsearch.com 3 Please see BCA Geopolitical Strategy Strategic Outlook 2017, "5 Themes For 2017", dated December 2016, available at gps.bcaresearch.com Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Overall Strategy: The global economy is entering a reflationary sweet spot that will last for the next two years. Investors should overweight equities, maintain slightly below benchmark exposure to government bonds, and underweight cash over a 12-month horizon. Fixed Income: Global bond yields will rise only modestly over the next two years, reflecting an abundance of spare capacity in many parts of the world. A major bond bear market will begin towards the end of the decade, as stagflationary forces gather steam. Equities: Investors should underweight the U.S. for the time being, while overweighting Europe and Japan in currency-hedged terms. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate another 6% from current levels. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is approaching a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks later this year. Feature I. Key Theme: A Reflationary Window The global economy is entering a reflationary sweet spot where deflationary forces are in retreat but fears of excess inflation have yet to surface. Activity data are surprising to the upside and leading economic indicators have turned higher (Chart 1). Falling unemployment in most major economies is boosting confidence, fueling a virtuous cycle of rising spending and even further declines in joblessness. Manufacturing activity is bouncing back after a protracted inventory destocking cycle (Chart 2). In addition, the stabilization in commodity prices has given some relief to emerging markets, while fueling a modest rebound in resource sector capital spending. Meanwhile, easier fiscal policy is providing a welcome tailwind to growth. The aggregate fiscal thrust for advanced economies turned positive in 2016 - the first time this has happened in six years. We expect this trend to persist for the foreseeable future. Reflecting these developments, market-based measures of inflation expectations have risen, offsetting the increase in nominal interest rates. In fact, real rates in the euro area and Japan have actually declined across most of the yield curve since the U.S. presidential election (Chart 3). This should translate into higher household and business spending in the months ahead. Chart 1Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating Chart 2Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 3Falling Real Rates In The Euro Area And Japan Falling Real Rates In The Euro Area And Japan Falling Real Rates In The Euro Area And Japan Supply Matters Yet, there has been a dark side to this reflationary trend, and one that could sow the seeds for stagflation as the decade wears on. Simply put, much of the reduction in spare capacity over the past eight years has occurred not because of much faster demand growth, but because of continued slow supply growth. Chart 4 shows that output gaps in the main developed economies would still be enormous today if potential GDP had grown at the rate the IMF forecasted back in 2008. Chart 4AWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Chart 4BWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Unfortunately, we do not expect this state of affairs to change much over the coming years. The decline in birth rates that began in the 1960s has caused working-age populations to grow more slowly in almost all developed and emerging economies (Chart 5). In some countries such as the U.S., the downward pressure on labor force growth has been exacerbated by a structural decline in participation rates, especially among the less educated (Chart 6). Chart 5Slowing Workforce Growth Slowing Workforce Growth Slowing Workforce Growth Chart 6U.S.: The Less Educated Are Shunning The Labor Force First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Productivity growth has also fallen (Chart 7). Part of this phenomenon is cyclical in nature, reflecting the impact of several years of weak corporate investment in new plant and equipment. However, much of it is structural. As Fed economist John Fernald has shown, the slowdown in productivity growth since 2004 has been concentrated in sectors that benefited the most from the adoption of new information technologies in the late 1990s (Chart 8).1 Recent technological innovations have focused more on consumers than on businesses. This has resulted in slower productivity growth. Chart 7Slowing Productivity Growth Around The World Slowing Productivity Growth Around The World Slowing Productivity Growth Around The World Chart 8The Productivity Slowdown Has Been ##br##Greatest In Sectors That Benefited The Most From The I.T. Revolution First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation To make matters worse, human capital accumulation has decelerated both in the U.S. and elsewhere, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the rate it did in the 1990s (Chart 9). Educational achievement, as measured by standardized test scores, has also peaked, and is now falling in many countries (Chart 10). Chart 9The Contribution To Growth ##br##From Rising Human Capital Is Falling First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 10Math Skills Around The World First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation From Deflation To Inflation To reiterate what we have discussed at length in the past, the slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on.2 Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 11). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period during which productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 12). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 12An Aging Population Eventually Pushes Up Interest Rates First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Is Debt Deflationary Or Inflationary? The answer is both. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Moreover, once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. Acting on that incentive also becomes easier as the output gap evaporates. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to maintain interest rates at ultra-low levels, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, an adverse economic shock, etc. In contrast, if the output gap is already close to zero, a promise to let the economy run hot is more likely to be taken seriously. The U.S. Economy: Still In A Reflationary Sweet Spot The stagflationary demons described above will eventually come back to haunt the U.S., but for now and probably for the next two years, the economy will remain in a reflationary sweet spot. After a weak start to 2016, growth has bounced back. Real GDP grew by 3.5% in Q3. The Atlanta Fed's GDPNow model points to still-healthy growth of 2.9% in Q4. We expect growth to stay robust in 2017, as improving confidence and a stabilization in energy-sector investment lift overall business capex, homebuilding picks up after contracting in both Q2 and Q3 of 2016, and rising wages push up real incomes and personal consumption. Above-trend growth will continue to erode spare capacity. The headline unemployment rate has fallen to 4.6%, close to most estimates of NAIRU. Broader measures of unemployment, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 13). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are all at or above 2007 levels (Chart 14). In contrast to most measures of labor market slack, industrial utilization still remains quite low by historic standards (Chart 15). In fact, the Congressional Budget Office's "capacity utilization-based" estimate of the output gap stands at around 3% of GDP, whereas its "unemployment-based" estimate is close to zero. Chart 13U.S. Labor Market: Not Much Slack Left First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 14Most U.S. Labor Market Measures ##br## Are Back To Pre-Recession Levels Most U.S. Labor Market Measures Are Back To Pre-Recession Levels Most U.S. Labor Market Measures Are Back To Pre-Recession Levels Chart 15U.S.: Industrial Capacity Utilization Remains Low U.S.: Industrial Capacity Utilization Remains Low U.S.: Industrial Capacity Utilization Remains Low A strong dollar, as well as the ongoing decline of the U.S. manufacturing base, partly explain the low level of industrial utilization. However, another important reason bears noting: Years of depressed real wage growth has made labor scarce compared with capital. The free market solution to this problem is higher wages for workers. Good news for Main Street; but perhaps not so good news for Wall Street. Stagflation Is Coming, Just Not Yet While inflation will creep higher in 2017, a major spike is unlikely over the next two years. There are two main reasons for this. First, if the economy does run into severe capacity constraints, the Fed will have to step up the pace of rate hikes. Higher interest rates will push up the value of the dollar, curbing growth and inflation. Second, the historic evidence suggests that it takes a while for an overheated economy to generate meaningfully higher inflation. Consider how inflation evolved during the 1960s. U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 due to rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 16). The relationship between economic slack and inflation is depicted by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 17). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Chart 16It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 17The Phillips Curve Has Flattened First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation The adoption of inflation targeting, coupled with more transparent Fed communication, has helped anchor inflation expectations. This has flattened the Phillips curve. A flatter Phillips curve implies a lower "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. Going forward, the temptation to exploit the flatness of the Phillips curve may be too great to resist. