Geopolitics

Highlights EM risk assets will continue to plunge as U.S. bond yields and the U.S. dollar have more upside. Asset allocators should maintain an underweight allocation to EM within global equity and credit portfolios. Upgrade Russian stocks from neutral to overweight within an EM equity portfolio. Reinstate the long Russia ruble / short Malaysian ringgit trade. Feature The rout in emerging markets (EM) risk assets will persist, regardless of the direction of the U.S. equity market. While president-elect Donald Trump's potential fiscal stimulus will boost U.S. growth, it will not be sufficient to offset the negative impact on EM from rising U.S. Treasury yields and a stronger U.S. dollar. On a broader scale, risks of protectionist measures from the incoming U.S. administration are non-trivial, which will make investors even more jittery on EM. Notably, from a historical perspective, firm U.S. growth has not been a panacea for EM, particularly when the latter's domestic fundamentals were poor and commodities prices were falling. For example, EM in general and emerging Asia in particular collapsed in 1997- '98 when U.S. real GDP growth was averaging 4.5%, and European real GDP growth was 3.5%. In particular, U.S. import volumes were booming at double-digit rates, but this was insufficient to circumvent the crisis in Asia (Chart I-1). Importantly, U.S. bond yields were falling during the 1997-'98 period. Chart I-1Strong U.S. Growth Is No Panacea For EM Stocks bca.ems_wr_2016_11_16_s1_c1 bca.ems_wr_2016_11_16_s1_c1 It is hard to expect similar U.S. growth nowadays, even with Trump's potential fiscal impetus. Meanwhile, any fiscal boost in Europe so far remains a forecast. Besides, back in the 1990s, the U.S. and Europe were dominant sources of global demand - and China was not at all an economic power. Since the late 1990s, the significance of China and the rest of EM has grown enormously, while the importance of the U.S. and Europe with respect to global demand in general and EM in particular has fallen. In short, the outlook for stronger growth in the U.S. is not a reason to turn bullish on EM because the latter's fundamentals are poor. The U.S. dollar rally will persist. The greenback is close to being fairly valued, or only slightly expensive (Chart I-2). Typically, major cycles run until a market becomes considerably expensive or very cheap. It is not often that markets bottom or peak at their fair value. Odds are that the U.S. dollar will become more expensive before this bull market is over. In effect, the U.S. dollar rally is reflective of America sucking in capital. This will leave EM current account deficit countries exposed. As the currencies of these countries plummet and their local bond yields rise, their share prices will plunge and credit spreads will widen. Importantly, Trump's trade protectionist rhetoric could accelerate the depreciation in the Chinese RMB. If and when America imposes import tariffs on China, the latter will compensate via further yuan depreciation. In fact, Chinese residents will "assist" the People's Bank of China in devaluing the currency by converting their RMBs into U.S. dollars. As the RMB weakens further, probably at a faster speed, other Asian currencies will plummet (Chart I-3). In fact, odds are high that EM financial markets will once again become sensitive to the RMB. Chart I-2The U.S. Dollar Is Not Expensive bca.ems_wr_2016_11_16_s1_c2 bca.ems_wr_2016_11_16_s1_c2 Chart I-3RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies RMB And Emerging Asian Currencies Apart from shorting the RMB versus the U.S. dollar, on October 19 we recommended shorting the KRW against the THB because the Korean won was one of most vulnerable EM currencies to continued RMB depreciation and renewed JPY weakness. We reiterate this trade today. Consistent with U.S. dollar appreciation, commodities prices will drop. One unsustainable post-U.S. presidential election move has been the rally in industrial metals in general, and copper in particular. Traders have bid up copper prices as the metal had lagged the rally in risk assets since February (Chart I-4). Nevertheless, expectations that U.S. infrastructure spending will considerably boost world demand for industrial metals are misplaced. The U.S. accounts for a very small portion of global industrial metals demand, including copper. Chart I-5 demonstrates that U.S. demand for copper is seven times smaller than that of China. On average, China accounts for about 50% of global demand for industrial metals, while the U.S. accounts for slightly less than 10%. Chart I-4The Rally In Copper ##br##Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable The Rally In Copper Prices Is Unsustainable Chart I-5Industrial Metals ##br##Consumption: U.S. Versus China EM Got "Trumped" EM Got "Trumped" Hence, any reasonable rise in U.S. demand will not be sufficient to offset a single-digit percentage drop in China's intake of industrial metals, which we expect to occur in 2017. Finally, the Chilean mining firm Codelco - the largest copper producer in the world - in recent weeks has cut its premiums on copper shipped to Asia and Europe.1 This is a move to reduce prices - and a sign that demand is weak relative to supply. This leads us to believe that a rally driven by financial investors at a time of inferior demand-supply balance will prove short-lived. Investors should consider shorting copper on any further price strength. The selloff in U.S. and global bonds will likely persist well into December, which in turn will unravel the turmoil in bond proxies and high-multiples stocks (Chart I-6). In our July 13 Weekly Report,2 we argued that U.S. bond yields had bottomed and a selloff would prove painful as lower yields increases their duration. As a result, even a small rise in yields would lead to considerable bond price declines. Since then, while G7 bond yields initially grinded higher, they have surged over the past week. U.S. 10-year and 30-year bond yields have risen by 40 and 36 basis points, respectively since November 1. This translates into a 3.5% and 7.5% price decline for 10-year and 30-year bonds, accordingly. A similar scenario has also played out with EM bonds - both U.S. dollar and local-currency denominated. Accumulating considerable losses will force further bond liquidation. Our feeling is that many bond proxies and markets that benefited from lower yields will be seriously damaged in the coming weeks. Consistently, EM carry trades are at risk of further unraveling. Interestingly, Chart I-7 demonstrates that many high-yielding EM local bond markets are at a critical technical juncture. Odds are that their yields are heading considerably higher after troughing at their long-term moving averages. Chart I-6U.S. Bond Yields ##br##And Bond Proxies bca.ems_wr_2016_11_16_s1_c6 bca.ems_wr_2016_11_16_s1_c6 Chart I-7AEM Local-Currency Bonds Are ##br##At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7a bca.ems_wr_2016_11_16_s1_c7a Chart I-7BEM Local-Currency Bonds Are##br## At Critical Technical Resistance Levels bca.ems_wr_2016_11_16_s1_c7b bca.ems_wr_2016_11_16_s1_c7b Bottom Line: EM risk assets will continue to plunge. Stay put and remain defensive. Asset allocators should maintain an underweight allocation to EM within both global equity and credit portfolios. Currency traders who are not already short should consider shorting a basket of the following EM currencies: BRL, CLP, ZAR, TRY, IDR and MYR. In addition, we recommend maintaining our short RMB versus USD trade, as well as our short KRW / long THB position. Today, we are also reinstating the long RUB / short MYR trade (see section on Russia below). For more details on other currency, fixed-income, credit and equity positions, please refer to our Open Position Tables on pages 12-13. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please see: Codelco cuts 2017 China copper premium by 27% to $72/t.- sources (2016, November 14). Retrieved from https://www.metalbulletin.com/Article/3601613/Latest-news/Codelco-cuts-2017-China-copper-premium-by-27-to-72-sources.html 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 14. Russia: Overweight Equities; Reinstate Long RUB / Short MYR Trade Chart II-1Overweight Russian Stocks ##br##Versus The EM Equity Benchmark Overweight Russian Stocks Versus The EM Equity Benchmark Overweight Russian Stocks Versus The EM Equity Benchmark Russia stands out as one of the few EM countries that will likely benefit from Trump's presidency. As such, we recommend dedicated EM investors overweight Russia within both EM equity and credit portfolios. The energy and financial equity sectors together account for 75% of the Russian MSCI equity index, and we think they will continue to outperform their EM peers for the following reasons: With the ruble serving as a shock absorber, Russia's oil and gas sector has been able to weather the volatility in energy prices. If it wasn't for the ruble's massive devaluation in 2014-15, Russian energy companies would have struggled to stay solvent. While we expect oil prices to drop toward $35 per barrell, Russian energy stocks will still perform better than their EM counterparts. Furthermore, going forward, oil prices will outpace industrial metals prices. This should help Russian stocks, credit, and the currency outperform their EM peers (Chart II-1). As we argued above (please refer to page 3), the latest rally in industrial metals prices - based on expectations of U.S. infrastructure spending - does not make sense to us. In fact, the U.S. is a much more important consumer of oil than industrial metals in total world aggregate demand. Hence, strong U.S. growth and weaker Chinese growth (our baseline assumption) should be associated with oil prices outperforming base metals prices. Russia is much more advanced in its deleveraging cycle than most other EM economies. This will help banks and consumer stocks outperform their EM peers. In March 2016 we highlighted our preference for Russia's banking system relative to Malaysia's, and initiated a relative equity trade: long Russian stocks / short Malaysian stocks. This trade has already returned 30% and we believe it still has further to go. Today, we extend this positive view on Russia's banking system vis-à-vis Malaysia, to one versus the entire EM bank universe. In contrast to other emerging markets, Russian banks have been recognizing NPLs and have increased their provisions significantly (Chart II-2). Russia has now been in recession for two years and its banks have increased their NPL provisions and their credit growth has already slowed down significantly. This stands in stark contrast to other emerging markets, where banks are failing to realize NPLs and increase provisions adequately, despite substantially slower economic growth and elevated debt levels. In fact, Russia's domestic credit impulse is already starting to head into positive territory (Chart II-3), while the same indicator for the overall EM aggregate will be negative over the next 12 months or so. Russia's financial market outperformance will be aided by orthodox macro policies. This stands in contrast to unorthodox measures in many other developing countries. In terms of monetary policy, the Central Bank of Russia has refrained from injecting excess liquidity into the system or intervening in the foreign exchange market. Moreover, the central bank has been canceling the licenses of smaller banks. This is bullish for listed banks, as their market share will increase (Chart II-4). Chart II-2Russian Banks Have Recognized ##br##NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Russian Banks Have Recognized NPLs And Raised Provisions Chart II-3Russia's Credit Impulse ##br##Is Turning Positive Russia's Credit Impulse Is Turning Positive Russia's Credit Impulse Is Turning Positive Chart iI-4Russia: Banking Sector Consolidation ##br##Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks Russia: Banking Sector Consolidation Is Bullish For Listed Banks With respect to fiscal policy, although the government has exceeded its planned budget deficit of 3% of GDP for 2016, we believe this is not an issue given that Russia's total government debt is very low at only 16.5% of GDP. Lastly, our bias is that the recent victory of President-elect Trump will be marginally positive for the Russian economy relative to other EM. While the U.S. is not a major importer of Russian exports, investors will begin to price in sanction relief. European sanctions are particularly important for Russia and a substantive improvement in U.S.