Geopolitics

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

Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further bca.gis_wr_2016_11_25_c1 bca.gis_wr_2016_11_25_c1 Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Global Trade Growth Is Slowing Global Trade Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked bca.gis_wr_2016_11_25_c3 bca.gis_wr_2016_11_25_c3 Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers bca.gis_wr_2016_11_25_c4 bca.gis_wr_2016_11_25_c4 As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity bca.gis_wr_2016_11_25_c5 bca.gis_wr_2016_11_25_c5 Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out The Elusive Gains From Globalization The Elusive Gains From Globalization Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession The Elusive Gains From Globalization The Elusive Gains From Globalization Chart 8Protectionist Measures ##br##Are On The Rise The Elusive Gains From Globalization The Elusive Gains From Globalization Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer The Elusive Gains From Globalization The Elusive Gains From Globalization Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism The Elusive Gains From Globalization The Elusive Gains From Globalization Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu.

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

Highlights Huge short-term moves have occurred in several markets in the wake of the U.S. election. From a tactical perspective, we believe the moves have gone too far, too fast. Beyond the tactical, the key question is whether or not the U.S. economy is at an inflection point. Will the incoming administration's policies boost activity enough to allow the U.S. to break free of the mushy growth that has characterized the post-crisis era? Key swing factors include the details of tax reform and spending proposals, revised regulatory measures and trade and immigration policy and their effects on consumption and capex. It is too early to tell if the U.S. is on the cusp of a durable inflection, but we list a range of indicators for investors to monitor as events unfold. Feature The hallmarks of president-elect Donald Trump's campaign promises - deregulation, de-globalization and aggressively reflationary fiscal policy - mark a sharp break with the post-crisis status quo and markets have responded in kind. Across asset classes and regions, prices have gone vertical (Chart 1). The policy proposals, and the market responses to them, have left investors facing two big questions: Have the markets gone too far in discounting the potential policy changes? Does the election herald an inflection point for the U.S. economy? The first question is tactical, the second is cyclical. Regarding the former, we are with the too-far, too-fast camp. Given the swiftness and the magnitude of the moves, it seems as if markets have brushed off any consideration of the uncertainties surrounding the details of the incoming administration's proposals and the compromises that will be required to implement them. Not since TARP has so much been assumed by so many on so few details. A reliable technical rule suggests that the biggest moves are unsustainable. Relative to their 40-week moving averages, USD/MXN, small-cap versus large-cap U.S. stocks, U.S. banks and 10-year Treasury yields are all two to two-and-a-half standard deviations from their post-crisis means (Chart 2). Our geopolitical strategists are more confident than the broad consensus that the new administration will get its policies through Congress, but even those who agree are advised to wait for a better entry point. Asset prices often retrace swiftly once they've been stretched two standard deviations from their 200-day moving average. Chart 1Awfully Far, Awfully Fast bca.bcasr_sr_2016_11_23_c1 bca.bcasr_sr_2016_11_23_c1 Chart 2Stretched To Extremes bca.bcasr_sr_2016_11_23_c2 bca.bcasr_sr_2016_11_23_c2 The GDP Equation The cyclical timeframe is BCA's sweet spot, however, and our main concern is whether or not the U.S. economy is poised to break out of the 2-2.25% growth range it's settled into (Table 1). GDP growth is no more than the sum of labor force growth and productivity growth, so any successful attempt to lift the trend rate of GDP will have to lift the trend rate of one or both of its components. These sorts of gains are not easily won. Labor force growth, for example, is mainly tied to the glacial pace of shifts in population growth, with shorter-cycle changes in labor force participation exerting a modest impact around the edges. The new administration's pledges to tighten America's borders and more stringently enforce existing immigration laws would curtail population growth if they were brought to fruition. The U.S. relies on new immigrants, especially those from Latin America, to maintain steady-state population growth1. While accelerating economic growth could bring some discouraged workers back into the labor force, the decline in participation is a secular phenomenon (Chart 3). The labor force is unlikely to grow enough to move the needle, and potential deportations and voluntary departures tilt the balance to the downside. Table 1The Mushy Post-Crisis Path Is The U.S. At An Inflection Point? Is The U.S. At An Inflection Point? Chart 3A Secular Decline bca.bcasr_sr_2016_11_23_c3 bca.bcasr_sr_2016_11_23_c3 Capital expenditures are the best predictor of productivity growth, as efficiency gains occur when workers are supported by new tools, facilities and software. Investment per worker consistently leads productivity growth by about a year in the U.S. (Chart 4, top panel) and is a leading productivity indicator around the world (Chart 4, bottom panel). Capex has disappointed across the developed world following the crisis, and all three elements of U.S. non-residential investment have recently fallen well short of past expansions (Chart 5). Chart 4Capex Leads Productivity bca.bcasr_sr_2016_11_23_c4 bca.bcasr_sr_2016_11_23_c4 Chart 5Falling Short bca.bcasr_sr_2016_11_23_c5 bca.bcasr_sr_2016_11_23_c5 Immediate expensing (as opposed to capitalization and depreciation) will increase the after-tax net present values of all projects, encouraging investment. Even so, attempts to give investment a cyclical jolt will run up against the powerful secular drags of declining trend growth, the capital-lite economy and expanding income inequality. The link between trend growth and investment is readily apparent; demand for industrial, office, retail, and residential construction is directly related to the pace of aggregate income growth. Capital-lite may be a new term, but it describes an entrenched phenomenon. Capital-intensive manufacturing's share of employment has been falling since the fifties (Chart 6). On-shoring could partially roll back this trend, boosting capex as manufacturing facilities are built or refurbished. Dollar strength and stricter immigration enforcement will increase the cost of on-shoring, however. Chart 6A Long Decline In Capital-Intensive Activity Is The U.S. At An Inflection Point? Is The U.S. At An Inflection Point? Expanding inequality weighs on trend growth because it concentrates income in the hands of those least likely to spend it. Reducing the top marginal income tax rate and eliminating the estate tax could squeeze aggregate demand if Congress demands cuts in the social safety net to help pay for it. On the other hand, increased employment opportunities for the low-skilled could help boost demand. Populist policies would generally be expected to narrow inequality, but it remains to be seen if the populist campaign will translate to a populist presidency. Bottom Line: Shifting trend GDP growth higher is a tall order, and stimulus efforts are unlikely to reverse secular drags. The Trouble With The Long Run We acknowledge the truth of Keynes' beef with overly long-run analyses. Even investors with the longest timeframes need to pay attention to the intermediate term. The most relevant question for the broad sweep of institutional investors is what might the incoming administration achieve over the next couple of years? To answer that question, it helps to go back to the GDP equation framework and consider the complete self-reinforcing productivity chain: productivity gains from capex, capex from consumption, consumption from employment, income and spending/saving preferences. All Roads Lead To The Consumer Do corporations build capacity ahead of a ramp-up in demand, or do