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that she is at least willing to entertain the idea. Interest rates are still fairly low and a few more hikes are unlikely to cause much distress among corporate and household borrowers. As rates continue to climb, however, this may change, making it difficult for the Fed to further tighten monetary policy. This is especially the case if potential real GDP growth remains lackluster, as this would make it harder for borrowers to generate enough income to service their debts. Trump's budget-busting fiscal deficits may also put some pressure on the Fed to eschew raising rates too much in an effort to hold down interest costs. Even if such political pressures do not materialize, the challenges posed by the zero bound constraint on nominal interest rates could still justify efforts to raise the Fed's 2% inflation target. After all, if inflation were higher, this would give the Federal Reserve the ability to push down real rates further into negative territory in the event of an economic downturn. Admittedly, such a step is unlikely to be taken anytime soon. Nevertheless, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF; San Francisco Fed President John Williams; and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. The bottom line is that inflation is likely to move up slowly over the next two years, but could begin to accelerate more sharply towards the end of the decade. Japan: The End Of Deflation? Like the U.S., Japan has also entered a reflationary window. Retail sales surprised on the upside in November, rising 1.7%, against market expectations of 0.8%. Industrial production and exports continue to rebound, a trend that should persist thanks to the yen's recent depreciation (Chart 18). Stronger economic growth is causing the labor market to heat up. The Bank of Japan estimates that the "labor input gap" is now positive, meaning that the economy has run out of surplus workers (Chart 19). Reflecting this, the ratio of job openings-to-applicants has reached a 25-year high (Chart 20). Chart 18Japan: Some Positive Economic News Japan: Some Positive Economic News Japan: Some Positive Economic News Chart 19Japan: Labor Market Slack Has Evaporated, But Industrial Capacity Utilization Has Fallen First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 20Japan: Sign Of Tightening Labor Market Japan: Sign Of Tightening Labor Market Japan: Sign Of Tightening Labor Market Wage growth so far has been tepid, but that should change over the next two years. The labor force expanded by 0.9% year-over-year in November - the latest month for which data are available - largely due to the continued influx of women into the labor force. Chart 21 shows that the employment-to-population ratio for Japanese prime-age women now exceeds that of the U.S. by three percentage points. As Japanese female labor participation stabilizes, overall labor force growth will turn negative, pushing up wages in the process. Chart 21Japan: Female Labor Force ##br##Participation Now Exceeds The U.S. Japan: Female Labor Force Participation Now Exceeds The U.S. Japan: Female Labor Force Participation Now Exceeds The U.S. In contrast to the Fed, the BoJ is unlikely to tighten monetary policy in response to higher inflation. As a consequence, real yields will continue to fall as inflation expectations rise further. This will lead to higher net exports via a weaker yen, as well as increased spending on interest-rate sensitive goods such as consumer durables and business equipment. Indeed, a virtuous circle could develop where an overheated labor market pushes down real rates, causing aggregate demand and inflation to rise, leading to even lower real rates. If this occurs, growth could accelerate sharply, avoiding the need for more radical measures such as "helicopter money." In short, Japan may be on the verge of escaping its deflationary trap. This is something that could have happened shortly after Prime Minister Abe assumed office, but was short-circuited by the government's lamentable decision to tighten fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. Europe: Fine... For Now The European economy grew at an above-trend pace in 2016. Real GDP in the EU is estimated to have expanded by 1.9%, compared to 1.6% in the U.S. The euro area is estimated to have grown by 1.7% - the first time that growth in the common currency bloc exceeded the U.S. since the Great Recession. Euro area growth should remain reasonably strong in 2017, as telegraphed by a number of leading economic indicators (Chart 22). Fiscal austerity has been shelved in favor of modest stimulus. The European Commission is now even advising member countries to loosen fiscal policy more than they themselves are targeting (Chart 23). Chart 22Euro Area Growth Will Remain On Solid Footing In 2017 Euro Area Growth Will Remain On Solid Footing In 2017 Euro Area Growth Will Remain On Solid Footing In 2017 Chart 23The European Commission Recommends Greater Fiscal Expansion First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Ongoing efforts to strengthen the euro area's banking system will also help. As we noted in the "Italian Bank Job," the costs of cleaning up the Italian banking system are modest compared with the size of the Italian economy.3 The failure to have done it earlier represents a massive "own goal" by the Italian and EU authorities. As banking stresses recede, the gap in economic performance between northern and southern Europe should narrow. The overall stance of monetary policy will facilitate this trend. If the ECB keeps interest rates near zero for the foreseeable future, as it almost certainly will, Germany's economy will overheat. Chart 24 shows that the German unemployment rate has fallen to a 25-year low, while wage growth is now running at twice the rate as elsewhere in the euro area. Chart 24German Labor Market Going Strong German Labor Market Going Strong German Labor Market Going Strong An overheated German economy will help the periphery in two important ways: First, higher wage inflation in Germany will give a competitive advantage to Club Med producers seeking to sell their goods in the euro area's biggest economy. Second, faster wage growth and stronger domestic demand in Germany will erode the country's gargantuan current account surplus of nearly 9% of GDP. This will put downward pressure on the euro, giving the periphery a further competitive boost. Of course, all this rests on the assumption that Germany accepts an overheated economy. One could objectively argue that it is in Germany's political best interest to do so, as this may be the only means by which to hold the euro area together. One could also argue that rebalancing German growth towards domestic demand, and away from its historic reliance on exports, would be in the country's long-term best interest. One might also contend that German banks would accept a few more years of low rates if this helped lower nonperforming loans across the euro area, while also paving the way for the eventual abandonment of ZIRP and NIRP. Chart 25Italy Lags Peers On Euro Support Italy Lags Peers On Euro Support Italy Lags Peers On Euro Support Whatever the merits of these arguments, they clash with Germany's historical antipathy towards inflation. This means that political risk could escalate over the coming years. Against the backdrop of growing anti-establishment sentiment - fueled in no small measure by the EU's deer-in-the-headlights response to the migration crisis - Europe's populist parties will continue to make gains at the polls. Timing is important, however. With unemployment trending lower, our hunch is that any truly disruptive populist shock may have to wait until the next recession, which is likely still a few years away. BCA's Geopolitical Strategy team holds a strong conviction view that Marine Le Pen, the leader of the eurosceptic National Front, will be defeated in the second round of the presidential election in May. They also think that Angela Merkel will cling to power, partly because Germany still lacks an effective anti-establishment opposition party. Italy is more of a concern, given that support for the common currency among Italians has been falling and is now lower than virtually anywhere else in the euro area (Chart 25). Nevertheless, our geopolitical strategists assign very low odds to Italy following Britain's example and voting to leave the EU. Indeed, it is still not even clear that the U.K. will actually follow through and exit the EU. Brussels is likely to play hardball with the U.K. during the negotiations slated to begin in March. EU officials are keen to send a clear warning to other EU members who may be tempted to leave the club. It is still quite possible that another referendum will be held in one or two years concerning the terms of the negotiated agreement that would govern Britain's future relationship with the EU. Given how close the first referendum was, there is a reasonable chance that U.K. voters will choose EU membership over a bad deal. In that case, Brussels will back off from its threat that triggering Article 50 would irrevocably lead to the U.K.'s expulsion from the EU. China: Still In Need Of A Spender-Of-Last Resort Investor angst about China rose to a fever pitch early last year, but has since faded into the background. The main reason for this is that the deflationary forces which once threatened to precipitate a hard landing for the economy have abated. Growth has picked up and producer price inflation has risen from -5.3% in early 2016 to 3.3% in November (Chart 26). As our China strategists have argued, the end of PPI deflation is a major positive development for the Chinese corporate sector, as it improves its pricing power while reducing its real cost of funding (Chart 27). Real bank lending rates deflated by the PPI rose to near-record highs early last year, but have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This has bestowed dramatic relief on some highly-levered, asset-heavy industries. These industries were the biggest casualties of the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bode well for banks. Chart 26China: Improving Growth Momentum China: Improving Growth Momentum China: Improving Growth Momentum Chart 27China: Real Interest Rates Dropping ##br## Thanks To Easing Deflation China: Real Interest Rates Dropping Thanks To Easing Deflation China: Real Interest Rates Dropping Thanks To Easing Deflation Unfortunately, the reflationary forces in China are masking deep underlying problems. Structural reform has been patchy at best; credit continues to expand much faster than GDP; and speculation in the real estate sector is rampant (Chart 28). Meanwhile, capital continues to flow out of the country, taking the PBOC's foreign exchange reserves down from a high of $4 