-Russia relations could lead some relatively pro-Russia European governments (Italy, Hungary, Greece, etc.) to demand that EU sanctions be either rolled back fully or significantly modified. Therefore, since Russia does not export as many goods to the U.S. compared to other emerging markets and sanctions may be easing soon, the nation is much more insulated from potential U.S. protectionist measures than many other EM countries. Investment Recommendations The Russian economy is further along its necessary adjustment path compared to the rest of the EM world, and there is less downside at the moment. Furthermore, Russian monetary and fiscal policymakers have undertaken orthodox policy measures in the face of an economic crisis - which cannot be said of many other EM countries. As such, we recommend dedicated EM investors upgrade Russia from neutral to overweight within an EM equity portfolio. We reiterate an overweight stance on Russian sovereign and corporate credit and recommend holding the following trades: Short Russian CDS / long South African CDS Long Russian and Chilean corporate credit / Short Chinese offshore corporate credit. We also recommend currency traders reinstate the long RUB / short MYR trade (Chart II-5). The two currencies are sensitive to energy prices, but the Russian economy is likely to recover soon, while the Malaysian economy has much more downside ahead. Excessive liquidity injections in Malaysia relative to somewhat tighter monetary conditions in Russia will lead to ringgit depreciation versus the ruble (Chart II-6). Lastly, the ruble offers a higher carry than the ringgit. Consistent with the currency trade, we are maintaining our long Russian / short Malaysian equity trade. Chart II-5Reinstate Long RUB / ##br##Short MYR Trade bca.ems_wr_2016_11_16_s2_c5 bca.ems_wr_2016_11_16_s2_c5 Chart II-6Malaysia And Russia: ##br##Non-Orthodox Versus Orthodox bca.ems_wr_2016_11_16_s2_c6 bca.ems_wr_2016_11_16_s2_c6 Stephan Gabillard, Research Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Trump's Win: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. Trump Stimulus & The Yield Curve: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Feature Chart of the WeekTrump Turmoil For Bonds Trump Turmoil For Bonds Trump Turmoil For Bonds America has been treated to a pair of major shocking events over the past couple of weeks. The Chicago Cubs won baseball's World Series for the first time in 108 years. And now, Donald Trump - real estate tycoon, reality TV star, Twitter addict - has become the 45th President of the United States. In the aftermath of that stunning election victory, investors are being treated to one more shocker that seemed impossible even just a few months ago - rapidly rising bond yields. Trump's victory has not only changed the political power structure in the U.S., but has seemingly altered many of the familiar financial market narratives as well. The idea of "deficit spending" by the government to boost growth has not been heard for many years in Washington, but Trump has made it clear that a big fiscal stimulus is coming soon to America. He has laid out a combination of large tax cuts and infrastructure spending that could result in both a surge in U.S. Treasury issuance in the coming years and a more structural rise in inflation - again, developments that have not been seen in the U.S. in quite a while. The prospect of fiscal easing amid still-accommodative monetary conditions in the U.S., with the economy running at full employment, has sent Treasury yields surging back to pre-Brexit levels, wiping out six months of positive bond returns in the process (Chart of the Week). While many details are still to be worked out with regards to Trump's proposed fiscal policy shift, the markets have taken its pro-business tilt as a bullish sign for growth and a bearish sign for bonds. There is more scope for yields to rise in the near term, in the U.S. and elsewhere, with the Fed likely to deliver another rate hike next month and the global economy now in a cyclical upswing. Duration risk remains the biggest immediate threat for bond investors, and we continue to recommend a below-benchmark portfolio duration stance. A New Sheriff In Washington Chart 2Markets Cheer Trump 'Bigly' Markets Cheer Trump 'Bigly' Markets Cheer Trump 'Bigly' The consensus opinion among investors going into the U.S. election was that a Trump victory would result in considerable market turmoil. This was a reasonable argument, as Trump ran a disruptive, anti-status-quo campaign that, by definition, would be expected to generate far more changes and uncertainty than a victory by Hillary Clinton. Yet outside of a few shaky moments in the wee hours of Election Night as markets began to realize that Trump would win, the big bond-bullish/equity-bearish risk-off moment never arrived. Perhaps Trump's more conciliatory tone in his victory speech helped to calm investors' fears that his caustic campaign demeanor would continue in the White House. More likely, investors saw the results in the U.S. Congressional elections and realized that the Republican Party had won a clean sweep in D.C. that would allow Trump to implement many of his campaign promises. Markets have been rapidly pricing the potential implications of a Trump presidency into many financial assets (Chart 2), from bank stocks (which would gain from Trump's proposed rollback of the Dodd-Frank regulations on bank activities and, more importantly, from the impact of higher bond yields and a steeper yield curve on profitability) to the U.S. dollar (which would benefit from Trump's protectionist trade agenda through narrower U.S. trade deficits and stronger U.S. growth that would raise the future trajectory of U.S. interest rates). Higher-quality USD-denominated credit spreads have been surprisingly well behaved, given the moves higher in U.S. yields and the USD itself. This may reflect an optimistic belief that Trump's pro-business, pro-growth policies can offset the negative impact on corporate profits from higher yields and a stronger USD. Markets are right to assume that Trump can actually deliver on his economic agenda. A detailed analysis of the implications of the Trump victory was laid in a Special Report sent last week to all BCA clients by our colleagues at BCA Geopolitical Strategy.1 One of their main conclusions was that Trump's ability to enact his plans will not be hindered much by the U.S. Congress. Republicans now control both the House of Representatives and Senate after last week's elections and Trump has been strongly supported even by the small government fiscal conservatives in Congress. After delivering such a stunning victory for the Republicans, Trump shouldn't face much serious resistance to his economic initiatives. Investors are starting to price in the potential inflationary implications of a President Trump, with the 5-year inflation breakeven, 5-years forward from the U.S. TIPS market now sitting at 1.84%. This is still well below the Fed's 2% inflation target (after adjusting for the usual historical difference between the CPI used to price TIPS and the Fed's preferred inflation gauge, the PCE deflator, which is around 0.4-0.5%). This measure can keep moving higher over the medium-term, given the timing of Trump's proposed fiscal stimulus. Bottom Line: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. The 1980s Called - They Want Their Economic Policy Back The U.S. economy is now showing few internal imbalances that would require wider government deficits as a counter-cyclical policy measure. The private sector savings/investment balance is close to zero, as the post-crisis household deleveraging phase has ended and corporate sector borrowing has skyrocketed in recent years (Chart 3, top panel). Also, measures of spare capacity in the U.S. economy like the output gap or the unemployment gap are also near zero (bottom panel), suggesting that any pickup in aggregate demand from current levels could trigger a rise in wage inflation and domestically-focused core inflation. Chart 3Deficit Spending At Full Employment: Back To The Future? Deficit Spending At Full Employment: Back To The Future? Deficit Spending At Full Employment: Back To The Future? The last time that such a combination of fiscal stimulus and full employment occurred was in the mid-1980s during the presidency of Ronald Reagan. Trump's plans for aggressive tax cuts and sharp increases in discretionary government spending do echo the policies of Reagan, who presided over one of the nation's largest peacetime run-ups in discretionary government budget deficits and debt (Chart 4). Perhaps there was a kernel of truth in the Trump/Reagan comparisons made during the election campaign! Chart 4Less Fiscal Space Than In The 1980s Less Fiscal Space Than In The 1980s Less Fiscal Space Than In The 1980s Clearly, a sharp run-up in federal budget deficits could have a much greater impact on longer-term interest rates and the shape of the yield curve, given the much higher starting point for federal debt/GDP now (74%) compared to the beginning of the Reagan presidency (26%). Especially given the potentially large budget deficits implied by Trump's campaign promises. Back in June, Moody's undertook an economic analysis of Trump's economic policies based on publically available information (i.e. Trump's campaign website) and their own assumptions based on Trump's campaign speeches.2 Moody's ran policies through its own U.S. economic model, which is similar to the forecasting and policy analysis models used by the Fed and the U.S. Congressional Budget Office. This model allows feedback from fiscal policy changes to the expected swings in growth and inflation and the likely shifts in monetary policy. The Moody's analysts used a variety of scenarios, ranging from full implementation of Trump's proposals3 to a heavily watered-down version if he faced a hostile Congress (which is clearly not the case now). We show the Moody's model forecasts for the U.S. Federal budget deficit as a percentage of GDP in Chart 5, along with the slope of the very long end of the U.S. Treasury curve. We also show the 10-year/30-year slope versus a measure of the Fed's policy stance, the real fed funds rate. According to Moody's, a full implementation of the Trump platform would push the U.S. budget deficit to double-digit levels by 2020, and would add nearly $7 trillion in debt over that time, pushing the federal debt/GDP ratio to 100%. The less extreme scenarios show smaller increases in deficits and debt, but the main point is that even if Trump implements only some fraction of his policies, the U.S. budget deficit will go up significantly during his first term in office. Looking at the historic relationship between the deficit and the slope of the Treasury yield curve, this implies that Trump's policies should put steepening pressures on the long-end of the curve as the bond market prices in greater Treasury issuance and higher future inflation rates. Of course, the bottom panel of Chart 5 shows that Fed policy also matters for the shape of the curve, and this is where the current debate over the Fed's next moves comes into play. Chart 5Trump's Deficits Will Steepen The Curve (Fed Permitting) Trump's Deficits Will Steepen The Curve (Fed Permitting) Trump's Deficits Will Steepen The Curve (Fed Permitting) The market is currently discounting a 70% probability that the Fed will hike at the December FOMC meeting, which has been our call for the past few months. The Fed has been projecting an increase next month and another 50bps of hikes in 2017, but these were forecasts made in the BT (Before Trump) era. The pricing from the Overnight Index Swap (OIS) curve shows that the market's expectations have started to shift upward towards the Fed's forecasts, in contrast to the BT dynamic where the Fed was having to cut its forecasts down towards the lower levels implied by the market (Chart 6). Will the Fed now look at the fiscal stimulus proposed by Trump as a reason to hike rates higher, or faster, than their latest set of projections? A big fiscal stimulus at full employment would certainly give the FOMC cover to raise its forecasts for growth and inflation, which would require a shift upwards in its interest rate projections. We do not expect that outcome at next month's FOMC meeting, as the Fed would likely want to see more specific budget details from the Trump administration in the New Year. More importantly, the Fed will want to avoid any additional strength in the U.S. dollar by moving to a more hawkish stance too soon, which would turn the dollar once again into a drag on U.S. growth, inflation and corporate profits, potentially disrupting financial markets. With the Fed unlikely to become more hawkish in the near term, the Treasury market will remain focused on the fiscal implications of Trump, placing bear-steepening pressures on the Treasury curve. For that reason, we are exiting our current Treasury curve flattener positions (2-year vs 10-year, 10-year vs 30-year) this week and moving to a neutral curve posture. We continue to maintain a below-benchmark stance on overall portfolio duration, as well as an underweight bias toward U.S. Treasuries within the developed market bond universe (on a currency-hedged basis). Treasuries are still not cheap, despite the recent run-up in yields, according to our global PMI model which incorporates variables for growth, U.S. dollar sentiment and policy uncertainty (Chart 7). Fair value has risen to 2.25% on the back of improving global growth and reduced