they wait for demand to emerge before they expand their ability to meet it? With all due respect to Monsieur Say2, the evidence suggests that consumption leads capex (Chart 7). This leaves open the possibility that a robust labor market generating real income gains, alongside a revival of C-suite animal spirits, could generate a self-reinforcing lift in activity over the next few years. A sizable fiscal impulse could energize both channels. All of the components of GDP have undershot past cycle averages at different points of this expansion, but government spending has consistently lagged since the stimulus act petered out at the end of 2010 (Chart 8). Viewed in terms of the year-over-year change in government outlays, the shortfall is especially sharp, as much as four or five percentage points below the typical pattern (Chart 9). Unfortunately, the optimal time for fiscal thrust has passed. As our U.S. Investment Strategy service has shown3, fiscal stimulus is more effective in recessions than in expansions. The mix of stimulus measures matters, too, and the CBO has estimated that tax cuts for high-income households - the central element of the incoming administration's fiscal package - have no more than a tepid impact. Chart 7First Consumption, Then Capex bca.bcasr_sr_2016_11_23_c7 bca.bcasr_sr_2016_11_23_c7 Chart 8A Lack Of Fiscal Spending... bca.bcasr_sr_2016_11_23_c8 bca.bcasr_sr_2016_11_23_c8 Chart 9...Has Held This Expansion Back bca.bcasr_sr_2016_11_23_c9 bca.bcasr_sr_2016_11_23_c9 The state of the labor market is more encouraging for consumption. Wages have begun to rise as the pool of available workers has shrunk and solid real income gains may well be in store. Both the Atlanta Fed's Wage Tracker (Chart 10, top panel) and average hourly earnings (Chart 10, bottom panel) have inflected higher over the last two years. Richer compensation is not good for corporate margins, but an optimistic scenario would allow increased revenues to make up much of the difference. Chart 10Wage Growth Is Surging bca.bcasr_sr_2016_11_23_c10 bca.bcasr_sr_2016_11_23_c10 Chart 11The Savings Rate Has Stabilized... bca.bcasr_sr_2016_11_23_c11 bca.bcasr_sr_2016_11_23_c11 Just because households are earning doesn't mean they're consuming. The propensity to save or dis-save, via taking on debt, can exert a strong influence. With no pressing need to pay down debt, the savings rate appears to have stabilized around 6% (Chart 11), while the household debt-to-GDP ratio has ticked higher for three straight quarters after falling 20 points from its 2008 peak (Chart 12, top panel). The Debt Supercycle may have run its course, but with the debt-service burden lighter than it's been at any point since Ronald Reagan took office (Chart 12, bottom panel), households once again have unused borrowing capacity. Chart 12...And The Household Debt Burden Is Much Lighter bca.bcasr_sr_2016_11_23_c12 bca.bcasr_sr_2016_11_23_c12 Bottom Line: With employment and wage growth already moving in the right direction, and households regaining the ability to add some debt, a pickup in consumption could amplify the effects of fiscal stimulus and give rise to two years of notably stronger growth. Potential Pitfalls Reflation efforts seven years into an expansion have more complicated consequences than reflation efforts undertaken near a cycle trough. They are much more likely to lead to overheating and monetary policy makers may be obliged to counteract them. With government debt-to-GDP at an already elevated level (Chart 13), the bond vigilantes may force yields sharply higher, subverting stimulus efforts and twisting reflation into something more like stagflation. Crowding out is a plausible threat. Chart 13Limited Capacity For Stimulus bca.bcasr_sr_2016_11_23_c13 bca.bcasr_sr_2016_11_23_c13 Infrastructure spending is difficult to get just right. There is not necessarily a correlation between a given project's shovel-readiness and its relative net present value. It is unclear just how many skilled workers are available to wield the shovels and operate the machinery to execute projects. Infrastructure is a comparatively small element of the proposed fiscal plan, but it is not likely to come on full blast in 2017. Mainstream economists unanimously agree that protectionist policies and immigration restrictions dampen growth. The U.S. economy is comparatively closed, but its multinational corporations are vulnerable to the imposition of new trade barriers. Limited access to foreign end-markets and disruptions to low-cost global supply chains would quickly show up in S&P 500 earnings. Continued dollar strength would be a headwind for many of the largest S&P 500 constituents as well. Our Reflation Checklist The incoming administration's discussions of its policy plans have so far been confined to generalities, making it difficult to assess their impact. Even if investors had a clearer outline of policy plans, there are too many moving parts to allow for much forecasting precision. Heeding our Geopolitical Strategy team's view, we are taking compliant Republican legislators as a given and assuming that the administration's signature objectives will not encounter much resistance. But even with legislative majorities, incoming administrations have short honeymoons, and the way the White House prioritizes its initiatives will be important. Investors will have to keep tabs on a wide range of factors to weigh reflation prospects. We are in the midst of building a checklist to track those factors, but are going to wait to finalize it with quantitative parameters until markets settle down to consolidate some of their initial moves. We expect to cull the final factors from the following preliminary list of questions. Fed Policy 1. Will the Fed feel confident enough to hike rates in December? 2. Will the Fed signal an increase in its expected pace of hikes, or an increase in the terminal rate, in its Summaries of Economic Projections? Market Signals 3. Will OIS rate-hike expectations continue to chase the FOMC dots higher? 4. How tight can monetary conditions get? 5. Where will dollar appreciation stop? 6. Are long rates pricing in higher real yields? 7. Are S&P 500 multiples expanding, contracting or holding steady? 8. Are credit spreads taking their cue from better growth prospects, or increased uncertainty? Economic Signals 9. How is the labor force participation rate responding to stronger growth and higher wages? 10. Is there upward pressure on wages? 11. Is the savings rate poised to break out in either direction? 12. Are households taking on more debt? 13. Are corporations using lower taxes to fund capex? 14. Are trade restrictions shaping up as cosmetic or substantive? 15. Is enforcement squeezing immigration and/or sparking reverse migration? Investment Implications The election results, and their promise of reflationary policy, were not friendly for our defensives-over-cyclicals tilt, or our income hybrids bucket. There is no guarantee, however, that policies will be enacted in their anticipated form. Even if they are, we view several moves as overdone. We will therefore wait two more weeks, until our scheduled model portfolio review on December 7, to make changes. We are contemplating pulling in our defensive horns by reducing our Consumer Staples positions. Our Staples overweights are our least favorite defensive positions given that they are an express play on a continued valuation overshoot. We are most likely to direct a reduced Staples allocation to Discretionaries. We are also considering increasing our exposure to spread product, most likely at the expense of the income hybrids bucket and/or Treasuries. Stronger growth, even if only on the order of 50 or 100 basis points, will make it easier to service debt, as will increased inflation, and the carry in spread product will help protect a fixed income portfolio better than Treasuries in a rising-rate environment. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 It takes a birthrate of 2.1 to keep the population at a steady state. Without immigration, the U.S. would look much more like its developed-world peers with mid-1-handle birthrates, as incumbent families tend to have fewer children than newly arrived families. 2 Say's Law, named for an early nineteenth-century French economist, posits that supply creates its own demand. 3 Please see the November 7, 2016 U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability," available at usis.bcaresearch.com.