trillion in June 2014 to $3.1 trillion at present. There are no easy solutions to these problems. Tightening monetary policy could help fend off capital flight, but this would hurt growth and potentially plunge the economy back into deflation. This week's spike in interbank rates is evidence of just how sensitive the economy has become to any withdrawal of monetary accommodation (Chart 29). Chart 28China: Credit Continues Expanding And The##br## Real Estate Sector Is Getting Frothy China: Credit Continues Expanding And The Real Estate Sector Is Getting Frothy China: Credit Continues Expanding And The Real Estate Sector Is Getting Frothy Chart 29China: Yet Another Spike In Interbank Rates China: Yet Another Spike In Interbank Rates China: Yet Another Spike In Interbank Rates As we controversially argued in "China Needs More Debt," China's underlying problem is a chronic excess of savings.4 This has kept aggregate demand below the level commensurate with the economy's productive capacity. In the past, China was able to export some of those excess savings abroad via a large current account surplus, which peaked at 10% of GDP in 2007 (Chart 30). However, China is now too large to export its way out of its problems. It was one thing for China to run a current account surplus of 10% of GDP when its economy represented 6% of global GDP. It is quite another to do so when the economy represents 15% of global GDP, as it does now. This is especially the case when other economies are also keen to have cheap currencies. Faced with this reality, the government has been trying to buttress aggregate demand by funneling a huge amount of credit towards state-owned companies, which have then used these funds to finance all sorts of investment projects. The problem is that China no longer needs as much new capacity as it once did. As trend GDP growth has slowed, the level of investment necessary to maintain a constant capital-to-output ratio has fallen by about 10% of GDP over the past decade.5 China's aging population will eventually lead to a drop in savings. Government plans to strengthen the social safety net should also help this transition along by reducing household precautionary savings. However, these are long-term developments. Over the next couple of years, China will have little choice but to let credit grow at a rapid pace. The good news is that China has ample domestic savings to continue financing credit expansion. The ratio of bank loans-to-deposits remains near all-time lows (Chart 31). The government also has plenty of fiscal resources to safeguard the banks from losses on nonperforming loans extended to local governments and state-owned enterprises. Chart 30China Used To Rely On Large ##br##Current Account Surplus To Export Excess Savings China Used To Rely On Large Current Account Surplus To Export Excess Savings China Used To Rely On Large Current Account Surplus To Export Excess Savings Chart 31China: Banks Have Ample Deposit Coverage China: Banks Have Ample Deposit Coverage China: Banks Have Ample Deposit Coverage All that may not be enough, however. Given the risks to financial stability from excessive investment by state-owned enterprises, the government may have little choice but to cajole households into spending more by suppressing bank deposit rates while purposely engineering higher inflation. The resulting decline in real rates will reduce the incentive to save while helping to inflate away the mountain of debt that has already been accumulated. II. Financial Markets Equities Chart 32Investors Are Optimistic Investors Are Optimistic Investors Are Optimistic Deflation is bad for equities, as is stagflation. But between deflation and stagflation there is reflation - and that is good for stocks. This reflationary window should remain open for the next two years. As such, we expect global equities to be higher in 12 months than they are today. However, the risks for stocks are tilted to the downside over both a shorter-term horizon of less than two months and a longer-term horizon exceeding two years. The near-term outlook is complicated by the fact that global equities are overbought, and hence vulnerable to a selloff. Chart 32 shows that bullish sentiment is stretched to the upside. Expectations of long-term U.S. earnings growth have also jumped to over 12%, something that strikes us as rather fanciful. Renewed rumblings in China could also spook the markets for a while. We expect global equities to correct 5%-to-10% from current levels, setting the stage for a more durable recovery. Once that recovery begins, higher-beta developed markets such as Japan and Europe should outperform the U.S. As my colleague, Mark McClellan, has shown, Europe and Japan are considerably cheaper than the U.S., even after adjusting for sector skews and structural valuation differences.6 The relative stance of monetary policy also favors Europe and Japan. Neither the ECB nor the BoJ is likely to hike rates anytime soon. This means that rising inflation expectations in these two economies will push down real rates, weakening their currencies in the process. Emerging markets are a tougher call. The combination of a strengthening dollar, growing protectionist sentiment in the developed world, and high debt levels are all bad news for emerging markets. EM equity valuations are also not especially cheap by historic standards (Chart 33). Nevertheless, a reflationary environment has typically been positive for EM equities. The tight correlation between EM and global cyclical stocks has broken down over the past three months (Chart 34). We suspect the relationship will reassert itself again over the course of 2017, giving EM stocks a bit of a boost. Chart 33EM Stocks Are Not Particularly Cheap EM Stocks Are Not Particularly Cheap EM Stocks Are Not Particularly Cheap Chart 34EM Stocks Are Lagging EM Stocks Are Lagging EM Stocks Are Lagging On balance, EM equities are likely in a bottoming phase where returns over the next 12 months will be positive but not spectacular. BCA's favored markets are Korea, Taiwan, China, India, Thailand, and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil, and Peru. Turning to global equity sectors, a bias towards cyclical names is appropriate in an environment of rising global growth. Longer term, our equity sector specialists like health care and technology names. The outlook for financial stocks remains a key area of debate within BCA. Most of my colleagues would still avoid banks. I am more partial to the sector. As I argued in September in "Three Controversial Calls: Global Banks Finally Outperform," steeper yield curves will boost net interest margins over the next few years while rising demand for credit will support top-line growth (Chart 35). On a price-to-earnings basis, global banks are quite cheap, despite being much better capitalized than they were in the past (Chart 36). Chart 35AHigher Yields Will Benefit Banks Higher Yields Will Benefit Banks Higher Yields Will Benefit Banks Chart 35BHigher Yields Will Benefit Banks Higher Yields Will Benefit Banks Higher Yields Will Benefit Banks Lastly, in terms of size exposure, we prefer small caps over large caps. Small capitalization stocks tend to do better in reflationary environments (Chart 37). The ongoing retreat from globalization will also benefit smaller domestically-focused firms at the expense of those with large global footprints. In the U.S. specifically, small caps face a potential additional benefit. If the new Trump administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Chart 36Global Banks Are Cheap ##br##And Better Capitalized Since The Crisis Global Banks Are Cheap And Better Capitalized Since The Crisis Global Banks Are Cheap And Better Capitalized Since The Crisis Chart 37Reflationary Backdrop ##br##Favors Small Caps Outperformance Reflationary Backdrop Favors Small Caps Outperformance Reflationary Backdrop Favors Small Caps Outperformance Fixed Income And Credit Back in March 2015, we predicted that the 10-year Treasury yield would fall to 1.5% even if the U.S. economy avoided a recession.7 The call was notably out of consensus at the time, but proved to be correct: The 10-year yield reached a record closing low of 1.37% on July 5th. As luck would have it, on that very same day, we sent out a note entitled "The End Of The 35-Year Bond Bull Market," advising clients to position for higher bond yields. Global bonds have sold off sharply since then, with the selloff intensifying after the U.S. presidential election. As discussed above, inflation in the U.S. and elsewhere will be slow to rise over the next two years. Hence, global bond yields are unlikely to move significantly higher from current levels. Indeed, the near-term path for yields is to the downside if our expectation of a global equity correction proves true. However, once the stagflationary forces described in this report begin to gather steam towards the end of the decade, bond yields could spike higher, imposing significant pain on fixed-income and equity investors alike. Regionally, we favor Japanese and euro area bonds relative to their U.S. counterparts over a 12-month horizon. Inflation in both Japan and the euro area remains well below target, suggesting that neither the BoJ nor the ECB will tighten monetary policy anytime soon. In contrast, the Fed is likely to raise rates three times in 2017, one more hike than the market is currently pricing in. In addition, we would underweight U.K. gilts. While U.K. growth will decelerate next year as uncertainty over the Brexit negotiations takes its toll, a weaker pound and some fiscal loosening will keep the economy from flying off the rails. In this light, the market's expectations that U.K. rates will rise to only 0.66% at end-2019 seems too pessimistic. Elsewhere in the developed world, our global fixed-income strategists are neutral on Canada and New Zealand bonds, but are underweight Australia. A modest underweight to EM government bonds is also warranted. Turning to credit, a reflationary backdrop is positive for spread product insofar as it will keep defaults in check, while also propping up the appetite for riskier assets. That said, U.S. high-yield credit is now quite expensive based on our fundamental models (Chart 38). Private-sector leverage remains at elevated levels and our Corporate Health Monitor is still in deteriorating territory (Chart 39). Rising government yields could also prompt