uncertainty post-Brexit, with rising dollar bullishness providing a downward offset. Chart 6Markets Moving UP To The Fed Forecasts bca.gfis_wr_2016_11_15_c6 bca.gfis_wr_2016_11_15_c6 Chart 7USTs Not Yet Cheap USTs Not Yet Cheap USTs Not Yet Cheap If the Fed were to move too quickly to a more hawkish stance, dollar bullishness would increase and limit the cyclical rise in yields. At the same time, greater policy uncertainty under a new President could also limit yield increases although, as we have laid out above, the nature of the Trump uncertainty is not bond-bullish if it results in rising levels of government debt. For now, it is best to maintain a cautious investment stance until there is greater clarity on the U.S. policy front, while being aware that Treasuries are no longer as sharply undervalued as they were just a week ago. Looking ahead, this bond bear phase could end if the ECB announces an extension of its bond-buying program beyond the March 2017 deadline. As we discussed in a recent Weekly Report, the ECB will not be able to credibly declare that European inflation will soon return to the 2% target.4 This will force the ECB to extend the bond buying for at least another six months, with some changes to the rules of the program to allow for smoother implementation of future purchases. If, however, the ECB does indeed announce a tapering of bond purchases starting in March, bond yields will reprice higher within the main developed bond markets, led by rising term premiums (Chart 8). Given the global bond market's current worries about the inflationary implications of a switch away from extremely accommodative monetary policy to greater fiscal stimulus, a spike in yields related to a less-accommodative ECB could turn nasty fairly quickly. Chart 8A Dovish ECB Will Prevent A Deeper Global Bond Rout A Dovish ECB Will Prevent A Deeper Global Bond Rout A Dovish ECB Will Prevent A Deeper Global Bond Rout Bottom Line: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: More Growth, Fewer Defaults In recent discussions with clients, many have asked whether the implications of Trump's pro-growth policies, coming at a time of a cyclical upturn in the U.S. economy and inflation, should provide a boost to corporate profits that will, by extension, reduce the default risk in U.S. high-yield bonds. Chart 9Higher Nominal Growth Is Good For Junk (During Expansions) Is The Trump Bump To Bond Yields Sustainable? Is The Trump Bump To Bond Yields Sustainable? Chart 10High-Yield Valuations Have Improved Slightly High-Yield Valuations Have Improved Slightly High-Yield Valuations Have Improved Slightly It is a valid question to ask, as the excess returns on U.S. junk bonds have been historically been higher during expansions when nominal GDP growth (currently 2.8%) has been 4% or greater (Chart 9).5 With real U.S. GDP growth likely to expand by at least 2.5% in 2017, with moderately higher inflation, nominal growth should accelerate to a pace that has historically been friendlier for junk returns. Chart 11Corporate Balance Sheets Are Still A Problem Corporate Balance Sheets Are Still A Problem Corporate Balance Sheets Are Still A Problem Of course, the state of the corporate leverage cycle matters too, and that remains the biggest problem for high-yield. We have been maintaining an extremely cautious stance on U.S. junk bonds over the past few months, as a combination of highly-levered balance sheets and unattractive valuations led us to expect an underwhelming return performance from junk, especially with a volatility-inducing Fed rate hike likely to occur by year-end. That has not been case, however, as junk spreads declined steadily as the summer turned to autumn and have been relatively stable during the U.S. election uncertainty. Our colleagues at our sister publication, BCA U.S. Bond Strategy, recently introduced a simple model to predict junk bond excess returns as a function of lagged junk spreads and realized default losses.6 That model had been predicting excess returns over the next year of close to zero, but at today's spread levels the expected excess return over duration-matched U.S. Treasuries during the next year is closer to 157bps (Chart 10). While this is not the usual return that investors expect from an allocation to high-yield, it is better than the previous model prediction. Given this slightly more attractive level of spreads, a bond market now more prepared for a Fed rate hike, and with the default risks potentially narrowing somewhat on the back of a better nominal growth outlook for 2017, we no longer see the case for a maximum underweight position in high-yield. We still have our concerns about the state of the corporate credit cycle, and the valuations have not improved enough to justify a move back to neutral (Chart 11). Thus, we are only moving our U.S. high-yield allocation to below-benchmark (2 of 5) from maximum underweight (1 of 5). We are maintaining our below-benchmark stance on Euro Area and Emerging Market high-yield within our model portfolio, in line with our stance on U.S. junk. Bottom Line: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com. 2 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf 3 Aggressive income tax cuts, no changes to entitlement spending, increased defense outlays, and even the more controversial protectionist promises such as a 46% tariff on Chinese imports and the deportation of 11 million undocumented immigrant workers. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com. 5 Excess returns are the highest during low growth or recession periods, as this is when credit spreads are at their widest and companies are deleveraging and actively acting to reduce default risks. That is not the case at the moment. 6 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Is The Trump Bump To Bond Yields Sustainable? Is The Trump Bump To Bond Yields Sustainable? Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. TIPS: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Yield Curve: An upward re-rating of the market's assessment of the equilibrium level of monetary conditions is necessary for the curve to steepen further from current levels. Spread Product: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Conversely, the sharp rise in yields turns us more cautious on MBS. Municipal Bonds: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Feature We had expected any flight to quality related to a Donald Trump victory to be brief, but would never have anticipated how brief it actually was. Treasury yields declined for about four hours as the results came in on election night, but since midnight EST last Tuesday the bond bear market has been supercharged. BCA's fixed income publications have maintained a below benchmark duration stance since July 19 with a year-end target of 1.95-2% for the 10-year Treasury yield. The 10-year yield is now above our year-end target, as Trump's surprise victory caused investors to question many long-held assumptions. Chief among them is the thesis of secular stagnation - the idea that a chronic imbalance between savings and investment has resulted in an extremely depressed equilibrium interest rate. The secular stagnation theory has ruled the day in U.S. bond markets, but even Larry Summers, who popularized the theory in recent years, has admitted that "an expansionary fiscal policy by the U.S. government can help overcome the secular stagnation problem and get growth back on track." 1 The market has been quick to take on board President Trump's promises of massive debt-financed infrastructure spending, and is now questioning the idea of permanently low interest rates. While much uncertainty about President Trump still abounds, one thing for certain is that the path of Treasury yields next year and beyond will be determined by whether Trumponomics can successfully tackle secular stagnation. As of now, we are cautious optimists. Last week BCA sent a Special Report2 to all clients that describes the likely outcomes of a Trump presidency. One of those outcomes is that a sizeable fiscal stimulus will be enacted next year. In this week's report we explore its potential impact on bond markets and re-assess our U.S. bond portfolio in light of this surprise change in the economic landscape. Duration The expected path of future rate hikes has moved sharply higher during the past week (Chart 1). If we assume that U.S. monetary conditions reach our estimate of equilibrium3 by the end of 2019, then the shaded region in Chart 1 shows a range of possible outcomes for the federal funds rate based on different scenarios for the U.S. dollar. The upper-bound of the shaded region corresponds to the path of the fed funds rate assuming the dollar depreciates by 2% per year, while the lower-bound assumes the dollar appreciates by 2% per year. The market's expected fed funds rate path has shifted into the upper-half of the shaded region, which assumes the U.S. dollar will depreciate. The thick black line corresponds to the assumption of a flat dollar. Chart 1The Market's Rate Hike Expectations: Pre- And Post-Election bca.usbs_wr_2016_11_15_c1 bca.usbs_wr_2016_11_15_c1 Since the U.S. dollar is very likely to appreciate in the event that a Trump administration enacts growth-enhancing fiscal stimulus, it would appear as though the market's expected interest rate path is already too high. However, we must consider the possibility that large-scale government investment could shift the savings/investment balance in the economy and lead to a higher equilibrium level of monetary conditions or that the U.S. economy reaches monetary equilibrium more quickly under President Trump. In that event, Treasury yields still have room to rise. Chart 2Not Much Gap Between Market & Fed bca.usbs_wr_2016_11_15_c2 bca.usbs_wr_2016_11_15_c2 Similarly, the gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart 2). The 5-year/5-year forward overnight index swap rate is now 2.05%, only about 80bps below the Fed's median estimate of the equilibrium fed funds rate. Meanwhile, our 12-month discounter - the market's expected change in the fed funds rate during the next 12 months - is already at 44bps. If there are no revisions to the Fed's interest rate forecasts at next month's meeting, then a level of 50bps on our discounter will be consistent with the Fed's expectations. This would be the first time the market and dots were lined up since 2014. The key point is that the balance of risks in the Treasury market has shifted. Prior to the election, Treasury yields had been under-estimating the potential for fiscal stimulus in 2017. Now, for Treasury yields to continue their move higher, we need to transition from a world where the Fed is continuously revising its interest rate forecasts lower to one where it is making upward revisions. To be clear, we do expect this transition to occur in 2017 but probably not during the next few months. Now that the Treasury market has reacted to the promise of fiscal stimulus, the next step is that it will demand to see some results. On that note, while Trump's infrastructure spending plan is assumed to be huge, at this point details are scarce. Further, our U.S. Investment Strategy service4 has pointed out that the effectiveness of fiscal stimulus depends critically on how well fiscal multipliers are working, and that estimates of fiscal multipliers can vary widely (Table 1). Table 1Ranges For U.S. Fiscal Multipliers Secular Stagnation Vs. Trumponomics Secular Stagnation Vs. Trumponomics Another risk to the bond bear market comes from a rapid increase in the U.S. dollar. Our modeling work shows that Treasury yields tend to rise alongside improvements in global growth (as proxied by the global manufacturing PMI), but that the impact of improving global growth on Treasury yields is dampened if bullish sentiment toward the U.S. dollar is also increasing (Chart 3). At present, the 10-year Treasury yield is very close to the fair value reading from our model, but the worry is that continued upward pressure on the dollar will cause the model's fair value to roll over in the months ahead. Another risk is the impact of a stronger dollar on emerging markets. A rebound in emerging market growth has contributed significantly to the strength in the overall global PMI since early this year (Chart 4). A strengthening dollar correlates with a weaker emerging market PMI (Chart 4, panel 2), and weakness on this front will weigh on the global growth component of our Treasury model. The possibility that President Trump will classify China as a "currency manipulator" once he takes office only exacerbates the risk from emerging markets. Chart 3Global PMI Model Global PMI Model Global PMI Model Chart 4EM Could Derail The Bond Bear bca.usbs_wr_2016_11_15_c4 bca.usbs_wr_2016_11_15_c4 Bottom Line: We continue to advocate a below benchmark duration stance, but the bond bear market is likely to take a pause once market rate expectations have fully converged with the Fed's forecasts. We therefore take this opportunity to book +35bps of profits on our tactical