Highlights Recent market moves have been emotionally driven and speculative in nature. The risk is now that tighter monetary conditions risk crimping growth in the near term. Since 2014, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected. This remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Fiscal stimulus will be a positive development and could dominate the investment landscape for some time. But investors should not view it as a panacea for growth headwinds. Feature Investors continue to digest the ramifications of the new configuration in Washington. In this week's report, we answer the most frequently asked queries that we have received from clients. As always, please do not hesitate to contact us with yours. 1. How Has Your Forecast For Markets Changed Since November 9? We had been cautious on risk assets, we had been dollar bulls, and we had been advocating slightly underweight/neutral bond duration positions prior to the elections, as highlighted in the November 7 Weekly Report. Our cautious stance on equities, particularly large-cap stocks, has not changed. Our main worry has been that corporations continue to lack pricing power and top-line growth will struggle to grow meaningfully in 2017. In other words, profit margins are a headwind - as they often are at this point of the cycle (Chart 1). But contrary to past recoveries, persistent low growth means that top-line growth will not provide the same offset to a margin squeeze driven by rising labor costs (Chart 2). Chart 1Equity Market On Fire Equity Market On Fire Equity Market On Fire Chart 2Profit Margin Squeeze Intact For Now bca.usis_wr_2016_11_21_c2 bca.usis_wr_2016_11_21_c2 Our expectations have been for earnings growth to be in the mid-single digits in 2017, with risks to the downside depending on the degree of dollar strength. True, although the above profit outlook is rather uninspiring, it does not justify an underweight allocation to equities. Monetary policy is still accommodative and a recession is unlikely. However, as the Fed drains the punchbowl, volatility will increase as the onus of equity price appreciation falls heavily on profit drivers. Leading up to the election, we made the case that any adverse reaction to a Trump win would be very short and was not the main event for financial markets on a 6-12 month time horizon. Since November 9, there has been a strong, emotional reaction to the Trump win. Our first read of potential policy outcomes is that the "new America" will be far less business-friendly than equity prices are currently suggesting. The headwinds to multinationals from trade reform and immigration constraints may well offset any positive developments from deregulation in the financial and energy sectors. Most importantly, fiscal spending is positive to the extent that new projects and spending will boost top-line growth. But as we discuss below, the violent Treasury sell-off risks crimping growth before any fiscal spending kicks in. Moreover, so far gauges of policy uncertainty have stayed subdued, but that may change quickly, given the number of unknowns ahead and potential negative reactions from other countries to the new U.S. government. Taken together, we see no reason to upgrade our view on equities. For bonds, we had been expecting that the Fed would raise rates in December, because the economic and inflation data have been sufficiently strong relative to policymakers' thresholds to proceed with a rate hike. The bond market had not been fully discounting this outcome; our view was that the 10-year Treasury could move to 2% or slightly higher, due to the re-pricing of the Fed. Our models suggested that fair value on the 10-year Treasury was around 2% and so once bond yields got that level, a trading range would be established. Treasuries were overvalued for most of this year, and a symmetric shift to undervaluation could now occur. However, we have doubts that we have entered a new bond bear market. Market expectations for U.S. interest rates are rapidly converging to the Fed's forecasts. The rise in yields should pause once the gap has closed. Finally, we have been cyclical dollar bulls for some time. Our principle reason is due to the favorable gap in interest rate differentials between the U.S. and most other major currencies. We see no reason to change our dollar bullish stance. 2. Is Fiscal Spending Really The New Panacea? Our view can be summarized as: Curb Your Enthusiasm. Fiscal stimulus is a positive development. Since the early days of the Great Recession, monetary policymakers have been working alone. Monetary policy has become ineffective at boosting growth, and currency depreciation only shifts growth between countries, it does not create more. Fiscal spending is an opportunity to increase the "GDP pie." But as we wrote two weeks ago, the type of fiscal spending matters, a lot. Income tax cuts on high income earners as well as corporate tax cuts tend to have a low multiplier effect (well below 1), while direct spending by government, e.g. infrastructure outlays, tends to have a much higher multiplier (above 1). Equally important is the interest rate regime that coincides with fiscal stimulus. When an economy is near full employment and there is a risk that above trend growth will create inflation, central banks tend to react, and thus dull the force of the initial stimulus. That is the current economic scenario. The bottom line is that fiscal spending will give a fillip to GDP growth for a few quarters in late in 2017 and perhaps in 2018, but investors should be careful in assuming that fiscal spending will meaningfully change the long-term U.S. growth trajectory as it is not a solution for structural headwinds, such as an aging population. Chart 3Can The Economy Handle Higher Yields? bca.usis_wr_2016_11_21_c3 bca.usis_wr_2016_11_21_c3 3. What Can We Monitor To Understand The Direction Of Policy With Trump As President? Cabinet appointments will be a key area of interest for financial markets. These personnel will ultimately help shape Donald Trump's policy path. There will likely be many rumors about potential appointments, but we believe it is best to ignore near-term noise and focus on Trump's announcements in December and the Senate's official appointments in January. 4. How High Can Bond Yields Get Before The Sell-off Becomes Economically Damaging? The economic backdrop has improved over the past two years and is much closer to full employment. Thus, underlying economic growth is better positioned to withstand a rise in yields. For example, better job prospects and security will allow prospective homeowners to better absorb higher mortgage rates. Still, investors should note that some equity sectors have already responded to the tightening. Chart 3 shows that home improvement stocks are underperforming significantly. What has changed is the greater role of the currency in overall monetary condition tightening. Indeed, the tightening in monetary conditions over the past twelve months has been principally due to the dollar rise. Our U.S. fixed income team's model of fair value for government bonds is based on global PMIs as a proxy for growth, policy uncertainty, and sentiment toward the U.S. dollar. The current reading suggests that 10-year Treasuries are fairly valued when at around 2.25%. Note that fair value has been moving higher in recent weeks on the back of better global economic news. Since 2014, i.e. the start of the dollar rally, whenever the 10-year Treasury yield has reached 2.5%, equity prices have corrected (Chart 4). We think this remains an important marker for when investors should begin to worry that the level of yields are moving into restrictive territory. Chart 4How Long Can Equities Shrug Off Rising Bond Yields? How Long Can Equities Shrug Off Rising Bond Yields? How Long Can Equities Shrug Off Rising Bond Yields? 