yield-hungry investors to move some of their money back into sovereign debt. On balance, U.S. corporate spreads are likely to narrow slightly this year, but corporate credit will still underperform equities. Regionally, we see more upside in European credit, given the ECB's continued bond-buying program and greater scope for corporate profit margins to rise across the region. Chart 38U.S. High-Yield Valuations U.S. High-Yield Valuations U.S. High-Yield Valuations Chart 39U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating Currencies And Commodities BCA's Global Investment Strategy service has been bullish on the dollar since October 2014, a view that has generated a gain of nearly 17% for our long DXY trade recommendation. We reiterated this position last October in a note entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"8 where we predicted that the dollar would rally a further 10%. Since that report was published, the real trade-weighted dollar has gained 4%, implying another 6% of upside from current levels. Chart 40Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Both economic and political forces have conspired to keep the dollar well bid. The resurgent U.S. economy has pushed up real rate expectations in the U.S. relative to its trading partners. Chart 40 shows the amazingly strong correlation between the trade-weighted dollar and real interest rate differentials. Rate differentials should widen further over the coming months as investors price in more Fed rate hikes, and rising inflation expectations abroad push down real rates in economies such as Japan and the euro area. As we predicted in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Wins And The Dollar Rallies," Donald Trump's triumph on November 8th has given the greenback an additional boost. Progress in implementing any of Trump's three signature policy proposals - fiscal stimulus, trade protectionism, and immigration restrictions - will cause the U.S. output gap to narrow more quickly than it otherwise would, forcing the Fed to pick up the pace of rate hikes. Chart 41The Pound Is A Bargain The Pound Is A Bargain The Pound Is A Bargain The adoption of a "destination-based tax system" would further strengthen the dollar. Under the existing corporate tax structure, taxes are assessed on corporate profits regardless of where they are derived. In contrast, under a destination-based system, taxes would be assessed only on the difference between domestic sales and domestic costs. In practice, this means that imports would be subject to taxes, while exports would receive a tax rebate. In the simplest economic models, the imposition of a destination-based tax has no effect on domestic economic activity, inflation, or the distribution of corporate profits across the various sectors of the economy. This is because the dollar is assumed to appreciate by precisely enough to keep net exports unchanged. For that to happen, however, the requisite change in the currency needs to be quite large. For example, if the Trump administration succeeds in bringing down effective corporate tax rates to 20%, the required appreciation would be 1/(1-tax rate)=25%. Under current law, the required appreciation would be over 30%! In reality, the dollar probably would not adjust that quickly, implying that the transition period to a destination-based tax system would disproportionately benefit exporters at the expense of importers. Partly for this reason, the proposal will probably be heavily watered down if it is ever passed. Nevertheless, overall U.S. policy will continue to be biased towards a stronger dollar. Looking at the various dollar crosses, we still see more downside for the yen. The BoJ's policy of pegging the 10-year nominal yield will result in ever-lower real yields as Japanese inflation expectations rise. The euro should also continue to drift lower, most likely reaching parity against the dollar later this year. The pound could dip further if an impasse is reached during Brexit negotiations, as is likely at some point this year. That said, sterling is now very cheap, which limits the downside for the currency (Chart 41). Chart 42The Dollar Has Weighed On Gold The Dollar Has Weighed On Gold The Dollar Has Weighed On Gold The Chinese yuan will continue to grind lower, in line with most other EM currencies. As we discussed in March 2015 in a report entitled "A Weaker RMB Ahead," China's excess savings problem necessitates a weaker currency. The real trade-weighted RMB has fallen by 7% since that report was written, but a bottom for the currency remains elusive.9 As noted above, the Chinese government may have no choice but to boost household spending by suppressing deposit rates while working to engineer higher inflation. Negative real borrowing rates will keep capital flowing out of the country, putting downward pressure on the yuan. The overall direction of the Canadian and Aussie dollars will be dictated by the path of commodity prices. A reflationary environment tends to be bullish for commodities. Nevertheless, an uncertain macro outlook in China muddies the waters. We prefer oil over metals, given that the former is more geared towards growth in developed economies while the latter is heavily dependent on Chinese demand. This also makes the Canadian dollar a more attractive currency than the Aussie dollar. Lastly, a few words on gold: The combination of political uncertainty, rising inflation expectations, and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar. The strengthening of the dollar clearly was a factor undermining gold prices in the second half of 2016 (Chart 42). On balance, we would maintain a modest position in gold for the time being, but would look to increase exposure later this year as the dollar peaks. Peter Berezin Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 John G. Fernald, "Productivity and Potential Output Before, During, and After the Great Recession," Federal Reserve Bank of San Francisco, Working Paper 2014-15, (June 2014), and John G. Fernald, "The Pre-Great Recession Slowdown in U.S. Productivity Growth," (November 16, 2015). 2 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. 5 Back in 2007, trend growth was around 10%. Consistent with the empirical literature, let us assume that an appropriate capital-to-GDP ratio is 250% and that the capital stock depreciates at 5% a year. With a trend growth of 10%, China needs 2.5*10%=25% of GDP in new investment before depreciation to keep its capital-to-GDP ratio constant, and an additional 2.5*5%=12.5% of GDP in investment to cover depreciation, for a grand total of 37.5% of GDP in required investment. With a trend GDP growth rate of 6%, however, the required investment-to-GDP ratio would only be 2.5*6%+2.5*5%=27.5%. 6 Please see The Bank Credit Analyst Monthly Reports Section 2, "Are Eurozone Stocks Really That Cheap?" dated June 30, 2016, and "Japanese Equities: Good Value Or Value Trap?" dated November 24, 2016, available at bca.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 06, 2015, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Future Development In Emerging Markets And What Sectors To Look Out For1 The global population is peaking. For Emerging Markets this means significant changes in economic development models. Commodity super-cycles are coming to an end and technological development will become more disruptive for the "old economy". Global growth will be driven by emerging and frontier markets and the accelerated speed of development will ensure leaps in technology and changes in the demographic structure of the workforce in countries that are catching up. The human population in different historic periods totalled roughly the same number, ten billion people. Periods of historic and economic development are becoming shorter. Until recently demographic growth was assumed to be exponential, but in reality it follows a hyperbolic curve, very slow in the beginning and rising faster as it approaches infinity. Growth cannot continue to infinity and models explaining tail events of the growth trajectory are of particular interest. Signs of a slowdown are apparent as humankind is approaching a global population of ten billion. The global growth model is shifting from a quantitative to a qualitative approach, with information and speed of information exchange becoming the determining factors for development. "The sciences do not try to explain, they hardly even try to interpret, they mainly make models. By a model is meant a mathematical construct which, with the addition of certain verbal interpretations, describes observed phenomena. The justification of such a mathematical construct is solely and precisely that it is expected to work - that is correctly to describe phenomena from a reasonably wide area. Furthermore, it must satisfy certain aesthetic criteria - that is, in relation to how much it describes, it must be rather simple". John von Neumann The purpose of describing the model framework in this paper is first of all to provide investors with a glimpse into our long-term investment philosophy and the way we try to think about future developments. We like the framework described below, because of the good fit to reality that it has shown. Considering that the initial parts of the theory were developed in the 1980s, the model accurately predicted many events we are witnessing now. Furthermore, we hope to achieve a certain degree of predictability of future events, and lay out scenarios for how these events might affect investors. This might stimulate modelling and the thought-process. We are not advising changes in investment policy based on this, but rather invite the reader to a dialog about scenario analysis. In the end, as with every theory or model, everybody is entitled to their own views and, in this academic spirit, we welcome ideas of how to develop the framework further and apply it to different areas. Modelling Of Demographic Growth "The main difference of a human being to an animal is the desire for knowledge and the capacity to reason". Aristotle The most cited theory on demographic growth was formulated by English cleric and scholar Thomas Malthus in 1798.2 The theory later became known as the Malthusian growth model and argued that the world population is growing exponentially: P (t) = P0e rt Where P0 is the initial population size, r is the population growth rate and t is time. In essence the theory