short December 2017 Eurodollar trade. Longer run, we expect Donald Trump will be able to deliver a sizeable fiscal stimulus package and that Treasury yields will be higher at the end of 2017. TIPS Chart 5TIPS Breakevens Still Depressed bca.usbs_wr_2016_11_15_c5 bca.usbs_wr_2016_11_15_c5 Our overweight recommendation on TIPS versus nominal Treasuries has also benefitted from Trump's win. The 10-year breakeven rate has increased +15bps since last Tuesday, but still has a long way to go before reaching levels that are consistent with the Fed hitting its inflation target (Chart 5). Trump's main economic policies - increased fiscal spending and more protectionist trade relationships - are both inflationary. The most likely candidate to derail the widening trend in breakevens would be a quicker pace of Fed rate hikes that offsets the inflationary fiscal impulse. We think a much more hawkish Fed policy is unlikely in the near term. With TIPS breakevens still so low the Fed will want to nurture their recovery toward pre-crisis levels. It is only once TIPS breakevens are much more firmly anchored at pre-crisis levels that the Fed will be enticed to significantly quicken the pace of hikes. Bottom Line: The Fed will be reluctant to offset any inflationary fiscal impulse until TIPS breakevens have recovered closer to pre-crisis levels. Remain overweight TIPS versus nominal Treasuries. Yield Curve We had been positioned in Treasury curve flatteners on the view that the curve would flatten in advance of a December Fed rate hike, much as it did last year. Trump's surprise win has steepened the curve dramatically, and today we close both our curve trades taking losses of -86bps on our 2/10 flattener and -42bps on our 10/30 flattener. The best determinant of the slope of the yield curve in the long run is the deviation from equilibrium of our monetary conditions index (MCI). The curve tends to flatten as monetary conditions are being tightened toward equilibrium and steepen when monetary conditions are easing away from equilibrium. Chart 6 shows a model of the 2/10 Treasury slope versus the deviation from equilibrium of our MCI. The model works well over both pre- and post-crisis time intervals, and the trailing 52-week beta between the slope of the curve and the MCI's deviation from equilibrium is in line with the beta estimated for the entire post-1990 time interval (Chart 6, bottom panel). Chart 6The Yield Curve & Monetary Conditions The Yield Curve & Monetary Conditions The Yield Curve & Monetary Conditions The curve had appeared too flat relative to fair value prior to last week's steepening, but now appears slightly too steep (Chart 6, panel 3). Since the dollar is unlikely to depreciate substantially and the fed funds rate is unlikely to be cut, the only way that the curve can continue steepening from current levels is if the market starts to revise up its assessment of the equilibrium level of monetary conditions. This is consistent with the dynamic we observed with the level of Treasury yields. Given the rapid moves we've seen in the past week, to be confident that further curve steepening is in store we need to forecast that Trump's fiscal measures will conquer secular stagnation and that the Fed will start revising up its assessment of the equilibrium rate. Much like with the level of Treasury yields, we are reluctant to bet on further steepening in the near term, before we have seen some action on Trump's fiscal policies. However, the steepening trade has gathered enough momentum at this juncture that betting on flatteners equally does not seem wise. Bottom Line: We advocate a laddered position across the Treasury curve at the moment, while we await clarity on President Trump's fiscal proposals. The Treasury curve has room to steepen further if sizeable fiscal stimulus is implemented next year. Spread Product In recent weeks we have advocated a maximum underweight (1 out of 5) allocation to high-yield and a neutral allocation (3 out of 5) to investment grade corporates, while also avoiding the Baa credit tier. This cautious stance on corporate debt was in place for two reasons. First, the junk spread had tightened in recent months despite a slight increase in the VIX and there was a sizeable risk that a Fed rate hike in December could prompt a spike in implied volatility, with a knock-on effect on spreads. Junk spreads have since widened to be more in-line with the VIX (Chart 7), and the much steeper Treasury curve tells us that the market is now less likely to consider a Fed rate hike in December - which we still expect - a policy mistake. Consequently, we are marginally less worried about a large spike in the VIX index that would translate into wider high-yield spreads. Second, high-yield spreads were simply too low relative to our forecast for default losses in 2017 (Chart 8). A model consisting of lagged junk spreads and realized default losses explains more than 50% of the variation in excess junk returns over 12-month periods.5 Previously, this model had predicted excess junk returns of close to zero, but today's spread levels are consistent with excess junk returns of +157bps during the next 12 months. Not inspiring by any means, but still better than nothing. Given the slightly better entry level for spreads and less near-term risk of a Fed-driven volatility event, we upgrade our allocation to high-yield from maximum underweight (1 out of 5) to underweight (2 out of 5). We maintain our neutral (3 out of 5) recommendation on investment grade corporates, but remove the recommendation to avoid the Baa credit tier. The past week's large increase in Treasury yields also leads us to downgrade our allocation to MBS from overweight (4 out of 5) to underweight (2 out of 5). The low level of option-adjusted spreads makes the long-term outlook for MBS uninspiring, but we had expected that the option cost component of spreads would tighten as Treasury yields moved higher (Chart 9). Now that Treasury yields have risen sharply and the option cost has tightened, we take the opportunity to adopt a more cautious outlook on the sector. Chart 7Spreads Re-Converge With VIX bca.usbs_wr_2016_11_15_c7 bca.usbs_wr_2016_11_15_c7 Chart 8Expect Low But Positive Excess Returns bca.usbs_wr_2016_11_15_c8 bca.usbs_wr_2016_11_15_c8 Chart 9Allocate Away From MBS bca.usbs_wr_2016_11_15_c9 bca.usbs_wr_2016_11_15_c9 Bottom Line: Slightly wider spreads and a steeper yield curve make us marginally more positive on corporate bonds (both investment grade and high-yield). Now that the MBS option cost has tightened in response to higher Treasury yields, the outlook for the sector is less inspiring. Municipal Bonds A Donald Trump presidency is full-stop negative for the municipal bond market. Further, as we highlighted in a recent Special Report,6 no matter the election result the outlook for state & local government health is likely to turn more negative in the second half of next year. Trump's tax cuts de-value the tax advantage of municipal debt and will drive flows out of the sector leading to wider Municipal / Treasury (M/T) yield ratios. We had been overweight municipal bonds since August 9, anticipating that a Clinton victory might provide us with a very attractive level from which to downgrade the sector heading into 2017. It was not to be, but municipal bond yields have still not quite kept pace with the sharp increase in Treasury yields, so we are able to downgrade today with M/T ratios not far off the low-end of their post-crisis range (Chart 10). In addition to tax cuts, Trump's infrastructure plan could also be a large negative for the muni market depending on how much of it is financed at the state & local government level. While the specifics of Trump's plan are not yet known, historically, most public infrastructure spending is financed at the level of state & local government (Chart 11). Another potential risk is that if large scale tax reform is on the table in 2017, then there is always the possibility that municipal bonds will lose their tax exemption altogether. At the moment it is difficult to assign odds to such an outcome. Chart 10Municipal / Treasury ##br##Yield Ratios bca.usbs_wr_2016_11_15_c10 bca.usbs_wr_2016_11_15_c10 Chart 11State & Local Government ##br##Drives Public Investment bca.usbs_wr_2016_11_15_c11 bca.usbs_wr_2016_11_15_c11 Bottom Line: A Trump presidency is full-stop negative for municipal bonds. Downgrade munis from overweight (4 out of 5) to underweight (2 out of 5). Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 http://larrysummers.com/2016/02/17/the-age-of-secular-stagnation/ 2 Please see BCA Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, 2016, available at www.bcaresearch.com 3 For further details on how we estimate the equilibrium level of monetary conditions please see U.S. Bond Strategy Special Report, "Peak Policy Divergence And What It Means For Treasury Valuation", dated February 9, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, 2016, available at usis.bcaresearch.com 5 For further details on this modeling framework please see U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer Reaganomics 2.0? Reaganomics 2.0? In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Room To Increase Infrastructure Spending Room To Increase Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them bca.fes_wr_2016_11_11_s1_c3 bca.fes_wr_2016_11_11_s1_c3 Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Populism Can Boost Growth Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too bca.fes_wr_2016_11_11_s1_c5 bca.fes_wr_2016_11_11_s1_c5 Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Reaganomics 2.0? Reaganomics 2.0? Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Household Debt Load Can Grow Again Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates bca.fes_wr_2016_11_11_s1_c8 bca.fes_wr_2016_11_11_s1_c8 Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump Reaganomics 2.0? Reaganomics 2.0? We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China Reaganomics 2.0? Reaganomics 2.0? This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall bca.fes_wr_2016_11_11_s1_c11 bca.fes_wr_2016_11_11_s1_c11 Chart I-12China Is The Giant In The Room Reaganomics 2.0? Reaganomics 2.0? The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals bca.fes_wr_2016_11_11_s1_c13 bca.fes_wr_2016_11_11_s1_c13 Chart I-14Better Supply/Demand Backdrop For Oil bca.fes_wr_2016_11_11_s1_c14 bca.fes_wr_2016_11_11_s1_c14 We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump bca.fes_wr_2016_11_11_s1_c15 bca.fes_wr_2016_11_11_s1_c15 Chart I-16European Labor Market##br## Slack Is Evident European Labor Market Slack Is Evident European Labor Market Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally bca.fes_wr_2016_11_11_s1_c17 bca.fes_wr_2016_11_11_s1_c17 Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? bca.fes_wr_2016_11_11_s1_c18 bca.fes_wr_2016_11_11_s1_c18 Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 bca.fes_wr_2016_11_11_s2_c2 bca.fes_wr_2016_11_11_s2_c2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_11_s2_c4 bca.fes_wr_2016_11_11_s2_c4 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_11_11_s2_c5 bca.fes_wr_2016_11_11_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_11_s2_c6 bca.fes_wr_2016_11_11_s2_c6 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_11_s2_c7 bca.fes_wr_2016_11_11_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_11_s2_c8 bca.fes_wr_2016_11_11_s2_c8 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 bca.fes_wr_2016_11_11_s2_c9 bca.fes_wr_2016_11_11_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 bca.fes_wr_2016_11_11_s2_c20 bca.fes_wr_2016_11_11_s2_c20 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights All three of Trump's signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - are dollar bullish. The implementation of these policies could cause the U.S. economy to overheat, forcing the Fed to raise rates more than it otherwise would. A Trump presidency is unlikely to lead to major institutional changes at the Fed. Trump is okay with a stronger dollar and higher rates, as long as these do not cause growth to stall. Investors have gone from too bearish to too bullish about what a Trump victory means for equities. A tactically cautious stance is still appropriate. Feature Trump Triumphant Chart 1Trumpism Trumps Unfavorability Trumpism Trumps Unfavorability Trumpism Trumps Unfavorability The late film critic Pauline Kael allegedly once said that there was no way that Richard Nixon could have won the 1972 election because she didn't know a single person who voted for him. Kael actually never said this, but the story rings true because one can imagine many people saying something like that. I spent the last few days meeting clients in New York City. The expression on the faces of people while walking down the streets in Manhattan - which went 87%-to-10% for Clinton over Trump - said it all. Most people seemed dazed and confused by what happened on November 8th. Trump did not win because of his personality. He won in