5. Deregulation And Other Pro-Business Reforms Will Surely Spur Improved Business Confidence And Investor Animal Spirits? We are unsure. History has shown that periods of deregulation (the 1980s and 1990s especially) were conducive to high equity market returns and strong business growth, so this is indeed a positive factor. But there is a lot that can go wrong. Allan Lichtman, a political historian who has correctly predicted all of the past eight Presidential elections, is now predicting that Trump will be impeached within the next four years, due to previous improper business dealings. If that were to occur, we would expect market sentiment to be negative, closely akin to the Worldcom and Enron accounting scandals, which shook faith in the role of the public company CEO. One important gauge will be the global uncertainty index (Chart 5). Uncertainty leads to an increase in risk aversion, and can spur a flight into the safety of government bonds. So far, readings are benign, but should be monitored closely. Chart 5Beware A Rise In Uncertainty bca.usis_wr_2016_11_21_c5 bca.usis_wr_2016_11_21_c5 6. What Are The Prospects For Fed Rate Hikes? We don't expect a major shift in the message from the Fed (i.e. the Fed dot plots) until monetary policymakers have better visibility on what the fiscal landscape will look like (Chart 6). Chart 6Fed Will Wait And See bca.usis_wr_2016_11_21_c6 bca.usis_wr_2016_11_21_c6 Janet Yellen's testimony last week indicates that a December rate hike is almost a certainty. However, there was no hint that the Fed is preparing for a more aggressive tightening cycle thereafter. Her assessment of the economy was balanced, noting that growth improved to 3% in Q3 from 1% in H1, but downplayed the full extent of the rebound due to a rise inventories and a surge in soybean exports. She described consumer spending to be posting "moderate gains," business investment as "relatively soft," manufacturing to be "restrained" and housing construction as "subdued." There was nothing to suggest that the Fed is revising its growth and inflation forecasts following last week's election. Yellen expects growth to continue at a "moderate pace" and inflation to return to 2% in the "next couple of years." Larger budget deficits would likely prompt the Fed to raise rates more aggressively, but for now, their bias is still to manage asymmetric downside risks. 7. Where Would You Deploy New Funds Today? Into cash. Recent market moves have been emotionally driven and speculative in nature. If the new American government succeeds in implementing a pro-business strategy of lower corporate taxes, increased infrastructure spending, a lighter regulatory burden for the financial services industry, while simultaneously avoiding any negative shocks from trade reform, foreign policy blunders, and general decline in economic and policy uncertainty, then perhaps the current risk-on market moves make some sense. However, that is a massive list, especially for a new President without political experience. In other words, markets have overshot and policy is likely to under-deliver. The risk is now that tighter monetary conditions risk crimping growth in the near term. 8. You Like Small Caps, But Are Cautious On High Yield Corporate Credit. These Two Markets Tend To Perform Similarly. Can You Comment? Historically, the absolute performance of small caps and high-yield corporate bond spreads have been tightly negatively correlated. This is because owning both investments tend to be considered a risk-on strategy. But over the past several years, this relationship has weakened and particularly, the correlation between high-yield corporate bond spreads and relative performance of small/large caps has loosened (Chart 7). This is in part because small cap sector weightings are now more closely aligned with large cap weightings. In other words, the S&P 600 index is no longer overly exposed to cyclical relative to the larger cap weightings. Chart 7Small Caps Are A Winner Small Caps Are A Winner Small Caps Are A Winner We expect small caps to outperform S&P 500 companies because they tend to have a domestic focus and will be more insulated from a rise in the dollar. As well, small caps, by virtue of being more geared to domestic growth, will benefit from ongoing better U.S. growth rates than global markets. Relative profit margins proxies favor small caps as well. 9. Is There A Structural Bear Market In Voter Turnout In The U.S.? A certain number of headlines have quoted a drastically lower turnout numbers for the 2016 election than in 2012. This has been reinforced by a theory of a structural downturn in voter participation. Both statements are incorrect. Early estimates for this year's election show that approximately 58.1 percent of eligible voters cast ballots, down from 58.6 percent in 2012.1 Note that these are just estimates. It is plausible that any decline in voter turnout in 2016 is due to the extreme unpopularity of both candidates (Chart 8). It is unlikely that this experience will be repeated in future elections. As for the longer-term picture, as Chart 9 shows that voter turnout had been, in fact, rising steadily since 2000. Chart 8Clinton And Trump Are Making (The Wrong Kind Of) History Q&A: The Top Ten Q&A: The Top Ten Chart 9Americans Like Voting, Just Not These Candidates bca.usis_wr_2016_11_21_c9 bca.usis_wr_2016_11_21_c9 10. What Are Your Expectations For Upcoming Elections In Europe? A narrative has emerged in the financial industry since Donald Trump's victory and the U.K.'s decision to leave the EU: there is a structural shift towards anti-establishment movements. But we feel this is overstated. France is a case in point as Marine Le Pen, leader of the Euroskeptic National Front (FN), is reportedly enjoying a tailwind. To be sure, she can win the 2017 Presidential election, but her probability of winning has been inappropriately inflated following the U.S. election and, according to our Geopolitical experts, is approximately only 10%.2 Because Marine Le Pen is going to face off against an "establishment" candidate, she offers the alternative to the status quo that the French are seeking. But she is trailing her likely second round opponent, Alain Juppé, by around 40% in the polls. Le Pen is sticking to her negative views on the EU and euro membership. That is a formidable obstacle, since 70% of the French support the euro. The bottom line is that we do not believe that the U.S. election has had a meaningful influence on European voters. Developed nations across the globe are struggling with the same structural issues such as low growth and income inequality. It should not be surprising that common reactions and responses are occurring in various countries. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please See "United States Elections Project," available at http://www.electproject.org/2016g. 2 Please see Geopolitical Strategy Special Report, "Will Marine Le Pen Win?," dated November 16, 2016, available at gps.bcaresearch.com.

Highlights As western society has become increasingly ethnically diverse, identity politics have flourished. Technological developments have facilitated this trend by giving like-minded people the opportunity to live in their own social bubbles. The U.S. median voter is moving to the left, while the median European voter may be set to move rightward. The "Great Transatlantic Political Convergence" is afoot. Structurally favor European over U.S. stocks. Trump's victory means more fiscal stimulus and less regulation, but could also lead to a stronger dollar and a rising threat of protectionism. Feature Lessons From Papua New Guinea As far as first jobs out of college go, one could do worse than being asked to fly first class to various tropical islands around the world. Such was my luck when I joined the IMF 16 years ago. After a brief stint in the Caribbean division, I began to cover the South Pacific, first working as the desk economist for Papua New Guinea. Papua New Guinea is about as close to a Stone Age society as one will find on earth. It has a long history of violence. If two strangers meet while trekking through the mountainous terrain, the custom is to begin the conversation by listing one's relatives until a match is found. Without a common ancestor, there is little reason not to kill the other guy. Due to the country's long history of cannibalism, a portion of the population has developed a genetic resistance to Mad Cow Disease, which is spread through the consumption of infectious prions contained within the brain and other body parts. Like many societies, Papua New Guinea is highly tribal. Not unrelatedly, it is also one of the most corrupt. I once asked a local friend of mine why this was so. His response was both disheartening and revealing. The people did not want to send honest leaders to Parliament, he explained. They preferred to elect someone from their own tribe who would use his influence to extract as much wealth as possible, with the understanding that a portion of the booty would be shared with fellow tribe members. There were no philosophical differences between members of Parliament. It was simply a question of whose team you were on. What makes Papua New Guinea's political system interesting is not that it is unique, but that it is the norm. Politics in most countries is about identity, not ideology. And now the U.S. and much of Europe are moving in that direction. The Return Of Identity Politics If one looks past the vitriol, one of the most striking features of the U.S. presidential campaign was the lack of disagreement between Trump and Clinton over a wide range of substantive issues. Both candidates campaigned on increasing infrastructure spending. Both pledged not to cut sacred entitlement programs such as Medicare and Social Security. Both played up the other's Wall Street connections. Neither championed an aggressively interventionist foreign policy, with Trump, if anything, moving to the left of Clinton on the issue. Where the gulf between the two candidates was most apparent was over classic identity issues, the chief of