suggests that the rate of population growth increases with the number of people living on the planet, while the main constraint for growth is the scarcity of resources (Chart 1). With time it has become obvious that the human population is not evolving according to the rules applicable to all other animal species, and that the Malthusian growth model does not describe the growth trajectory correctly (Chart 2). For example, humankind represents the only exception to the inverse relationship rule between the body mass of an animal species and its population size (lower body mass equals larger population).3 Chart 1Malthusian Growth Model ##br## For The World Population The Ten Billion People Rule The Ten Billion People Rule Chart 2Malthusian Growth Model Vs. ##br## Actual Population Growth The Ten Billion People Rule The Ten Billion People Rule In 1960, von Forester, Mora and Amiot, and later Hoerner in 1975,4 demonstrated that population growth is much better described by a hyperbolic growth function5 - very slow in the early stages and exploding as we approach the present day (Charts 3A & 3B). In other words the growth-momentum relationship is not dependant on the number of people, but rather on the number of interactions between those people (the so-called "second order reaction" in physics or chemistry). Chart 3AHyperbolic Growth Function Vs. Malthusian Growth Model ##br## And Real Population Growth The Ten Billion People Rule The Ten Billion People Rule Chart 3BExamples Of Linear, Exponential ##br## And Hyperbolic Growth The Ten Billion People Rule The Ten Billion People Rule Further research tried to connect the population growth model to the economic growth function and understand where the trajectory of population growth is going.6 For example, Nielsen7 (2015) makes the assumption that the world population is going through a demographic transition process (the third in the world's history) from the latest hyperbolic trajectory to a yet unknown trend. One interesting theory was developed by Russian physicist and demographer Sergey Kapitsa (1928 - 2012). Sergey Kapitsa was the son of Nobel laureate physicist and Cambridge professor Petr Kapitsa. Being a physicist himself, Kapitsa applied physical principles to explain population growth in the perspective of the whole planet, and concentrated on the changing phases of growth at the tails of the hyperbolic curve. "Only Contradiciton Stimulates The Development Of Science. It Should Be Embraced, Not Hidden Under The Rug". Sergey Kapitsa In his work to explain population growth, Kapitsa applied methods developed in physics to describe systems with many particles and degrees of freedom.8 Kapitsa saw an advantage in the complexity of the world population, as it would allow a statistical approach to the solution of the problem, averaging out all temporary processes. Kapitsa found several constraints in the simple hyperbolic growth model, occurring at the tail ends of the trajectory. The hyperbolic model would assume that at the beginning of time, approximately 10 people would have inhabited the planet and would have lived for a billion years. At the same time, approaching 2025 our population is due to double each year. To solve these tail problems, Kapitsa introduced a so-called "cut-off growth rate", to tackle growth in the very early stages of humankind, and a "cut-off time" constant. This led to the population growth formula: dN/dt = N 2/K 2 Chart 4World Population Growth The Ten Billion People Rule The Ten Billion People Rule This states that "growth depends on the total number of people in the world N, and is a function - the square - of the number of people, as an expression of the network complexity of the global population".9 Furthermore, the "growth rate is limited, that is to say by the internal nature of the growth process, not by the lack of external resources" (Chart 4). The easy way to understand the population growth relationship is to think about it the following way - if each BCA client would write an investment advice letter to all the other BCA clients, the total number of letters written would be equal the square of the number of clients. Kapitsa also formulated three periods in the development of humankind: "Epoch A", which began 4.4 million years ago and lasted 2.8 million years. This period was characterized by linear growth of the population. "Epoch B", which included the Palaeolithic, Neolithic periods and up to recent history and lasted 1.6 million years, and growth was hyperbolic (1, 2, 3 on the chart). "Epoch C", which according to Kapitsa's calculations, started in approximately 1965, when the global population reached 3.5 billion people (4 and 5 on the chart) and population growth started to slow globally (Chart 5). Chart 5World Population Growth Rate Is Falling World Population Growth Rate Is Falling World Population Growth Rate Is Falling The model was found to be a good connecting medium between a pure mathematical approach to demographics and observations made by palaeontologists, anthropologists and historians. The main conclusions made by Kapitsa are the following: Historical periods are becoming shorter over time. The Palaeolithic period lasted over 2 million years, the Neolithic period lasted "just" 5,000-8,000 years, while the Middle Ages spanned only about 500 years. Time is passing faster, the more complex the global system of interaction becomes. Or, in other words, the larger the world population becomes. Over each historic period, approximately the same number of people have lived on the planet, in the range of 9 to 12 billion. In later papers Kapitsa singles out 10 billion as the exact number (this depends on input parameters in the formula). World population will reach the 10 billion mark before 2060. Growth is determined by social and technological changes and is driven by the number of social and economic interactions within the global system. On a historical timescale, each cycle is 2.5 - 3 times shorter than the previous one, driving the overall growth in population. Information is the controlling factor of growth. Kapitsa equates his population growth model to the economic production function and explains the non-linearity of the function by "information interaction, which is multiplicative and irreversible, and is the dominant feature of the system, determining or rather moderating its growth". Food or other resources are not a constraint factor, as through the whole of history, humankind never actually encountered any constraints in resources which would derail population growth from its hyperbolic trajectory. Humankind is now in a period of demographic transition, where the beginning is the point of most rapid increase of the growth rate (around 1965) and the end is the point of most rapid decrease. On a historic scale this transition is happening in an extremely short period - 1/50,000 of total historical time - while one in ten people who ever lived will experience this period. The rate of transition in this last period is approximately 90 years, which is just a touch longer than the life expectancy in developed countries. Furthermore, changes in the developing world are happening twice as fast as in the developed. And the reason for that is the increase in speed with which we, as human beings, exchange information. Demographic Transition And Implications For The Economy If the demographic transition period is estimated correctly and the population growth trajectory will level off, as the population stabilizes at around 10 billion, the world will face two scenarios. Either we are approaching a zero-growth reality, or development will shift from the usual "quantitative" growth model of the economy (agriculturally and later industrially driven), to a qualitative approach, where the generation and exchange of information will be paramount. This fits very well with the current reality, where we can see both scenarios happening simultaneously. While growth is approaching zero in the developed world, the move to an information-driven society is pronounced in emerging and developed markets alike. The transition period is characterized by a decrease in death rates among the population, followed by a fall in birth rates. At the same time, a surge in wealth levels and standard of living occurs, followed by longer life expectancy as a result (Charts 6A & 6B). These processes are accompanied by urbanization and a shift of the workforce from production sectors to services. Chart 6AGlobal Population ##br## Is Getting Older Global Population Is Getting Older Global Population Is Getting Older Chart 6BAge Dependency Ratio ##br## (Old Population % Of Working Population) Age Dependency Ratio (Old Population % Of Working Population) Age Dependency Ratio (Old Population % Of Working Population) While this transition has taken decades, and sometimes centuries, in the old world, emerging markets are catching up much faster and the gap in development, estimated by the model, might be not more than 50 years (Chart 7). In fact, we already can observe that the later the transition started, the faster the catch-up period. Kapitsa argues that this narrowing is "due to the nonlinear interaction between countries", or in other words, the increased speed of information transfer. What implications will this have for the global economy and emerging market economies in particular? Chart 7Population Transition, As Described By The Model, ##br## In Different Countries bca.emes_sr_2016_12_13_c7 bca.emes_sr_2016_12_13_c7 Chart 8Global Economic Growth ##br## Driven By EM And FM Global Economic Growth Driven By EM And FM Global Economic Growth Driven By EM And FM Global growth will be driven by emerging and frontier markets for the next decades. Developed countries are already at the final stage of development, where growth will oscillate around zero (Chart 8). The implications of demographics for developed world growth have been studied in a recent paper by the Federal Reserve,10 and so we will not go into too much detail. Investors should be aware that, according to the trajectory suggested by the model, the catch-up period and, hence, the period of high growth, will be shorter for emerging and frontier markets than experienced in the developed world. It is fair to assume that by the time frontier countries move into the "emerging" classification, their period of high growth might be limited to several years to a decade. The model suggests