spite of it. As I have emphasized over the past 18 months - starting with my presentation at the 2015 BCA New York Conference, which featured the prediction that "The Trumpists Will Win" - Trumpism is a lot more popular than Trump. How else can someone with a 62% unfavorability rating become the next president of the United States (Chart 1)? The reason that Trump won is because he addressed many of the legitimate grievances of blue collar workers in swing states that establishment politicians had long ignored. As we discussed last year in a report entitled "Trumponomics: What Investors Need To Know,"1 trade with China has led to a hollowing out of the U.S. manufacturing base; low-skilled immigration has dragged down blue collar wages; and the flow of drugs into the U.S. from across the southern border is a legitimate problem. Donald Trump And The Markets I will have much more to say about the long-term economic and political consequences of Trump's victory in a special report that I intend to publish next week. For now, however, let me concentrate on the near-term investment implications. Global equities plunged in the immediate aftermath of the election results, while the dollar weakened and Treasurys rallied. This knee-jerk reaction largely stemmed from the fear that a Trump presidency would be highly destabilizing for the global economy. In such an environment, the Fed would not be able to raise rates very much, which is a clear negative for the greenback. Trump's conciliatory victory speech helped soothe frayed nerves, sending both the dollar and Treasury yields higher. This was consistent with our expectations. As we argued in "A Trump Victory Would Be Bullish For The Dollar" and in "Three New Controversial Calls: Trump Wins And The Dollar Rallies," all three of Trump's signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - are bullish for the dollar and bearish for bonds.2 Fiscal Stimulus On The Horizon Now that Donald Trump has a Republican House and Senate to work with, there is a high probability that he will be able to push through a sizable infrastructure bill (sidebar: I am writing these words from the Kabul-like departure area at LaGuardia airport. My flight to Montreal is delayed because Trump's plane, which he dubs Trump Force One, will be taking off soon). In addition to increasing infrastructure spending, Trump has pledged to raise defense expenditures and enact sizable tax cuts. The Tax Policy Center estimates that Trump's tax plan alone would increase the federal debt by $6.2 trillion over the next ten years (excluding additional interest), representing approximately 2.6% of GDP of fiscal stimulus per year.3 We doubt that Congress will approve anything close to that. Nevertheless, even if he gets one quarter of the revenue and expenditure measures that he is seeking, this would be enough to boost aggregate demand growth by 0.5%-to-1% per year over the next two years. Pulling Back The Welcome Mat Chart 2Trump's Hard Line On Trade ##br##And Illegal Immigration Would##br## Benefit Low-Skilled Workers Trump's Hard Line On Trade And Illegal Immigration Would Benefit Low-Skilled Workers Trump's Hard Line On Trade And Illegal Immigration Would Benefit Low-Skilled Workers Immigration policy is one of those areas where the president can do a lot without congressional approval. Existing U.S. immigration laws are already very strict; they just happen to be enforced in a highly haphazard manner. High-skilled workers who want to go through the proper legal channels to gain residency must jump through all sorts of burdensome hoops; in contrast, low-skilled workers who enter the country illegally can generally evade detection and prosecution. This obviously makes for a suboptimal immigration system. Trump's campaign rhetoric has generally focused on combating illegal immigration. Although his official immigration policy paper - allegedly ghost-written by Senator Jeff Sessions - mentions cutting back on high-skill H1-B visas, at times Trump has appeared to disavow that view, stressing his desire to bring in only "the best" immigrants. Our suspicion is that a Trump presidency would generally take a fairly soft stance towards high-skilled immigrants, focusing instead on curbing illegal immigration through increased border security and the rollout of a mandatory national E-Verify system. Since illegal immigrants are generally poorly educated, such an outcome would raise the wages of low-skilled workers. Chart 2 shows that the pool of unemployed low-skilled workers has largely evaporated in recent years. Higher wage growth, in turn, could cause the Fed to hike rates more aggressively than it otherwise would, helping to push up the value of the dollar. Protectionism And The Dollar As with immigration, the executive branch has a lot of discretion over trade policy. There is an ongoing debate about whether sitting presidents can withdraw from trade deals that they do not like without congressional approval. The prevailing legal view is that they can, but even if that turns out not to be the case, they can certainly take other measures that increase import barriers. Such tactics have often been used by Republican presidents who liked to portray themselves as free traders. For instance, Ronald Reagan imposed voluntary export restraints on Japanese automakers and major foreign steel producers, raised tariffs on Japanese motorcycles, and tightened quotas on sugar imports. George W. Bush also increased tariffs on steel imports and imposed quotas on Chinese textiles. It goes without saying that Donald Trump would not be averse to taking similar steps. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. 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. This could help reduce the U.S. trade deficit. A smaller trade deficit, in turn, would increase aggregate demand. This, in conjunction with the adverse supply-side effects that protectionist measures typically result in, would cause the output gap to narrow further, forcing the Fed to step up the pace of rate hikes. In addition, standard trade theory suggests that higher trade barriers would raise real wages for low-skilled workers. Since such workers tend to have the highest marginal propensity to consume, this, too, would boost aggregate demand. Trump And The Fed While Trump's policy proposals are all dollar bullish and bond bearish, where does Trump himself want the dollar and bond yields to go? The answer will obviously influence his relationship with the Fed and how he responds to any dollar strength. As with many of his policy ideas, it is hard to know exactly where Trump stands. Investors are accustomed to politicians who constantly flip-flop on the issues. Trump takes it a step further. He may be the first "quantum" candidate to run for office: Just like an electron can have a different spin and position at the same time, Trump seems capable of believing multiple things at the same time and spinning any position to his liking. With that caveat in mind, we think that a Trump presidency would not represent a significant departure from existing monetary policy. While Trump has said that he would like to replace Janet Yellen with a Republican once her term expires in 2018, he has also said he has "great respect" for the Fed Chair, and that he is "not a person who thinks Janet Yellen is doing a bad job." As far as the direction of interest rates is concerned, Trump has acknowledged that "as a real estate person, I always like low interest rates," but "from the country's standpoint, I'm just not sure it's a very good thing, because I really do believe we're creating a bubble." Chart 3Still Below Past Peaks Still Below Past Peaks Still Below Past Peaks He also seemed to acknowledge that there is a limit to how strong the dollar can get. "If we raise interest rates," he said, "and if the dollar starts getting too strong, we're going to have some very major problems." Our conclusion is that Trump would welcome higher rates, so long as any dollar appreciation does not choke off growth. As we discussed last month in a report entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen," the combination of a rebound in business capex, less inventory destocking, and continued strong personal consumption growth thanks to rising wages could cause aggregate demand growth to rise to 2.5%-to-3% this year.4 Trump's victory increases the risk to these numbers to the upside. Since we published that report, the broad real trade-weighted dollar has gained about 1.5%. We are still comfortable with our view that the dollar will rise by another 8.5% over the next 11 months. As Chart 3 shows, this would still leave the greenback below its previous 1985 and 2001 highs. Trump And Other Central Banks A more difficult issue to handicap is how a Trump presidency will influence policy outside the U.S. Would China, for example, feel the need to prop up the RMB in order to avoid Trump's wrath? Would Japan be less willing to pursue an accommodative monetary policy in an indirect effort to weaken the yen, if this led to the threat of higher tariffs on Japanese exports to the U.S.? Our sense is that yes, a Trump administration will, to some extent, constrain the ability of other nations to weaken their currencies. That said, the impact is unlikely to be especially dramatic. China does manipulate its currency. But lately it has been selling foreign-exchange reserves in an effort to keep the RMB from falling more than it otherwise would. Thus, an end to China's intervention would mean a weaker yuan, not a stronger one. Likewise, as long as the Bank of Japan is not engaged in direct foreign asset purchases, the ability of the Trump administration to cry foul is limited. Equity Implications We must admit that we are surprised that global equities were so quick to shrug off their losses. Our expectation had been that stocks would weaken somewhat in the wake of a Trump victory. What happened? A few things come to mind. First, there has probably been a fair amount of short-covering from investors who had bought insurance against a Trump win. Second, investors, like all humans, tend to draw on analogies in making their decisions. The best analogy for what happened on November 8th is what occurred after the Brexit vote. The lesson from that episode is that one should buy stocks after a supposedly negative voting outcome. That is exactly what investors did Wednesday morning. Third, there are in fact some legitimate reasons why President Trump may be good for stocks. In addition to the prospect of lower corporate tax rates and fiscal stimulus, a Trump administration is likely to go soft on financial regulation. This, in tandem with a steeper yield curve, could prove to be a positive development for banks. A Trump administration is also good news for energy companies, particularly coal. Defense contractors should benefit from increased military expenditures. The implications for health care stocks is harder to gauge. While the potential repeal of the Affordable Care Act could hurt some companies, it may benefit others. Our hunch is that the net effect for health care earnings will be positive. Even if Obamacare is repealed, it is likely to be replaced with something that looks a lot like the existing legislation, just with more subsidies and giveaways for health care providers and drugmakers (think of Medicare Part D). Having said all this, investors now seem to be a bit too complacent about what a Trump presidency means for stocks. The risk of a trade war is still present. And even if Trump pulls in his protectionist horns, a tighter labor market, exacerbated by a potential shortage of immigrant workers, is likely to eat into corporate profit margins. Higher rates and a stronger dollar will also hurt. As such, we are maintaining our tactically cautious stance on global equities. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 2 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," (Call #1: Trump Wins, And The Dollar Rallies), dated September 30, 2016, available at gis.bcaresearch.com. 3 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. 