which was immigration. Young people often assume that the Left has always supported freer immigration policy. Not so. It wasn't that long ago that Bernie Sanders described "open borders" as a "Koch Brothers idea." In 2000, The New York Times penned an editorial opposing efforts to grant amnesty to illegal immigrants on the grounds that it would depress working class wages.1 Why did things change? It wasn't because voting preferences shifted all that much. As Chart 1 shows, Hispanics have preferred Democrats over Republicans by roughly the same 30-to-40 percentage-point margin for the past 40 years. What changed was that the Hispanic share of all eligible voters rose from 4% in 1980 to 13% today, and is expected to increase to 18% in 2032 (Chart 2). For the Democrats, the allure of millions of new supporters has been simply too good to pass up. Chart 1Voting Preferences By Ethnicity ##br##In Presidential Elections Voting Preferences By Ethnicity In Presidential Elections Voting Preferences By Ethnicity In Presidential Elections Chart 2The Eligible Voters Of The Past,##br##Present, And Future The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood For the Republicans, the transformation of the U.S. into a more ethnically diverse society has led to an existential crisis of sorts. Many top Republican officials, ever focused on the next election campaign, have sought to reach out to Hispanic voters, often by talking up the prospect of passing a comprehensive immigration reform bill. The fact that open borders means lower wages for less-skilled workers has also ensured a steady flow of campaign donations into party coffers from a variety of business interests who rely on cheap labor.2 In contrast, a large chunk of the Republican base has opposed any effort to increase the size of a voting bloc that historically favored the other party, especially if such efforts lead to lower wages. Nationalism Versus Globalism Chart 3The Huddled Masses Keep Coming The Huddled Masses Keep Coming The Huddled Masses Keep Coming The U.S. has a long history of successfully integrating immigrants. Consider the once prominent Catholic/Protestant split, which was driven in large measure by the overwhelming tendency for Irish Americans to vote Democrat. Richard Nixon won 63% of the white Protestant vote in 1960, but still lost the election due to the fact that 78% of Catholics voted for John F. Kennedy.3 By the late 1960s, the Catholic/Protestant split began to recede, to the point where few people are now aware that it ever existed. There is a good chance that the current immigration wave will prove to be no different. That being said, full integration can take a long time - the Irish, for example, overwhelmingly favored the Democrats for more than a century. Three other things complicate the picture. First, the current wave is much larger than any previous one (Chart 3). Second, it is much more ethnically, racially, and religiously diverse. Third, and perhaps most importantly, it is coming at a time when government policy has moved away from fostering assimilation towards encouraging multiculturalism. As multiculturalism has gained ascendency, the traditional glue that held countries together - nationalism - has frayed. For many, this has been a welcome development. Nationalism produced two world wars and countless other bloody conflicts. Much better, it is argued, to replace squabbling nation states with regional institutions such as the European Union, or better yet, global bodies such as the United Nations. The problem is that it is very difficult to get people to expand their circle of loyalty by decree. Thomas Friedman famously asked in 2002: "Is Iraq the way it is today because Saddam Hussein is the way he is? Or is Saddam Hussein the way he is because Iraq is the way it is?"4 We now know that the answer was the latter. From this perspective, the rise of religious fundamentalism in the Middle East is a natural reaction to the vacuum created by the collapse of pan-Arab nationalism. Many of today's leaders have a lot of trouble seeing this point. For them, globalism is a natural creed. What they miss is that they themselves have formed a unique subculture that makes this possible. Today's cosmopolitan elite attend the same schools, read the same books, enjoy the same movies, eat at the same restaurants, and in most cases, can easily converse in the same language: English. They are as much at home on the streets of Manhattan as they are on the streets of London and Hong Kong. However, put them in Cynthiana, Kentucky and they become a fish out of water. In short, they are multicultural only in the narrow ethnic sense of the word. In all other respects, they are the same tribe. Political Polarization Is Growing Chart 4Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization This leads us to the crux of the problem. Today's political elites have been trying to subvert nationalist feelings without offering the masses a sufficiently attractive alternative. This has allowed once-dormant tribal cleavages to make a comeback. Technology has exacerbated this trend. When I came to Canada as a young refugee in 1979, there were just a handful of television networks to choose from, all of which were more or less the same. Today, there are hundreds of channels and countless websites. Social media has become ubiquitous. While refreshing in many respects, this trend has allowed people to live in their own social bubbles, leading to the fraying of the cultural bonds that hold society together. In some cases, it has facilitated the radicalization of impressionable youth, often with dire consequences. The polarization in the cultural realm has been mirrored in the political arena.5 According to political scientists Keith Poole and Howard Rosenthal, polarization in Congress is currently at its highest level since World War II (Chart 4). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension. Meanwhile, a 2014 Pew Research study documented that the middle ground between Republican and Democratic voters is breaking apart (Chart 5). This has led to growing mutual distrust. Chart 6 shows that 45% of Republicans and 41% of Democrats now regard the other party as a threat to the nation's well-being. Chart 5U.S. Political Polarization: Growing Apart The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Chart 6Increasing Animosity The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Gerrymandering, or "redistricting," as it is euphemistically called, has made things worse. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart 7). For most incumbents, the threat is not from the other party, but from their own. As former House Majority Leader Eric Cantor learned the hard way when he lost to primary challenger Dave Brat in 2014, failing to tow the ideological line can carry a heavy price. Needless to say, such a system discourages bipartisan cooperation. Chart 7Gerrymandering Reduces Competitive Seats Gerrymandering Reduces Competitive Seats Gerrymandering Reduces Competitive Seats Trump And The Markets After a brief selloff, risk assets have rallied hard on the heels of Trump's victory. As we discussed in greater detail last week,6 a Trump administration will mean more fiscal stimulus - chiefly in the form of lower taxes and increased infrastructure and defense expenditures - as well as a softer line on energy and financial sector regulation. Republicans are also likely to push for greater private-sector involvement in health care. Equity investors should not rejoice too much, however. Trump's saber rattling over trade issues is bad news for many multinational companies. In addition, larger budget deficits are likely to prompt the Fed to raise rates more aggressively. This will push up bond yields, reducing the relative attractiveness of stocks. Higher rates will also put upward pressure on the dollar. The real broad trade-weighted dollar has appreciated by 3% since the election and 4% since we published "Three New Controversial Calls: Trump Will Win And The Dollar Will Rally" on September 30th.7 We expect the dollar to rise by another 7% from current levels. Chart 8Immigrants Want More Government Services The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood A Leftward Shift In The U.S. Median Voter Perhaps more worrisome, as my colleague Marko Papic discussed in a recent report, Trump's victory signals that America's political center is moving to the left.8 The Republican Party is likely to become increasingly populist. Pro-business Democratic candidates such as Hillary Clinton could also turn out to be a dying breed. The future may belong more to politicians such as Massachusetts Senator Elizabeth Warren and Ohio Senator Sherrod Brown. As Wayne Gretzky likes to say, we need to look at where the puck is going, not where it has been. As noted above, this trend partly reflects demographic factors. Immigrants tend to favor redistributionist policies (Chart 8). As such, it is not surprising that California, a