that the period of high GDP growth rates is coming to an end and that investors should be prepared for lower growth for longer. World economy will move to a qualitative focus. Kapitsa argues that humankind will not face any resource constraints, as it never has in the past. Resource constraints are overcome by migration and new technology, while the real issue is in the equal distribution of resources (including wealth and knowledge). As a result, in the coming decades the industrial sector might repeat the destiny of the agricultural sector, as seen in the U.S. and other developed economies (Chart 9). Currently only 2.5 - 3% of the world population are working in the agricultural sector, and this is sufficient to produce food for the world. It can be argued that with the further development of technology, such as 3D printing, the problem of industrial overcapacity will become even more prominent and countries with an industrial focus will face a difficult transition period. China is currently one of the EM countries undergoing such a transition, and we can see how the overcapacity created by the "old economy" is weighing on the performance of the overall economy (Chart 10). Chart 9U.S.: Move Of Working Population ##br## From Agriculture And Manufacturing To Services bca.emes_sr_2016_12_13_c9 bca.emes_sr_2016_12_13_c9 Chart 10Decline Of The bca.emes_sr_2016_12_13_c10 bca.emes_sr_2016_12_13_c10 No more commodity super-cycles? This might not be exactly true, but investors need to change the way they look at commodities and resource companies (and materials sector overall) (Chart 11). Long-term projections of supply and demand should resemble or incorporate the population growth function, which will have implications for capital expenditure. We have already seen a shift to acquire more technology rather than focus on the resource base (fields, mines etc.) (Chart 12). Chart 11Commodity Super-Cycles Coming To An End? bca.emes_sr_2016_12_13_c11 bca.emes_sr_2016_12_13_c11 Chart 12Capex Expenditures In The Oil Sector Are Falling bca.emes_sr_2016_12_13_c12 bca.emes_sr_2016_12_13_c12 The trend is towards cost-saving technology, rather than betting on higher prices and production volume. From the model's perspective, no resources will ever become scarce enough to drive prices sky high for a long period. It is rather a question of getting the timing right and finding a relative long-term dislocation between supply and demand, rather than playing fundamental "peak" stories. Chart 13South African Mining Vs. ##br## U.S. Shale Oil, ##br## A Striking Difference bca.emes_sr_2016_12_13_c13 bca.emes_sr_2016_12_13_c13 A good example of a winner in the commodity sector is U.S. shale oil: even after two years of low oil prices many companies are ready to restart production and compete on the market within a short period of time. On the other hand, the once mighty mining sector in South Africa is only a shadow of its former self, since most companies have been chasing quantity (mine expansion) and forgot about quality (extraction methods) (Chart 13). The shift of the workforce from the "old economy" to services. This process is nearly complete in the developed world, while still in full swing in the emerging markets. With an ever-aging population even in emerging markets, social spending will have to increase and new sectors - such as education, healthcare, information technology and leisure - will come into investors' focus. Information Technology. The driver of all progress. Kapitsa suggests that information cannot be treated as a commodity, due to its irreversible nature once shared with other participants. Nevertheless, in the way in which the model determines future progress, there will be surely an ever-growing industry built around information protection. It is also interesting to note that the confusion arising between generations of parents and their children is probably the effect of the ever-growing speed of information generation and exchange, where significant technological shifts are happening within the lifetime of one generation and the old generation finds it hard to keep up. The main outcomes of the appearance of an information-centric society will be the following: Disruption to old industries. We see this all over the place: the oil industry being threatened by renewables, brick-and-mortar retailers by online stores, and the banking industry might be the next victim (Chart 14). If banks fail to adopt blockchain technology into their business model, they might be excluded as an unnecessary middle man. Chart 14Change In The S&P Index Composition 1990 - 2016 The Ten Billion People Rule The Ten Billion People Rule Leaps in development stages in countries. Assuming historical periods are getting shorter and information exchange is intensifying, we might see more leaps in development stages in emerging, but especially in frontier, markets. This will become a central part of any research: to identify which countries might be "jumping" one or several stages in their development, and what those stages/industries/products might be. Chart 15Computer Companies Vs. Smartphone Producers bca.emes_sr_2016_12_13_c15 bca.emes_sr_2016_12_13_c15 In the past 10 years we witnessed several such precedents. One was China skipping the PC stage completely, with the appearance of the broadly affordable smartphone. At the end of the 1990s, tech research would have suggested investing in PC makers, extrapolating growth numbers to the Chinese population. How has this worked out (Chart 15)? Another good example is the banking industry in Africa. Apart from South Africa, which has a rich banking tradition, more and more countries in the region see growing numbers of users in the online banking space. People use their phones for every day banking needs. Many banks do not even have a brick-and-mortar presence. Maybe that is why we see so many established institutions struggling in this part of the world (Charts 16A & 16B). Chart 16AMobile Money Use By Region The Ten Billion People Rule The Ten Billion People Rule Chart 16BNumber Of Mobile Money Services In Sub-Saharan Africa bca.emes_sr_2016_12_13_c16b bca.emes_sr_2016_12_13_c16b Education. The population growth model says that information will be the main growth driver in the future and, as a consequence, education will be the most important process in human life. Education will take up more time and effort than in any other period of human history (Chart 17). Already now, education can last as long as 20 to 30 years. Compare that to the learning period of any animal. In many jobs, we are required to learn for the better part of our working life and take tests, write exams and attend seminars to keep up-to-date with progress in our industry. Healthcare. Probably the most obvious outcome because, as the older generation requires more treatment and care, the whole social system will need to be adjusted. Many countries will be unable to bear this burden financially, and the private sector will have to step in. This is what we have seen in China since 2015 (Chart 18). Chart 17Tuition Fees In The U.S. Are A Large Part Of Inflation bca.emes_sr_2016_12_13_c17 bca.emes_sr_2016_12_13_c17 Chart 18Healthcare As Proportion Of GDP bca.emes_sr_2016_12_13_c18 bca.emes_sr_2016_12_13_c18 Leisure and entertainment. Maybe not as large or obvious, but it's one of the industries that will benefit. The younger generation has already made a shift from material values, such as luxury brands, to assigning higher values to experiences and creating memories (Chart 19). The appearance of "experience day" offerings (such as driving a super-car or jumping out of an airplane), shifting shopping patterns, or the growing number of travellers even in emerging markets confirms this view. One of the questions that remains is: will government turn out to be the largest employer and provider of services, as for example in the UK (largely because of the National Health Service), or will the private sector take over a large part in this role? Chart 19China Spending On Luxury Goods ##br## Growing More Slowly Than On Travel bca.emes_sr_2016_12_13_c19 bca.emes_sr_2016_12_13_c19 Chart 20Still Calling Your ##br## Broker? The Ten Billion People Rule The Ten Billion People Rule Financial markets: future in the algorithms? It is fair to assume that financial markets will move in the direction of total automation, and will probably be "ruled" by algorithms focusing on short-term strategies (Chart 20). Robo-advisors and passive strategies will decrease commission income and force managers to rethink their investment strategies. On the other hand, people tend to save more as they get older (Chart 21). This pattern reverses, once retirement age is hit (think about medical bills etc.). Consequently, we might see lower demand for savings products once the wave of baby boomers hits retirement, which is bad news for insurance companies and for the bond market. Chart 21Consumption And Income In Perspective The Ten Billion People Rule The Ten Billion People Rule Geopolitics - no more large-scale conflicts, but lots of migration? Chart 22Worldwide Battle-related Deaths On The Decline bca.emes_sr_2016_12_13_c22 bca.emes_sr_2016_12_13_c22 Kapitsa also touched on some controversial topics in his papers - the probability of a global war and a migration crisis (keep in mind there was no migration crisis at the time the theory was developed). Kapitsa argued that, on a global scale, factors such as migration or wars do not really matter for the outcome of the model, creating only statistical "noise". But he also drew some interesting conclusions, arguing that large wars, as we saw them in the 20th century, are unlikely to happen anymore. Because of the restriction on "human resources", states will not be able to conscript and sustain large armies, as it was the case in the past, and conflicts will arise only on a local scale (Chart 22). Chart 23Population In The Baltic States Reducing Dramatically bca.emes_sr_2016_12_13_c23 bca.emes_sr_2016_12_13_c23 Conflicts are most likely to arise in areas of the world experiencing a spike in their population growth trajectory. This period of time is characterized by the highest instability in the "system". This means that inequality in the distribution of resources is peaking together with the population growth rate, which causes social unrest. Such inequalities in resource distribution are evened out over time together with the levelling-off of the population, or more rapidly through war or migration. On the topic of migration, Kapitsa noted that in general migration flows are driven by the search for resources, but have reduced substantially over time. Some 2,000 years ago or earlier, whole nations moved, but nowadays migration flows barely exceed 0.1% of global population. From Kapitsa's point of view, migration should be nothing to worry about. In the framework of a complex physical system, as long as migration does not come from another planet, it is unlikely to cause any harm. In Europe we might be witnessing the first countries in history with drastically shrinking populations, due to the policy of freedom of movement, and people migrating in search of resources (better work and life prospects) (Chart 23). Furthermore, the older generation will probably become more influential in terms of casting votes and deciding future development of countries or whole continents. This year's two black swan events (Brexit and the outcome of the U.S. election) were essentially driven by the older generation, and the divide in opinion may become even more pronounced in future (Chart 24). Chart 24Election Results Determined By Older Generations The Ten Billion People Rule The Ten Billion People Rule Oleg Babanov, Editor/Strategist obabanov@bcaresearch.co.uk 1 Based on the work of Sergey Kapitsa (1928 - 2012) 2 Malthus T.R. 1978. An Essay on the Principle of Population. Oxford World's Classics reprint. 