4 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights We remain positive on Chinese stocks both from structural and cyclical point of view, especially on H shares. In the near term, stay on the sidelines due to developing global uncertainty. The Q3 earnings scorecard of listed companies confirms an upturn in the Chinese profit cycle. Earnings momentum will likely be carried forward to at least early next year. The Chinese economy has improved notably, especially in the industrial sector. We expect the economy will likely continue to surprise to the upside. Feature Tuesday's U.S. election surprise sent strong shockwaves to global risk assets, including Chinese stocks. We tactically downgraded our "bullishness" rating on Chinese H shares in early October,1 partly due to brewing global uncertainty, but were still caught off guard by the election result. World financial markets have yet to fully grasp the implication and consequences of a President Trump. Yesterday, we sent clients a Special Report titled "U.S. Election: Outcomes & Investment Implications" prepared by Marko Papic, our Chief Geopolitical Strategist, providing our initial assessment on these important issues. As far as China is concerned, the biggest threat is the harsh anti-China trade policies that dominantly featured Mr. Trump's election campaign. A full-blown protectionist backlash is undoubtedly bearish for China and the rest of the world; this is a disturbing uncertainty that has to be carefully monitored and assessed going forward. However, it is also worth noting that anti-China rhetoric has been regularly featured in all U.S. presidential election campaigns by candidates from both parties as soon as the diplomatic tie between these two countries was established in 1979, but the economic integration has continued to deepen. For now, we do not advocate any kneejerk adjustment to investment strategy, as it is utterly unpredictable how much of Mr. Trump's campaign rhetoric will become real policy. An easier bet over the near term is that the Chinese authorities will likely maintain policy support to boost domestic demand in the wake of rising external uncertainty. Strategically, China will likely press forward its ongoing long-term initiatives to expand its global influence, such as the "One Belt One Road" (OBOR) project and Asian Infrastructure Development Bank. Meanwhile, China will continue to explore bilateral and multi-lateral free trade deals with its major trade partners to foster a more predictable global trade environment. We will follow up on these issues in our future research. While Chinese stocks have suffered badly from global contagion this week, Chinese domestic factors have, ironically, continued to turn more positive of late, with an improving cyclical economic profile, a largely accommodative policy stance and a strong recovery in profits. In the near term we are staying on the sidelines, as the uncertainty unleashed by the U.S. presidential elections continues to play out. Nonetheless, barring a major protectionist backlash, we remain positive on Chinese H shares both from a structural and cyclical perspective, and expect this asset class to outperform both global and EM peers. A Strong Earnings Recovery From an investor's stand point, the most important development is the sharp recovery in earnings reported by Chinese domestically listed A-share companies in the third quarter. Specifically: A share-listed companies' average earnings increased by 22% in the third quarter from Q3 2015, or by 3% for the first three quarters compared with a year ago (Table 1). Excluding financials and petroleum firms, earnings jumped by almost 50% in Q3, according to our calculations, or 21% year-to-date. While the sharp earnings recovery in Q3 is partially attributable to last year's low base, our model suggests that earnings momentum will likely be carried forward to at least early next year (Chart 1). Table 1Earnings Scorecard Chinese Stocks: Between Domestic Improvement And External Uncertainty Chinese Stocks: Between Domestic Improvement And External Uncertainty The earnings recovery reflects both top-line growth and margin expansion. Improving producer prices have eased deflationary pressure in the economy, particularly for the corporate sector. Total sales of A share-listed firms have benefited from the pickup in nominal GDP growth, and profit margins have also continued to widen in the last quarter, both of which are conducive for earnings growth (Chart 2). Cash flow positions have also continued to improve, especially in select sectors. Overall cash and cash equivalents held by Chinese non-bank firms as a share of assets currently stand at elevated levels, underscoring an overall cautious stance on business expansion and liquid balance sheets (Chart 3).2 Specifically, real estate developers' operating cash flow continues to increase sharply, boosted by strong sales, but capital expenditures have been muted, leading to a significant hoarding of cash. This will likely reduce financial stress among developers, even if housing policies begin to be tightened. Chart 1Strong Earnings Grow... bca.cis_wr_2016_11_10_c1 bca.cis_wr_2016_11_10_c1 Chart 2... Due To Rising Sales And Improving Margin bca.cis_wr_2016_11_10_c2 bca.cis_wr_2016_11_10_c2 Chart 3Developers' Improving Cash Flow And Balance Sheet bca.cis_wr_2016_11_10_c3 bca.cis_wr_2016_11_10_c3 In short, the Q3 earnings scorecard confirms our long-held view of an upturn in the Chinese profit cycle.3 We expect bottom-up analysts will continue to upgrade earnings expectations, which will provide a positive cyclical backdrop for Chinese stocks (Chart 4). The Economy Will Remain Resilient China's recent macro numbers have largely come in stronger than expected, albeit modestly. Overall, the economy has maintained positive momentum, especially in the industrial sector. The Keqiang Index - a combination of bank loan growth, railway freight activity and electricity consumption - has strengthened sharply, underscoring significant improvement in industrial activity (Chart 5). Looking forward, we expect the economy will likely continue to surprise to the upside. Chart 4Net Earnings Revision Will Continue To Improve bca.cis_wr_2016_11_10_c4 bca.cis_wr_2016_11_10_c4 Chart 5Keqiang Index Versus GDP Growth bca.cis_wr_2016_11_10_c5 bca.cis_wr_2016_11_10_c5 Business managers have largely been cautious, and have been focused on inventory destocking instead of business expansion. Industrial production has so far been muted, despite improvement in some leading indicators (Chart 6). Meanwhile, slowing capital spending among private enterprises has been one of the key reasons for slower growth in recent years; this should turn around as profitability improves (Chart 7). At minimum, downward pressure on private sector investment should diminish going forward. This, together with government-sponsored infrastructure construction, should underpin overall capital spending. Chart 6Industrial Production Has Been Muted bca.cis_wr_2016_11_10_c6 bca.cis_wr_2016_11_10_c6 Chart 7Profit Recovery Helps Capex bca.cis_wr_2016_11_10_c7 bca.cis_wr_2016_11_10_c7 On the policy front, monetary conditions continue to be accommodative. The trade-weighted exchange rate has remained low, and real interest rates have continued to drift lower through nominal declines and rising producer prices. Furthermore, inflation is unlikely to become a meaningful policy constraint anytime soon. Headline CPI picked up slightly last month, driven by food prices (Chart 8). However, this was largely due to the base effect. Agricultural wholesale prices have been mostly flat in recent years, and there is no case for generalized food inflation. The risk of any near term policy tightening has further diminished in the wake of the global uncertainty. Meanwhile, previous stimulative policies should continue to allow the economy to build forward momentum. The housing tightening policies imposed last month have begun to have a negative impact on home sales, which introduces a new risk factor for the economy, as discussed in a previous report. Anecdotal evidence suggests that property transactions in some major cities have dropped notably, even though home sales nationwide appear to remain buoyant (Chart 9).4 In addition, new housing construction has rolled over in the past few months, as developers have also focused on destocking inventories despite rising sales. However, inventories were already headed lower, which will eventually support new construction. Already, developers' land purchases have turned positive in recent months. In short, the impact of tightened housing policies should continue to be closely monitored. For now, our base case remains that housing construction will likely remain sluggish, but will not go through another major downturn. This view is further reinforced by the strong earnings and cash positions of real estate developers in the last quarter. Chart 8No Case For Food Inflation bca.cis_wr_2016_11_10_c8 bca.cis_wr_2016_11_10_c8 Chart 9Housing: Another Major Downturn Is Unlikely bca.cis_wr_2016_11_10_c9 bca.cis_wr_2016_11_10_c9 Chinese Stocks And Global Risk Aversion As far as Chinese stocks are concerned, we are positive both from structural and cyclical point of view, especially on H shares. Structurally, this asset class has been deeply depressed in recent years with an unduly high risk premium, which will eventually be renormalized through multiples expansion. Cyclically, the economy's budding forward momentum, strong profit recovery and accommodative policy stance are all supportive for stock prices. At a minimum, Chinese H shares should continue to outperform their global and EM peers. Tactically, however, we remain cautious as knee-jerk reactions in the stock market following the U.S. election surprise will continue to dominate the broader market trends. Furthermore, even as the impact of the election shock begins to fade, investors' focus may shift back over to a possible December rate hike by the Federal Reserve and another up leg in the U.S. dollar - both of which are negative for global liquidity and risk assets. Chart 10 shows that our proxy of global dollar liquidity has deteriorated significantly of late, which historically has often been accompanied by an increase in volatility in stocks. This time around, however, the market appears to have so far been rather sanguine, and is vulnerable to negative surprises. This is especially true, as global bellwether U.S. stocks are not cheap. In addition, Chinese stocks are overbought in the near term, and a period of consolidation or even correction is overdue (Chart 11). Our technical models for both A shares and H shares remain elevated even after the recent correction, which heralded further near-term difficulties. A favorable cyclical profile and large valuation buffer, particularly for H shares, should limit the downside for Chinese stocks, but the risk-return tradeoff in the near term is not particularly attractive, and warrants a more cautious stance. Chart 10Dollar Liquidity And Equity Volatility bca.cis_wr_2016_11_10_c10 bca.cis_wr_2016_11_10_c10 Chart 11Chinese Stocks Remain Near Term Overbought Chinese Stocks Remain Near Term Overbought Chinese Stocks Remain Near Term Overbought The bottom line is that we downgraded our "bullish rating" on Chinese H shares last month, and for now remain on the sidelines. Beyond near-term volatility we reiterate our positive conviction for this asset class, and expect Chinese H shares to continue to advance both in absolute terms and against the EM and global benchmarks. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Special Report, "Rethinking Chinese Leverage", dated October 27, 2016, available at cis.bcaresearch.com 3 Please see China Investment Strategy Weekly Reports, "2016: A Choppy Bottoming" , dated January 6, 2016 and "China: Four Important Charts" , dated April 13, 2016 and "Chinese Growth, Profits And Stock Prices", dated July 20, 2016, available at cis.bcaresearch.com 4 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010" , dated October 13, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights The credibility of ECB QE is set to diminish, one way or another. Stay long euro/dollar. Expect a continued compression in the German Bund yield spread versus the U.S. T-bond. Until the U.K. Supreme Court provides further legal clarity about the Brexit process, expectations for a softer Brexit should prop up the pound. In which case, the Eurostoxx600 will outperform the FTSE100 and the FTSE250 will outperform the FTSE100. Feature Nobody saw Brexit coming on June 23, and few saw a President Trump coming on November 8. Just as in the days after June 23, financial markets are trying to regain a footing after another political earthquake. The dust will settle. Our geopolitical strategists will provide a post-election analysis in a separate report. In this report, we would like to look through the immediate haze and focus on three major institutions whose policy options and degrees of freedom were becoming constrained, irrespective of the U.S. election shock. The institutions are: the ECB, the Federal Reserve, and the U.K. government. Chart of the WeekExpected Policy Rate Differential Drives ##br##The German Bund Yield Spread Versus The U.S. T-Bond bca.eis_wr_2016_11_10_s1_c1 bca.eis_wr_2016_11_10_s1_c1 The ECB Is Facing A Lose-Lose Decision Central bank quantitative easing (QE) remains one of the most misunderstood concepts within economics and finance. Contrary to the popular myth, it is not the central bank's asset purchases per se that matter. If the central bank's act of buying assets works at all, it is because QE signals a long period of ultra-low interest rates ahead.1 This then reduces the yields on other financial assets through the so-called "portfolio balance channel." Chart I-2Through 2011-13 Markets Interpreted A Lower ##br##Flow Of QE As A Monetary Tightening Through 2011-13 Markets Interpreted A Lower Flow Of QE As A Monetary Tightening Through 2011-13 