once solid Republican state, has become reliably Democratic. In this sense, the transformation of the U.S. electorate has parallels with the extension of the voting franchise to women in 1920. Economists John Lott and Larry Kenny have shown that this led to a substantial leftward shift in political outcomes.9 Ethnic voting preferences, however, are only one part of the story, and perhaps not even the most important part. As a larger share of the general population approaches retirement, resistance to cutting Social Security and Medicare will increase. To pay for these programs, taxes will rise. In addition, slower productivity growth and high levels of income inequality will make voters less enthusiastic about capitalism. The fact that all of this is happening in the aftermath of the worst financial crisis since the Great Depression will only serve to sour free-market sentiment. The Great Transatlantic Political Convergence There are many commonalities in political trends between Europe and the United States, but also a number of critical differences. Unlike those in the U.S., European immigrants still represent a small fraction of the electorate. Their integration into labor markets is also much worse, especially in European countries with generous welfare systems (Chart 9 and Chart 10). This suggests that public support for lavish welfare programs may begin to wane, particularly in northern Europe. As Chart 11 shows, this is already happening in the U.K. Chart 9Low Levels Of Immigrant ##br##Labor Participation In Parts Of Europe The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Chart 10Immigration Is Straining Generous ##br##European Welfare States The Future Of Western Democracy: Back To Blood The Future Of Western Democracy: Back To Blood Chart 11British Attitudes Towards Welfare ##br##Recipients Have Hardened British Attitudes Towards Welfare Recipients Have Hardened British Attitudes Towards Welfare Recipients Have Hardened Other forces will also lead to a partial rollback of the European welfare state.10 The euro crisis brought home the lesson that countries with high levels of public debt are especially vulnerable to speculative attacks when they no longer have their own printing press. Going forward, euro area governments will continue trying to pay back debt in order to keep the bond vigilantes at bay. In an environment of high capital and labor mobility, fiscal tightening is likely to come more from spending cuts than tax hikes. The failure of France's "millionaire tax" to raise significant new revenue illustrates this point. The loss of an independent monetary policy that comes with having a common currency will also make it more difficult for euro area states to maintain generous welfare programs. If a country cannot respond to an adverse economic shock by cutting rates or devaluing its currency, it must perform an "internal devaluation" instead. However, successful internal devaluations require a high degree of wage and price flexibility. Generous unemployment insurance programs, high minimum wages, and strong unions are anathema to that. This is bad news for many European workers, but good news for European corporate interests. The net effect of all these changes is that European politics are likely to move to the right, while U.S. politics will move to the left. The Great Transatlantic Political Convergence is afoot. This suggests that European equities should outperform their U.S. counterparts over the long haul. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 "Hasty Call For Amnesty," The New York Times, February 22, 2000. 2 Please see The Bank Credit Analyst Monthly Report, "The Immigration Debate: What It Means For Investors," dated February 27, 2014, available at bca.bcaresearch.com. 3 Michael Barone, "Race, Ethnicity, And Politics In American History," in Beyond the Color Line: New Perspectives on Race and Ethnicity in America, Hoover Institution Press (2002): pp. 343-358. 4 Thomas L. Friedman, "Iraq Without Saddam," The New York Times, September 1, 2002. 5 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com. 6 Please see Global Investment Strategy Weekly Report, "The Trumpenproletariat Strikes Back," dated November 11, 2016, 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. 8 Please see Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 9 John R. Lott and Larry Kenny, "Did Women's Suffrage Change The Size And Scope Of Government?," Journal Of Political Economy, Vol. 107: 6 (part 1), (December 1999): pp. 1163-1198. 10 Please see Global Investment Strategy Weekly Report, "The End Of Europe's Welfare State," dated June 26, 2015, available at gis.bcaresearch.com. Strategy & Market Trends* Tactical Trades Strategic Recommendations Closed Trades

Highlights The 50bps spike in the JPM global government bond yield since August constitutes one of the most aggressive tightenings since the Great Recession. Higher bond yields weaken credit growth, and weaker credit growth almost always depresses subsequent GDP growth. Maintain at most a neutral weighting to equities. Lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds. Lean against the aggressive rally in Financials. Feature November 9 is an important date in the annals of history. November 9, 1989 was the day that the Berlin Wall came down. Chart of the WeekGlobalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Globalization Has Been Good For Profits, Bad For Wages Through 1961-89, the Berlin Wall divided a city. More significantly, it symbolized a divided world. So when the wall came down on November 9, 1989, it marked a new era of globalization. Goods, services, capital and people started to move around the world much more freely, resulting in greater efficiencies and lower costs. In developed economies, profits surged. Using the United States as an example, in the 27 years since the Berlin Wall came down, stock market real earnings per share have gone up 200% (Chart I-2). Chart I-2The Backdrop For Populism bca.eis_wr_2016_11_17_s1_c2 bca.eis_wr_2016_11_17_s1_c2 But globalization has exacted a heavy price: the pressure on wages means that in the 27 years since the Berlin Wall came down, U.S. median household real income has gone up just 10%. By comparison, in the 28 years that the Berlin Wall stood, the median household real income went up 60% (Chart of the Week). November 9 is also the date that Donald Trump won the presidency of the United States. So exactly 27 years after one symbolic wall fell, is another one about to go up? Will Mr. Trump's promised wall with Mexico symbolize a new era of anti-globalization, and a reversal of the economic and financial trends since the Berlin Wall came down? Flaws In The Trump Plan Economists are almost unanimous that protectionism, trade barriers and tariffs - in other words, "building walls" - depresses long-term global growth. It is conceivable that protectionism could help some parts of the U.S. economy, though other parts might lose out as trading partners retaliated. It is inconceivable that protectionism would be good for the world economy as a whole. Chart I-3One Of The Most Aggressive Tightenings ##br##Since The Great Recession bca.eis_wr_2016_11_17_s1_c3 bca.eis_wr_2016_11_17_s1_c3 But what about Trump's noise about fiscal stimulus, and specifically infrastructure spending - why would anybody not get excited about that? The two word answer is: crowding out. If a dollar that is borrowed and spent by the government (or even forecast to be borrowed and spent by the government) pushes up the bond yield (Chart I-3), it makes it more expensive for the private sector to borrow and spend. If, as a result, the private sector scales back its borrowing by a dollar, the dollar of government spending would have no impact on GDP. This is because the dollar of government spending has crowded out a dollar of private sector spending. The fiscal multiplier would be zero. But doesn't the euro area debt crisis provide compelling evidence of the power of fiscal thrust and a very high fiscal multiplier? No, not exactly. The fiscal multiplier was high through the debt crisis because euro area austerity - a fiscal tightening - very unusually coincided with sharply rising bond yields - which killed private sector borrowing. In other words, fiscal tightening and private sector tightening were reinforcing each other. Through 2009-12, when the euro area debt crisis escalated, the relationship between fiscal tightening and growth in GDP per capita in 13 sampled economies had a near-perfect explanatory power (r-squared of 0.9); and its slope of 1.5 indicated an extremely high average fiscal multiplier (Chart I-4). But through 2012-15, after Mario Draghi "did whatever it takes" the unusual combination of fiscal tightening and higher bond yields no longer existed, and both the explanatory power of the relationship and fiscal multiplier collapsed (Chart I-5). Chart I-4A Very Strong Connection Between Fiscal Policy And Growth Through 