3 Brody, S. Bioenergetics and Growth (Reinhold, New York, 1945) Moen, A. N. Wildlife Ecology: an Analytical Approach (Freeman, San Francisco, 1973) Van Valen, L. Evol. Theory 4, 33-44 (1978). 4 Hoerner, von S. Journal of British Interplanetary Society 28 691 (1975) 5 U.S. Census Bureau (2016). International Data Base. http://www.census.gov/ipc/www/idb/worldpopinfo.php. von Foerster, H., Mora, P., & Amiot, L. (1960). Doomsday: Friday, 13 November, A.D. 2026. Science, 132, 255-296. 6 Maddison, A. (2001). The World Economy: A Millennial Perspective. Paris: OECD. Maddison, A. (2010). Historical Statistics of the World Economy: 1-2008 AD. http://www.ggdc.net/maddison/Historical Statistics/horizontal-file_02-2010.xls. 7 Nielsen, R. W. (2015). Hyperbolic Growth of the World Population in the Past 12,000 Years. http://arxiv.org/ftp/arxiv/papers/1510/1510.00992.pdf 8 From here onwards both papers are quoted extensively: S. P. Kapitsa (1996). The Phenomenological Theory of World Population Growth. Russian Academy of Sciences 9 S.P. Kapitsa (2000). Global Population Growth and Social Economics. Russian Academy of Sciences 10 Gagnon, Etienne, Benjamin K. Johannsen, and David Lopez-Salido (2016). "Understanding the New Normal: The Role of Demographics," Finance and Economics Discussion Series 2016-080. Washington: Board of Governors of the Federal Reserve System, http://dx.doi.org/10.17016/FEDS.2016.08

Feature Dear Client, For the last publication of 2016, we have opted to do something a little different. 2016 was a year were political shocks took pre-eminence. Whether we are talking Brexit, Trump, Italian referendum, Japanese upper-house elections, or Rousseff's impeachment; it often felt like economics took the back seat to political events. While this kind of regime shift toward more politically-driven markets can feel jarring, it is not new. In the late 1970s and early 1980s, a similar event occurred. Populations in Western democracies - the U.S. and the U.K. in particular - exhausted by a decade of elevated inflation, created one of these shifts by putting Thatcher and Reagan in power. With the benefit of insight, we know how the story ended: with great economic successes in both the U.K. and the U.S. However, when Thatcher and Reagan actually took power, it was far from obvious that Western economies were about to leave stagflation and begin a low inflation boom. Today, we do not know how the Trump experiment will end. It is a similarly radical shift that politician wants to implement. Trump and his team want to beat deflation, especially wage deflation for the middle class. This is easier said than done. While we cannot claim to know how a Trump presidency will unfold, BCA has tried to provide some clarity among the noise by focusing on the implications and risks created by the various policies proposed, as well as the threat to the actual implementation of the policies. To finish the year, we would like to provide our client with some perspective. We are sending you the "Mr X" BCA Outlook published in December 1980, when Reagan was the President-elect. What is striking is that then as today, BCA was trying to make a balanced assessment of the potential for positive or disastrous changes that were about to affect the U.S. and global economy. The worries were very pronounced but ultimately proved to be unfounded. We are not saying that worries regarding Trump's proposed policies are unwarranted, but it is important to remember that investors need to remain very nimble when such shifts are emerging. Ultimately, the final direction and effect of the shifts Trump wants to implement will take years to materialize. Looking at historical reactions to similar political sea-changes is a comforting way to put things into perspective. After all, according to Zhou Enlai, it is still too early to judge the effect of the French Revolution.1 Have a great holiday period and a happy and prosperous new year. Best regards, Mathieu Savary, Vice President

Highlights 1.How Will The European Economy Cope With Higher Interest Rates? 2. How Will The European Stock Market Cope With Higher Interest Rates? 3. How Will The EU Respond To The Start Of Brexit? 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? Feature Our strong sense is that the promised elixir of 'Trumponomics' has disoriented investors' concept of value. Suddenly thrown out of their comfort zone, long-term investors are struggling to assess: how much of Trumponomics is reality and how much is just fantasy? Chart of the WeekBrexit And Pound/Euro bca.eis_wr_2016_12_22_s1_c1 bca.eis_wr_2016_12_22_s1_c1 As rational and analytical long-term investors have become disoriented, emotional and impulsive short-term traders have been left unchecked to drive markets (Chart I-2). Chart I-2Markets Are Excessively Emotional Markets Are Excessively Emotional Markets Are Excessively Emotional Understand that the financial markets are an ecosystem in which long-term investors jostle with short-term traders. The stable equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. And therein, perhaps, lies the essence of life itself. The descriptions "rationality and analysis" versus "emotion and impulse" are not judgements. They are simply the very different qualities needed to do very different jobs. Long-term investors must take time to rationalise and analyse the concept of fundamental value; whereas traders must use their immediate emotions and impulses to ride short-term market momentum. Therefore what happens in 2017 will depend on what the rational and analytical long-term investors conclude after their pause for reflection. This brings us to our five pressing questions for the coming year. 1. How Will The European Economy Cope With Higher Interest Rates? Now you could argue that the level of interest rates is very low by historical standards, even after last week's rate hike by the Federal Reserve. However, it is the change in interest rates that drives the change in credit growth (Chart I-3); and it is the change in credit growth that drives the change in GDP growth (Chart I-4). Chart I-3The Change In Bond Yield Drives##br## The Change In Credit Growth... bca.eis_wr_2016_12_22_s1_c3 bca.eis_wr_2016_12_22_s1_c3 Chart I-4...And The Change In Credit Growth Drives ##br##The Change In GDP Growth bca.eis_wr_2016_12_22_s1_c4 bca.eis_wr_2016_12_22_s1_c4 You could also argue that a 25bps hike in the Fed funds rate constitutes the tiniest of baby steps of monetary tightening. The problem is that bond yields have already jumped many multiples of this: the U.S. 15-year and 30-year bond yield and mortgage rate have spiked by over 75bps; the German 30-year bond yield is up 90bps; the Italian 30-year bond yield is up 100bps; and so on. It is these substantial increases in market interest rates that will weigh on credit-sensitive sectors and prospective 6-month GDP growth. Chart I-5Despite Dollar Strength, The Trade-Weighted##br## Euro Has Hardly Budged Despite Dollar Strength, The Trade-Weighted Euro Has Hardly Budged Despite Dollar Strength, The Trade-Weighted Euro Has Hardly Budged Another argument we hear is that higher bond yields are simply discounting better growth prospects ahead. The problem here is the inter-temporal distribution of growth. Higher market interest rates are a near-certain headwind to be felt within 3-6 months. Whereas Trumponomics is a very uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Then there is the geographical distribution of growth. Trumponomics, at best, would boost U.S. growth. Yet market rates have also gone up aggressively in Europe, where there would be a minimal boost to growth. Bear in mind that despite dollar strength, the trade-weighted euro has depreciated just 3% from its October high (Chart I-5). Likewise, emerging market economies will see minimal growth benefits. Whereas higher dollar funding costs, stronger dollar-linked currencies, and the threat of protectionism constitute a meaningful headwind. The bigger question is: can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? There is much debate about this issue at BCA, but on balance this publication believes that the tide has not turned. 