Markets Interpreted A Lower Flow Of QE As A Monetary Tightening As Fed Chair Janet Yellen succinctly explains, once there is ample liquidity in the banking system: "QE has no discernible economic effects aside from those associated with communicating the central bank's commitment to the zero interest rate policy" The fundamental point is that the precise amount and asset-class composition of a QE program does not matter. The program just has to be large enough to demonstrate a credible commitment to ultra-low rates. But once a central bank establishes a monthly purchase amount, for example, the current €80bn for the ECB, the flow becomes an anchor. Financial markets then interpret a decrease in that monthly flow as a weakening commitment to ultra-low rates: in effect, a monetary tightening (Chart I-2). On the other hand, if the monthly asset-purchase promise goes on indefinitely, it also loses credibility. The financial markets know full well that there is only a finite pool of safe-assets that the central bank can buy, as the recent experience of the Bank of Japan testifies. For the ECB, the so-called "degrees of freedom" are even more limited than for the Bank of Japan. Asset purchases are constrained by politically determined upper-limits to individual euro area country exposure and by liquidity determined upper-limits to individual financial asset exposure. Hence, the ECB now faces a lose-lose decision. If it signals an intention - even a delayed intention - to taper its €80bn monthly flow of QE, the financial markets will interpret it as a de facto tightening. But if it does not signal an intention to taper it will have to use more and more smoke, mirrors, and chicanery to justify how it can keep delivering on its promise to buy. Bottom Line: one way or another, the credibility of ECB QE is set to diminish. The Federal Reserve's Track Record In Predicting Its Own Policy Is Abysmal To take a position on the euro/dollar exchange rate or the yield differential between German Bunds and U.S. T-bonds, we must now consider the other central bank in the equation: the U.S. Federal Reserve. When it comes to predicting the stance of its own monetary policy, the track record of the Federal Reserve is nothing short of abysmal. The Federal Reserve's famous dot forecasts have consistently missed the mark. In fact, they have not even come close to the mark. Just two years ago, the median Fed dot was predicting ten rate hikes by now (Chart I-3). Yes, seriously - ten! Chart I-3Two Years Ago, The Median Fed Dot Was Predicting Ten Rate Hikes By Now bca.eis_wr_2016_11_10_s1_c3 bca.eis_wr_2016_11_10_s1_c3 In its own defence, the Fed might respond that its monetary policy is "data-dependent" or even "events-dependent", and that this contingency prevented it from hiking the ten times that it had forecast. That's fine. But it then raises a bigger question about credibility. If central bank policy is contingent, then is it really possible to give credible forward guidance on the level of interest rates stretching out years ahead? We think not. Indeed, by publishing dots that turn out to be so consistently and deeply wrong, the central bank is seriously damaging its own credibility and authority. Rather than relying on Federal Reserve dots or market forecasts, investors must make up their own minds about the likely path of the Fed funds rate. For bond investors, the medium-term question is: at what level will the policy rate peak in this tightening cycle? This is because at the peak of the tightening cycle, the 0-10 year yield curve tends to be more or less flat (Chart I-4). In other words, the 10-year bond yield ends up eventually trading at the same level at which the policy rate peaks. After the election shock, the knee-jerk response has been a higher 10-year T-bond yield, and this direction may continue in the near-term. But further out, the question is: will the Fed funds rate peak above or below where today's 10-year T-bond yield of 1.9% implies that it will peak? We think below. Note that a first and second interest rate hike interspersed by a full year is unprecedented in modern economic history. And now, even the intended second hike in December might be in jeopardy. Given that the Fed has struggled to get two 25bps hikes through in two years, the idea that it will succeed in hiking another four or five times in this tightening cycle really does not seem credible to us. Bottom Line: Combined with the diminishing credibility of ECB QE, stay long euro/dollar (Chart I-5); and expect a continued compression in the German Bund yield spread versus the U.S. T-bond. In other words, maintain the pair-trade: long T-bonds, short German bunds (currency hedged) (Chart of the Week). Chart I-4At The Peak Of A Tightening Cycle, ##br##The 0-10 Year Yield Curve Is Flat bca.eis_wr_2016_11_10_s1_c4 bca.eis_wr_2016_11_10_s1_c4 Chart I-5Expected Policy Rate Differential##br## Drives Euro/Dollar bca.eis_wr_2016_11_10_s1_c5 bca.eis_wr_2016_11_10_s1_c5 The U.K. Government Has Had Its Wings Clipped The U.K. Government is another institution that has suffered a huge blow to its credibility and authority. Prime Minister Theresa May brazenly thought that she could start the legal process to exit the EU using the so-called 'royal prerogative', the power granted to governments to make certain decisions without a vote from parliament. But as we presciently warned two weeks ago in The Pound: Next Stop $1.10 Or $1.35,2 the U.K. High Court has judged the government does not have the authority to overturn domestic law - in this case, the European Communities Act (1972) and European Union Act (2011) - without obtaining parliamentary approval. The irony is that the sovereignty of the U.K. Parliament is the very thing that Brexiteers supposedly are fighting for. The High Court has clipped the U.K. Government's wings by deferring the Article 50 trigger to parliament. The government is appealing the High Court decision at the Supreme Court whose verdict is expected in January. But given that the government itself concedes that the Article 50 trigger will irrevocably change domestic law, it is hard to see how the government will win the appeal. Hence, there is a high likelihood that Members of Parliament will get to scrutinise the government's negotiating hand before it is allowed to fire the Brexit starting gun. Given that the precise form of Brexit has huge implications for British people's economic future and legal rights, parliament could water down or delay Brexit before voting it through. Bottom Line: Until the Supreme Court provides further legal clarity3 in January, expectations for a softer Brexit should prop up the pound. In which case: the Eurostoxx600 will outperform the FTSE100; the FTSE250 will outperform the FTSE100; U.K. retailers, travel and real estate equities will outperform the U.K. market; but U.K. goods exporters will underperform (Chart I-6 and Chart I-7). Chart I-6A Soft Or Hard ##br##Brexit... bca.eis_wr_2016_11_10_s1_c6 bca.eis_wr_2016_11_10_s1_c6 Chart I-7...Determines The Prospects ##br##For Most U.K. Assets bca.eis_wr_2016_11_10_s1_c7 bca.eis_wr_2016_11_10_s1_c7 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Because while an asset-purchase program is underway, it would be difficult to raise rates. 2 Published on October 27 2016 and available at eis.bcaresearch.com 3 The Supreme Court will judge the government's appeal against the High Court decision. If the appeal is lost, it may also judge what type of parliamentary approval is required to trigger Article 50: a full Bill or a simple Resolution. Fractal Trading Model* This week's recommended trade is to go long U.K. healthcare versus the market. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 bca.eis_wr_2016_11_10_s1_c8 bca.eis_wr_2016_11_10_s1_c8 * 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_10_s2_c1 bca.eis_wr_2016_11_10_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_11_10_s2_c2 bca.eis_wr_2016_11_10_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_11_10_s2_c3 bca.eis_wr_2016_11_10_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_11_10_s2_c4 bca.eis_wr_2016_11_10_s2_c4 Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c5 bca.eis_wr_2016_11_10_s2_c5 Chart II-6Indicators To Watch ##br##- Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c6 bca.eis_wr_2016_11_10_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c7 bca.eis_wr_2016_11_10_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_11_10_s2_c8 bca.eis_wr_2016_11_10_s2_c8

Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." — Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.1 Election Post-Mortem Chart II-1Election Polls Usually ##br##Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."2 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!3 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.4 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.5 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are Not ##br##Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.6 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.7 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.8 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.9 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.10 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.11 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). 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.12 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.13 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality And Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.14 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."15 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.16 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering ##br##Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.17 Another contested election in a contested era. Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.18 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.19 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.20 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.21 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Except that it is better armed. 2 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 3 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 4 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 8 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 9 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 10 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 11 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 12 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 13 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 14 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 15 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 16 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 17 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 18 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 20 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 21 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com.

Highlight Growth perked up in the major economies in October, and the manufacturing recession appears to have passed without event. The October employment report testified to the underlying health of the U.S. economy and clears the way for a rate hike at the FOMC's December meeting. Markets are skeptical that December's hike will be the first in a series, opening the door for a dollar rally while the Fed moves to meet its projected timetable. Unconvinced that global growth is about to accelerate in a meaningful way, and concerned about the ripple effects of a stronger dollar, we maintain the defensive bias in our model portfolios. Feature October was a good month for growth, as highlighted by broadly encouraging data across the major developed economies. U.S. GDP had its best print in two years in the third quarter, and European PMIs, firmly ensconced above 50, point to Eurozone growth around 1.5%. The plunge in sterling appears to have sheltered the U.K. from the worst effects of Brexit, even if it has triggered some unease about inflation. Japan remains hobbled, but our Global Investment Strategy service argues that reduced fiscal drag and a weaker yen will boost growth. The October employment data painted a portrait of a vibrant U.S. labor market. Job gains remained steady while the broad U-6 measure of unemployment, including discouraged job seekers and those working part time who would prefer to be working full time, fell by two ticks to a new post-crisis low (Chart 1). Consistent with the shrinking pool of idled workers, average hourly earnings surged, notching their biggest year-over-year gains of the expansion. The pickup in wages rekindled hopes of a virtuous circle linking hiring, wages, consumption, capex and more hiring. Chart 1The Supply Of Idled Workers Is Shrinking The Supply Of Idled Workers Is Shrinking The Supply Of Idled Workers Is Shrinking One GDP print does not make a trend, of course, and the hoped-for inflection point has remained out of reach