2009-12... From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall Chart I-5...But No Connection Between Fiscal Policy And Growth Through 2012-15 From Berlin Wall To Mexican Wall From Berlin Wall To Mexican Wall The lesson is that the efficacy of fiscal stimulus and infrastructure spending crucially depends on its impact on the bond yield - and thereby on private sector borrowing. Now note that the 6-month increase in the U.S. (and global) 10-year bond yield constitutes one of the sharpest tightenings since the Great Recession. Higher borrowing costs depress credit growth as captured in the 6-month credit impulse (Chart I-6). A weaker 6-month credit impulse then almost always depresses subsequent 6-month GDP growth (Chart I-7). Chart I-6Higher Borrowing Costs Depress##br## Credit Growth... bca.eis_wr_2016_11_17_s1_c6 bca.eis_wr_2016_11_17_s1_c6 Chart I-7...And Weaker Credit Growth Depresses ##br##Subsequent GDP Growth bca.eis_wr_2016_11_17_s1_c7 bca.eis_wr_2016_11_17_s1_c7 So yes, fiscal stimulus and infrastructure spending could be effective as long as the bond yield is anchored, as it is in Japan. But if the bond yield goes up sharply, the consequent drag from the private sector will partly or entirely negate any putative boost from the government. Explaining Market Shocks And Electoral Shocks In his seminal book Thinking, Fast And Slow psychologist and Nobel Laureate Daniel Kahneman1 proposed that the human brain has evolved two separate and independent systems for decision making: a fast, rapid-response, associative way of thinking which he calls "System 1" and a slow, analytical, measured way of thinking which he calls "System 2". The two ways of thinking, fast and slow, have evolved to protect us from two types of threat to our survival: immediate, and long-term. Thousands of years ago, the immediate threat to survival might have been a sudden noise in the bushes suggesting that a predator was stalking. Today, for a bond investor, the immediate threat might be a sudden noise about aggressive U.S. fiscal stimulus, suggesting that the end of deflationary pressures is nigh. Faced with this immediate but uncertain threat, using the slow and measured thinking of System 2 could be fatal. So we obey the fast-thinking, associative, emotional System 1 and run for cover - or sell bonds. Thousands of years ago, a long-term threat might have been a war of attrition against an enemy tribe. Today, for the bond investor, the long-term threat might be the end of the debt super cycle, suggesting that deflationary pressures will persist. Faced with this long war of attrition, an over-reliance on the impulsive decisions of System 1 could also be fatal. We must use the measured analysis and strategies of slow-thinking System 2. Kahneman's System 1 and 2 is also an excellent framework to help explain how the simple messages of the Brexiteers and Donald Trump led to stunning success at the ballot box. Faced with job destruction and stagnant real wages, many people intuitively believe that less globalization, less competition and less immigration must mean more jobs and a better standard of living. Associative and emotional System 1 immediately identifies with simple messages such as "take back control" or "build a wall". The success of the Brexiteers and Donald Trump was to acknowledge the deep malaise that many people are feeling and offer simple and intuitive cures. To be absolutely clear, this is neither an endorsement nor a criticism of the Brexiteers or Donald Trump, but simply an explanation of why their message hit home. Still, as we have argued, the more analytical and measured System 2 will find that the simple and intuitive cures that the Brexiteers and Donald Trump offer are not the panaceas that they might first seem. The Immediate Investment Decision Short-term traders generally use the rapid-response, associative, emotional System 1 for their decision making. Long-term investors generally use the slow, analytical, measured System 2. But after a shock, disoriented long-term investors may also switch from System 2 to System 1 and just follow the herd. Eventually though, System 2 switches back on, and the excessive herding and trend-following reverses. At the moment, several sector trends are at or near such a point of reversal according to our excessive groupthink indicator (Chart I-8, Chart I-9, Chart I-10, Chart I-11, Chart I-12). Chart I-8Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Healthcare Reversals After Excessive Trend-Following Chart I-9Consumer Goods Reversals After Excessive Trend-Following bca.eis_wr_2016_11_17_s1_c9 bca.eis_wr_2016_11_17_s1_c9 Chart I-10Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Telecoms Reversals After Excessive Trend-Following Chart I-11Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Financials Reversals After Excessive Trend-Following Chart I-12Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Government Bond Reversals After Excessive Trend-Following Specifically, on a 3-month trading view, we would lean against the aggressive sell-offs in Healthcare, Consumer Goods, Telecoms and government bonds; and we would lean against the aggressive rally in Financials. More generally, what does the Trump victory mean for European equities? In today's highly-connected financial markets, mainstream investments in Europe overwhelmingly depend on global developments, and not on parochial issues. The dominant components of the Eurostoxx600, FTSE100, DAX30, CAC40, AEX, SMI, and other major indices, are multinationals with a truly global footprint. So the answer rests on two subsidiary questions: What does the Trump victory mean for global monetary conditions? What does the Trump victory mean for global growth? As already mentioned, global monetary conditions have tightened significantly in recent months, and in accelerated fashion after the Trump victory. The 50bps tightening in the JPM global government bond yield since August constitutes one of the sharpest 3-month spikes since the Great Recession. But as in previous cases, the spike may be self-limiting given its squeeze on credit sensitive sectors and emerging markets. Since August, the dividend yield on equities is little changed - meaning that equities have become more expensive relative to bonds. But this is hard to justify as short-term growth prospects have, if anything, worsened. To repeat the powerful messages from Chart 6 and Chart 7, higher bond yields weaken credit growth; and weaker credit growth almost always depresses subsequent GDP growth. Putting all this together, asset allocators should maintain at most a neutral weighting to equities. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Daniel Kahneman won the Nobel Prize in economics in 2002 for his work on decision making. Fractal Trading Model* There are no new trades this week. After the big recent moves in markets, four open positions were closed at their trading-rule limits, two at profit targets, two at stop-losses. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart 1-13 Copper Vs. Tin Copper Vs. Tin * 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_11_17_s2_c1 bca.eis_wr_2016_11_17_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c2 bca.eis_wr_2016_11_17_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c3 bca.eis_wr_2016_11_17_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_17_s2_c4 bca.eis_wr_2016_11_17_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c5 bca.eis_wr_2016_11_17_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c6 bca.eis_wr_2016_11_17_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c7 bca.eis_wr_2016_11_17_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_17_s2_c8 bca.eis_wr_2016_11_17_s2_c8