2. How Will The European Stock Market Cope With Higher Interest Rates? Trumponomics is not the structural game changer that the market seems to believe. But even if we are wrong on this, there is one over-arching relationship that will hold true irrespective: the relationship between stock market valuation and subsequent 10-year total nominal return (Chart I-6). This long-term relationship is independent of the economic backdrop: Keynesian, monetarist, neo-classical, deflationary, inflationary, or Trumponomics. Chart I-6Long-Term Returns Always Depend On Valuation Long-Term Returns Always Depend On Valuation Long-Term Returns Always Depend On Valuation The reason is that the 10-year total nominal stock market return comprises two components: the nominal income received through the next 10 years; and the terminal value of the market at the end of the 10 years. Crucially, an environment that boosts one component symmetrically depresses the second component, and vice-versa. For example, inflation boosts nominal income received, but depresses the terminal value (because the discount rate is then much higher). Deflation has the opposite effect. Therefore the relationship between valuation and subsequent 10-year total nominal return is environment-independent. Today, stock markets are priced to generate very low single-digit 10-year returns. But with the recent spike in long-term interest rates, investors can now obtain similar 10-year returns from bonds. In other words, the equity risk premium is dangerously compressed. Emotional and impulsive short-term traders do not care about this structural relationship, but rational and analytical long-term investors ultimately do. Bear in mind that the cross-asset and cross-sector moves over the past six weeks - whether in equity market, bond yield and dollar elevation, or bank outperformance, or yield-proxy and defensive underperformance - are all just various guises of the Trump reflation trade. We expect that rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now. The trade: an unwinding of the various guises of the Trump reflation trade is likely, at least tactically. 3. How Will The EU Respond To The Start Of Brexit? Chart I-7Brexit Must Not Be A Gift To Le Pen Five Pressing Questions (And Four Trades) For 2017 Five Pressing Questions (And Four Trades) For 2017 The silence is deafening. While there is much daily noise from the U.K. about the type of Brexit it wants, the EU has been intentionally silent. Once the formal legal process of Brexit begins, it will be the EU that holds the balance of power on what Brexit ultimately looks like. The chatter from some U.K. government quarters is that it can negotiate advantageous Brexit terms. Good luck with that. Given the proximity of the French Presidential Election in April/May, the EU's opening position has to be uncompromising - so as to not hand Marine Le Pen any gifts (Chart I-7). The EU must make an example of the U.K. "pour encourager les autres". And if exiting the EU must come with a demonstrable cost, one casualty would be the pound. That said, 2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive. For example, if the Supreme Court grants the Scottish parliament a greater say in the terms of Brexit, it could compromise Theresa May's current strategy. The pound would rally on that tail-event possibility. The trade: the pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other (Chart of the Week). A good strategy might be to sell the middle of the distribution. There are many permutations of this but one example would be to short the pound and simultaneously buy call options at, say, €1.30. 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? Chart I-8Pegs Get Broken bca.eis_wr_2016_12_22_s1_c8 bca.eis_wr_2016_12_22_s1_c8 2016 was the year when QE peaked. The ECB committed to lowering its monthly asset purchases. More significantly, the BoJ shifted its policy aim from targeting an amount of asset purchases to targeting a price (or yield) on the 10-year JGB. Thereby, the central bank policy experiment has moved into a more dangerous phase. As we explained in Dangers Of Linear-Thinking In A Non-Linear World 2 economies and markets are complex, non-linear systems. The inherent unpredictability of a non-linear system makes it futile and dangerous to aim for an over-precise point target in anything that we do. And that principle applies to central banks as much as to anybody else. Indeed, a 2% inflation target is a price target, albeit a price of a basket of goods and services, and the annual change of that price. The track record of any central bank achieving its self-imposed 2% inflation target in recent years is truly disastrous. Recall also that the Swiss National Bank had to break the franc's peg with the euro, one of the more recent in a long list of failed price pegs (Chart I-8). Our Fixed Income strategists believe the JGB 0% yield peg will hold. Nevertheless, the risk is underestimated that the BoJ will have to break the peg, in 2017 or beyond. The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero. The trade: stay underweight French OATS. 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? One defining feature of the last 40 years is a steady sequence of private sector credit booms which have inevitably turned to busts: notably, Japan in 1990, the Asian 'tigers' in 1998, the U.S. in 2007, and the U.K., Spain and other European countries in 2008 (Chart I-9). Chart I-9Credit Booms Sequentially Turned To Bust. Who's Next? Credit Booms Sequentially Turned To Bust. Who's Next? Credit Booms Sequentially Turned To Bust. Who's Next? In this defining feature, China's is the last of the major credit booms that hasn't turned to bust - yet. Admittedly, the ability of the Chinese authorities to 'extend and pretend' is probably greater than elsewhere in the world, and this might prevent another violent tipping point. Irrespective, the debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation. With private sector indebtedness (including SOEs) now at, or beyond, the level where every other credit boom peaked, China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses. The trade: go long euro/yuan. And with that, we are signing off for 2016. I do hope that this year's reports have provided some insight during particularly turbulent times, and that you might have even enjoyed the reading experience! It just remains for me to wish you a Merry Christmas and a successful and happy 2017. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Published on February 11, 2016 and available at eis.bcaresearch.com. Fractal Trading Model* Pleasingly, two of our open trades hit their profit targets: long platinum / short palladium and short the Greek 10-year bond. Given the extended break, we are not opening any new trades over the Christmas and New Year holiday period. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long Platinum / Short Palladium Long Platinum / Short Palladium * 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 bca.eis_wr_2016_12_22_s2_c1 bca.eis_wr_2016_12_22_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c2 bca.eis_wr_2016_12_22_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c3 bca.eis_wr_2016_12_22_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c4 bca.eis_wr_2016_12_22_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c5 bca.eis_wr_2016_12_22_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c6 bca.eis_wr_2016_12_22_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c7 bca.eis_wr_2016_12_22_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c8 bca.eis_wr_2016_12_22_s2_c8

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

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

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

Recommendation Allocation Quarterly - December 2016 Quarterly - December 2016 Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up bca.gaa_qpo_2016_12_15_c1 bca.gaa_qpo_2016_12_15_c1 Chart 2U.S. Earnings Growing Again bca.gaa_qpo_2016_12_15_c2 bca.gaa_qpo_2016_12_15_c2 The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 bca.gaa_qpo_2016_12_15_c3 bca.gaa_qpo_2016_12_15_c3 Chart 4Will This Trigger Inflation Pressures? bca.gaa_qpo_2016_12_15_c4 bca.gaa_qpo_2016_12_15_c4 As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Quarterly - December 2016 Quarterly - December 2016 Chart 9GDP Impact Of U.S. Fiscal Stimulus Quarterly - December 2016 Quarterly - December 2016 Chart 10A Lot of Stimulus, And Extra Debt bca.gaa_qpo_2016_12_15_c10 bca.gaa_qpo_2016_12_15_c10 Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings bca.gaa_qpo_2016_12_15_c11 bca.gaa_qpo_2016_12_15_c11 Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? What's Up Brexit? What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish bca.gaa_qpo_2016_12_15_c13 bca.gaa_qpo_2016_12_15_c13 Chart 14An Oversold Bounce bca.gaa_qpo_2016_12_15_c14 bca.gaa_qpo_2016_12_15_c14 Chart 15Policy Tightening = Underperformance bca.gaa_qpo_2016_12_15_c15 bca.gaa_qpo_2016_12_15_c15 Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside bca.gaa_qpo_2016_12_15_c16 bca.gaa_qpo_2016_12_15_c16 Chart 17Growth Picks Up In##br## Most DMs And China bca.gaa_qpo_2016_12_15_c17 bca.gaa_qpo_2016_12_15_c17 Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched bca.gaa_qpo_2016_12_15_c18 bca.gaa_qpo_2016_12_15_c18 Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook bca.gaa_qpo_2016_12_15_c19 bca.gaa_qpo_2016_12_15_c19 It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence bca.gaa_qpo_2016_12_15_c20 bca.gaa_qpo_2016_12_15_c20 Chart 21Global Equities: No Style Bet bca.gaa_qpo_2016_12_15_c21 bca.gaa_qpo_2016_12_15_c21 Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration bca.gaa_qpo_2016_12_15_c22 bca.gaa_qpo_2016_12_15_c22 Chart 23Inflation Uptrend Intact bca.gaa_qpo_2016_12_15_c23 bca.gaa_qpo_2016_12_15_c23 Chart 24Overweight JGBs bca.gaa_qpo_2016_12_15_c24 bca.gaa_qpo_2016_12_15_c24 Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 26Still Accommodative bca.gaa_qpo_2016_12_15_c26 bca.gaa_qpo_2016_12_15_c26 Chart 27Expensive Valuations bca.gaa_qpo_2016_12_15_c27 bca.gaa_qpo_2016_12_15_c27 Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue bca.gaa_qpo_2016_12_15_c28 bca.gaa_qpo_2016_12_15_c28 Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance bca.gaa_qpo_2016_12_15_c29 bca.gaa_qpo_2016_12_15_c29 Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth bca.gaa_qpo_2016_12_15_c30 bca.gaa_qpo_2016_12_15_c30 Chart 31Commodities: A Secular Bear Market bca.gaa_qpo_2016_12_15_c31 bca.gaa_qpo_2016_12_15_c31 Chart 32Structured Products Outperform In Recessions bca.gaa_qpo_2016_12_15_c32 bca.gaa_qpo_2016_12_15_c32 Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex bca.gaa_qpo_2016_12_15_c33 bca.gaa_qpo_2016_12_15_c33 Chart 34Policy Uncertainty Is High bca.gaa_qpo_2016_12_15_c34 bca.gaa_qpo_2016_12_15_c34 Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Dollar Already Above Fair Value Dollar Already Above Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? bca.gaa_qpo_2016_12_15_c36 bca.gaa_qpo_2016_12_15_c36 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation

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