throughout the post-crisis period (Chart 2 and Chart 3). Aggregate demand remains mushy even if it is improving. Forward-looking markets typically take their cues from direction rather than level, and punk post-crisis growth certainly hasn't hurt U.S. equities. The valuation backdrop has become much less hospitable, however, and the Fed appears less inclined to spike the punch bowl with its most potent fuel. The unsettled picture could make for a bumpy U.S. equity ride, especially if markets have become overly complacent about the pace of rate hikes. Chart 2The Post-Crisis Inflection: Ever In Sight... bca.bcasr_sr_2016_11_09_001_c2 bca.bcasr_sr_2016_11_09_001_c2 Chart 3...But Always Out Of Reach bca.bcasr_sr_2016_11_09_001_c3 bca.bcasr_sr_2016_11_09_001_c3 Economic Growth In The U.S. And Beyond What matters most to markets, a metric's current position (level), or its path (direction)? Favoring direction is generally a reliable stock market rule of thumb, though it's not always easy to recognize in real time. The key challenge for investors today is determining if the recent improvements are short-lived wiggles or a true inflection point. It would be helpful to know if extraordinary policy measures can boost organic growth or if they will simply redistribute it via exchange-rate adjustments. Measures of global trade are inconclusive. While things look much better in hubs like Korea and Taiwan (Chart 4), aggregate global trade volume is still mired in a one-step-forward, one-step-back pattern around the zero line (Chart 5). Isolated improvements in a handful of economies against a flat global backdrop highlight that a broad rebound has yet to take hold. Signs of life in individual countries should not be written off - it is promising that Korean and Taiwanese exports have staged their rebounds despite steady exchange-rate gains - but overall global export activity remains at a level more commonly associated with recessions than quickening expansions. Chart 4Some Exporters Are Stirring... Some Exporters Are Stirring... Some Exporters Are Stirring... Chart 5...But Aggregate Trade Is Stagnant ...But Aggregate Trade Is Stagnant ...But Aggregate Trade Is Stagnant Global PMI data are more broadly encouraging. Major-economy manufacturing PMIs are at levels consistent with decent growth and are sending a message, echoed by G7 industrial production (Chart 6), that the manufacturing recession is over. Although manufacturing typically accounts for less than a third of major-economy activity, its cyclicality helps it punch above its weight, and industrial slowdowns have the potential to trigger recessions. This time around, manufacturing failed to heat up enough to induce a broader slowdown and reliable recession signals are quiet (Chart 7). Chart 6The End Of The Manufacturing Recession The End Of The Manufacturing Recession The End Of The Manufacturing Recession Chart 7No Recession In Sight No Recession In Sight No Recession In Sight The October employment situation report was solidly encouraging. The U.S. labor market has found firm footing. Job gains have been remarkably steady, and our employment model projects they will persist, even if at a slightly slower pace (Chart 8). Both the average hourly earnings series and the Atlanta Fed's wage tracker show that rank-and-file workers are finally capturing some real income gains (Chart 9). Chart 8When The Economy Tests NAIRU... bca.bcasr_sr_2016_11_09_001_c8 bca.bcasr_sr_2016_11_09_001_c8 Chart 9...Wages Get A Boost bca.bcasr_sr_2016_11_09_001_c9 bca.bcasr_sr_2016_11_09_001_c9 Third Quarter Earnings Season S&P 500 operating earnings present another level/direction dichotomy. Per Standard & Poor's projections,1 trailing four-quarter operating earnings will finish the quarter 11% below their 3Q14 high-water mark (Chart 10, top). But the direction is as strong as the level is weak. Not only does this quarter mark the first year-over-year earnings gain since 3Q14, it is the second strongest since the pace of earnings growth normalized in 2012 (Chart 10, bottom). Chart 10Breaking Out Of The Earnings Recession Breaking Out Of The Earnings Recession Breaking Out Of The Earnings Recession Margins widened and earnings grew broadly across sectors without a clear cyclical or defensive theme. Rate sensitives achieved the strongest top-line growth, but endured margin contraction (Chart 11). Looking ahead, margins seem more likely to contract than expand in the coming quarters, given building wage pressures. On the other hand, an end to the sharp declines in Energy earnings will remove a drag that has weighed on S&P 500 results for several quarters. Chart 11Margins' Last Gasp? Spotlight On U.S. Equities Spotlight On U.S. Equities Margins' seeming inability to defy budding wage gains makes it unclear exactly how investors should position themselves, but the outlook for the dollar could provide some insight. Multinationals are prominent among the S&P 500's largest constituents, and since 2011, the broad trade-weighted dollar index has exhibited a robust negative correlation with S&P 500 earnings. Peak acceleration in the dollar has led earnings troughs by a quarter or two and earnings growth has quickened when the dollar has consolidated or retraced its gains (Chart 12). In a rising-dollar environment, U.S. firms competing globally face the unpalatable choice of protecting their margins and ceding share, or ceding share to defend their margins. Chart 12Strong Dollar, Weak Earnings Strong Dollar, Weak Earnings Strong Dollar, Weak Earnings Fed Policy: The Known Unknown Chart 13Markets Are Sleeping On The Fed Markets Are Sleeping On The Fed Markets Are Sleeping On The Fed The Fed has evinced a clear desire to hike rates, and investors know that it will be withdrawing accommodation at the edges. But the terminal fed funds rate for this cycle, and the pace at which the FOMC approaches it, are unknown. Market expectations, as implied by OIS2 contracts, reveal that investors have become complacent about the pace of hikes. While the consensus expects a quarter-point hike at the FOMC's December meeting, money markets are discounting just an 11% chance of a second 25-bps hike by the end of October 2017 (Chart 13, top panel), and a 75% chance of a second hike by the end of October 2018 (Chart 13, bottom panel). The Fed's dot-plot rate hike forecasts have been laughably off the mark, and to this point investors have tuned them out to their benefit. The preconditions for a progression of hikes seem to be coming together, however, as labor slack disappears, wage pressures emerge and the output gap steadily narrows. Every FOMC voter or regional Fed president who's stepped within range of an open microphone the last few weeks has gone out of his or her way to endorse the notion that two 2017 rate hikes are reasonable, and those with a more hawkish bent appear to be comfortable with three. Viewed beside the data and the guidance, markets seem to be in denial. Currency exchange rates are subject to multiple cross-currents, but policy rate differentials have taken a leading role since the dollar's surge began in the second half of 2014. Some Fed hikes are already baked into the EUR-USD and USD-JPY crosses, but the implied expectation that it could take two years for the FOMC to lift the fed funds rate by 50 bps suggests that the path of least resistance for the dollar is up. The implications for global equity positioning point to favoring Europe- and Japan-based multinationals (on a currency-hedged basis) over their U.S. counterparts. They also argue for caution around emerging market assets, as a stronger dollar is a drag on commodity prices, makes it more difficult for domestic borrowers to service dollar-denominated debt, and imperils the supply of external capital that helps fund fiscal deficits. Investment Implications Putting it all together, we continue to favor a defensive stance. Real rates haven't budged during the post-Brexit sovereign yield backup (Chart 14, top panel), which has entirely been a function of less depressed term premiums (Chart 14, middle panel) and varying increases in inflation expectations (Chart 14, bottom panel). We are not yet convinced that the quickening in growth measures is anything other than one more of the false dawns that have been a regular feature of the last several years. We also see the uncertainty accompanying the Fed's turn away from accommodation at the margin as carrying considerable potential for disruption. It seems overly optimistic to think that policy makers will be able to shift course without causing at least a hiccup or two. With the S&P 500 trading at an elevated forward multiple (Chart 15), U.S. equities have little if any cushion against disappointment. Chart 14Bonds Aren't Pricing In Better Growth Bonds Aren't Pricing In Better Growth Bonds Aren't Pricing In Better Growth Chart 15Little Cushion Against Disappointment Little Cushion Against Disappointment Little Cushion Against Disappointment Maintaining a defensive portfolio bias is consistent with our qualms about growth and the potential for policy hiccups. We attribute cyclical sectors' outperformance relative to defensive sectors to technical rather than fundamental factors. Cyclicals had become oversold relative to defensives, as had emerging markets, at a time when the dollar needed to take a break from its upward sprint. We view the whole commodity/cyclical/EM complex as participating in a countertrend rally. We are vigilant, however, and we are asking ourselves where we could be getting it wrong even more frequently than usual. Many of the defensive spaces we currently favor have been bid up to levels where they would not seem to have any cushion at all. It is not comforting to invest on the basis of overshoots that are expected to become even more extended, but that is life with TINA in the ZIRP/NIRP era. Our model portfolios have underperformed over their first four weeks thanks to our income hybrids' underperformance versus plain-vanilla fixed income and defensives' underperformance versus cyclicals, but we think they will enhance the overall portfolios' risk-adjusted return profiles over time. The lack of a credible recession threat argues for maintaining our underweight in plain-vanilla fixed income products, but uncomfortably tight high-yield spreads have us concentrating our spread product exposure in the investment-grade space. We maintain our (currency-hedged) equity tilts toward Europe and Japan, and away from the U.S., largely on our expectations for ongoing dollar strength. That view also informs our allocations to mid- and small-cap U.S. equities, which are more domestically focused than their large- and mega-cap counterparts. Our Fed view underpins our dollar expectations, and any change in our policy take would result in portfolio changes. We will undertake a comprehensive view of our model portfolios in December, once they have two months of performance under their belts. Postscript: Dewey Defeats Truman Global ETF Strategy has a cyclical, not a tactical, orientation. Our process is directed toward catching cyclical moves and we avoid the chasing-our-own-tail spiral of trying to handicap short-term wiggles. As a result, when this report went to press Tuesday afternoon, we looked through the election and rejected tweaking our portfolios to position for any particular outcome. While we were surprised by the results of the election, our U.S. portfolios' domestic orientation, and the generally defensive cast to all of our portfolios, should help insulate them from any incremental volatility that may ensue over the rest of the year. The immediate market reaction soundly rejected our stance on the course of Fed rate hikes, but we think investors may change their tune given more time to reflect. We think it is far from certain that the Fed will tear up its playbook. Upheaval in the financial markets could well stay the FOMC's hand in December, but the first half hour of New York trading suggests that the potential for upheaval was rather overhyped. We do not see why the election results would have any impact on the labor market and the creeping upward pressure on wages. Markets are said to hate uncertainty and the actions of a Trump administration are surely harder to predict than the actions of a Clinton administration. We are not going to become traders, but we will be more vigilant over the two-plus months before the Inauguration and the first weeks of the new administration. We will adopt a more tactical orientation if conditions warrant, but we are not acting hastily now. We expect that there will be a lot of head fakes before markets find their true course. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 With 84% of S&P 500 constituents having reported through November 3rd, Standard & Poor's projected year-over-year growth in operating earnings of nearly 14%. 2 Overnight index swaps (OIS) are our preferred vehicle for deriving rate hike expectations because they represent contracts between real-life market participants and are thus more reliable than survey measures.