Highlights The polls were not wrong in the Brexit and U.S. election cases, pundits were; Marine Le Pen is trailing her likely second round opponent by around 40%; She can win, but her probability of winning has been inappropriately inflated following the U.S. election; Buy EUR/USD if the euro breakup risk premium spikes again; we are not there yet, but may be soon. Feature There are two narratives that have emerged in the financial industry since the Trump victory: Polls are inaccurate and cannot be trusted. Marine Le Pen, leader of the Euroskeptic National Front (FN), has a high probability of winning the 2017 presidential election in France. In this brief Client Note, we want to address both of these narratives as they will be central to investors in 2017 - a year when Europe will hold three (maybe four) crucial elections. The French election - set to take place on April 23 and May 7 - is the most important geopolitical event of 2017. We have already addressed the election in some detail in our November Monthly Report and will continue to follow it closely for our clients.1 Polls Were Not Wrong, Pundits Were The polls did not get Brexit wrong, the pundits did. If anything, the polls were showing the Brexit camp comfortably ahead throughout the first two weeks of June. It was only once MP Jo Cox was tragically murdered on June 16 that polls favored the "Stay" vote for the last week of the vote. But on the day of the vote, the "Stay" camp was ahead by only 4%. That should not have given investors the level of confidence they had in the pro-EU vote. The probability of Brexit, in other words, should have been a lot higher than the 30% imbued by the betting markets (Chart 1). We made a case for alarm early in 2016 based on a fundamental analysis of the British electorate.2 Chart 1AOnline Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Online Betting Got Brexit Wrong... Chart 1B... Not The Polls ... Not The Polls ... Not The Polls Similarly, the national polls in the U.S. election were not wrong. Rather, the pundits and quantitative models overstated the probability of a Clinton victory. What the modelers missed is the unfavorable structural backdrop for Clinton: the challenges associated with one party holding the White House for three terms, lackluster economic growth, lukewarm approval ratings for Barack Obama, and the presence of third-party challengers. We addressed these, as well as Trump's "White Hype" strategy, early on in the electoral process.3 In addition, the modelers ignored that American polls have a consistent track record of underestimating, or overestimating, performance by about 3% (Chart 2). And crucially, that the 2016 election was different in that the level of undecided voters was nearly triple the average of the previous three elections (Chart 3).4 Chart 2Election Polls Usually##br## Miss By A Few Points Will Marine Le Pen Win? Will Marine Le Pen Win? Chart 3More Undecided ##br##Voters This Time Around More Undecided Voters This Time Around More Undecided Voters This Time Around Our quantitative and qualitative models were telling us throughout the election that the race would be close. Our model gave Trump a 41% chance of winning on the day of the election, a very high estimate versus other prognosticators. We used the exact same polls incorporated in the quantitative models of the New York Times, Reuters, and FiveThirtyEight.com. But ours did better. As we said on November 1, a Donald Trump victory would not be some sort of mathematical oddity. It wasn't. Bottom Line: The polls in both the Brexit referendum and the U.S. election were close. Yes, they overstated the establishment probability of victory. But not by an extraordinary figure. Marine Le Pen Can Win, But What Is Priced In? Marine Le Pen is going to face off against an "establishment" candidate in the second round of the French election on May 7. As such, she definitely can win the election. Once Le Pen becomes one of the two candidates contesting the election, her probability of winning is certainly not zero. However, her probability is not over 10% either. At least not yet. She is trailing her likely opponent, Alain Juppé, by around 40% in the polls (Chart 4). And yes, we are aware that Donald Trump trailed Hillary Clinton by 20% in July 2015. But there are significant differences between Trump and Le Pen: Marine Le Pen is not a political "unknown." She was her party's presidential candidate in the 2012 election. Her father, Jean-Marie Le Pen, contested elections in 2007, 2002, 1995, and 1988. The National Front has contested elections in France since the 1970s. Voters know what they are getting with Le Pen. As we have repeatedly stressed to clients, Marine Le Pen's personal approval rating peaked in 2012 (Chart 5). She peaked despite the European refugee crisis, multiple terrorist attacks in France, and sluggish economic growth over the past two years, which should have all helped boost her popularity. Why haven't they? France conducts a two-round electoral system, primarily to prevent anyone like Marine Le Pen from coming to power. For Le Pen to win, she has to have millions of French centrist voters swing to her, rather than to her centrist opponent, in the second round. Chart 4Are Polls Underestimating Le Pen By 40%? Will Marine Le Pen Win? Will Marine Le Pen Win? Chart 5Le Pen's Popularity In A Secular Decline Le Pen's Popularity In A Secular Decline Le Pen's Popularity In A Secular Decline The last point is a critical problem for Le Pen as she refuses to change her rhetoric toward the EU and euro membership. The problem for Le Pen is that 70% of the French support the euro (Chart 6). Leaving the euro area would mean redenomination risk for Baby Boomer retirees, default on sovereign debt, higher interest rates, higher inflation, and an immediate economic recession. Judging by the high level of support for the euro, we suspect that the French population understands these risks.5 We therefore do not doubt that Marine Le Pen is a long-shot to win the French elections. Her subjective probability of winning is around 10%. For it to improve, we would have to see: Dramatic, and immediate upward momentum in her poll figures, particularly relative to likely centrist opponents in the second round. Le Pen's probability of victory would increase if she faced an unpopular centrist politician. For example, if the incumbent President François Hollande wins the late January primary of the French Socialist Party, and somehow manages to get into the second round. Similarly, if ex-President Nicolas Sarkozy wins the November 20-27 primary of the Republicans. Both primary elections are a two-round affair. Investors will know the center-right candidate by the end of November. A re-start of the refugee crisis, which has abated significantly since October 2015 (Chart 7). We expected the crisis to unwind and clients can read our September 2015 report titled "The Great Migration - Europe, Refugees, And Investment Implications," to see why.6 Marine Le Pen changes her stance on EU membership or the currency union. On the other hand, such a rhetorical shift would cease to differentiate her from the other center-right policymakers in France. Chart 6French Support The Euro French Support The Euro French Support The Euro Chart 7Read Our Chart: Migration Crisis Is Over Read Our Chart: Migration Crisis Is Over Read Our Chart: Migration Crisis Is Over Bottom Line: Marine Le Pen can win the 2017 election in France. But she remains a long-shot. The only way that Donald Trump and Brexit increase the probability of Marine Le Pen is if the polls are systemically wrong. This is not the case. Marine Le Pen would have to narrow her gap with centrist politicians to 3-5% for us to adjust our probability. Of course, the French could decide to vote for Marine Le Pen because they want to be like Americans and British. We would advise clients not to hold their breath expecting that one. Investment Implications Investors may wake up in mid-2017 to find that the U.K. is firmly on its way out of the EU and that the U.S. is embroiled in deepening political polarization. Meanwhile, France and Spain will be led by reformist governments, Italy will remain in the euro area, and Germany will be mid-way through a rather boring electoral campaign that features pro-euro establishment parties. What is keeping the European establishment in power? In early 2016, we argued that it was its large social welfare state. Unlike the laissez-faire economies of the U.S. and the U.K., European "socialism" has managed to redistribute the gains of globalization sufficiently to keep the populists at bay. As such, European voters are not flocking to populist alternatives, despite considerable challenges such as the migration crisis and terrorism. We encourage clients to re-visit our argument, which we elaborated on in our April Special Report titled, "The End Of The Anglo-Saxon Economy?"7 Populists are gaining votes in Europe nonetheless. To counter that trend, we should expect to see Europe's establishment parties turn more negative towards immigration, positive on fiscal activism, and more assertive towards security and defense policy. But on the key investment-relevant issue of euro area membership and European integration, we see the public consensus continuing to support the status quo. Given our sanguine view, any upward movement in French sovereign debt yields or downward move in the euro could reflect an overstated euro breakup risk premium. We will monitor these assets carefully, since an entry point could develop for investors willing to bet against euro area dissolution. Betting against headline risks has certainly paid dividends in Europe since 2010. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see BCA Geopolitical Strategy, "Europe: Election Fever Continues," in Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "It Ain't Over Till The Fat Man Sings," dated November 1, 2016, available at gps.bcaresearch.com. 5 In other words, we do not understand why the French population would otherwise support the common currency, if it were not for the risks of leaving it. 6 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refugees, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?," dated April 13, 2016, available at gps.bcaresearch.com.