Geopolitics

Dear Client, This week, I am currently on the road visiting clients across Europe. We are sending you an abbreviated weekly report as well as a Special Report from our Geopolitical Strategy team entitled “U.S. Election: Final Forecast & Implications”. Not only does this report encompass a detailed analysis of the upcoming U.S. presidential election and its implications for the future of U.S. politics, it also introduces GPS’s poll-plus model, a model which currently forecasts a Clinton victory. I trust you will find this piece very informative. Best regards, Mathieu Savary, Vice President Foreign Exchange Strategy Highlights The U.S. dollar is consolidating its recent gains, but it offers more upside in the months ahead A Trump victory would supercharge any dollar strength, but is likely to hurt the dollar in the long-term. In Japan, no more fiscal drag and a tightening in the labor market will ultimately result in a lower yen, courtesy of higher inflation expectations and falling real rates. The Australian labor market points to weaknesses in the domestic economy. Any EM turmoil could launch an AUD bear phase. Feature The U.S. dollar continues to consolidate its recent gains. While the dollar is expensive, it still offers upside potential. Monetary divergences remain in favor of the U.S. economy. U.S. labor market slack is disappearing and the rising share of salaries and wages in the national income pie is likely to further support consumption. Shifting the distribution of economic gains toward workers signifies that the middle class is gaining ground relative to households at the summit of the income ladder. This process should help consumption because the middle class has a much higher marginal propensity to consume than the top 1% (Chart I-1). If consumption growth remains healthy, job creation is likely to fan additional wage pressures, creating a virtuous circle for U.S. households and consumption. This virtuous cycle is likely to help the Fed increase rates over the next two years, providing a source of support for the dollar (Chart I-2). Chart I-1Shifting Income To The Middle Class Will Support Consumption bca.fes_wr_2016_10_28_s1_c1 bca.fes_wr_2016_10_28_s1_c1 Chart I-2A Virtuous Cycle For The Dollar A Virtuous Cycle For The Dollar A Virtuous Cycle For The Dollar In terms of the presidential election outcome, the shift of the median voter to the left signifies that redistributionist policies are likely to become an ever growing part of the U.S. political discourse. This reality is likely to provide another source of support for the U.S. dollar, at least for now. While a Clinton victory will not halt these trends, a Trump victory would likely supercharge any dollar bull market. While vague in details, Trump's economic plan involves much more infrastructure spending financed with debt issuance, i.e. a large amount of fiscal stimulus that would remove the need for any dovish tilt to the Fed's stance. Moreover, by raising the specter of protectionism, a Trump victory could revive inflationary forces in the U.S. economy. Protectionism, while negative for profits, would decrease the trade deficit, temporarily lifting U.S. GDP. Since the supply side of the economy has been hampered by tepid levels of investment (Chart I-3), we could see a situation where demand is in excess of supply. This would prompt an even more hawkish Fed. However, although a Trump victory would be a dream for dollar bulls, caution is warranted. In the long-term, a Trump administration implies a falling fair value for the dollar. For one, by lifting inflation, a Trump victory would hurt the PPP value of the greenback. Second, a Trump victory would also ultimately lead to a degradation of the USD's role as the global reserve currency, making the -40% of GDP net international investment position of the U.S. more difficult to sustain (Chart I-4). Finally, by shielding the economy from the competitive pressures of globalization, a Trump victory would likely result in a deterioration of U.S. productivity vis-à-vis the rest of the world. Chart I-3Low Capital Stock Growth Would Crystalize The##br## Inflationary Effect Of A Trump Presidency bca.fes_wr_2016_10_28_s1_c3 bca.fes_wr_2016_10_28_s1_c3 Chart I-4The Dollar Needs Its ##br##Reserve-Currency Status bca.fes_wr_2016_10_28_s1_c4 bca.fes_wr_2016_10_28_s1_c4 Yen Signs pointing toward a strong wave of yen weakness are slowly coming together. In recent years, the yen has closely followed real rates differentials (Chart I-5). With the BoJ guaranteeing a limit on the upside for nominal rates, any improvement in the economy is likely to cause inflation expectations to increase, and thus real rates, to fall. What are the signals pointing toward higher inflation expectations and a lower yen? First, the labor market is tightening. The job-opening-to-applicants ratio is at a 15 year high and employment growth remains healthy (Chart I-6). Meanwhile, the participation rate of women in the labor force is at all-time highs, and at 73.5%, the employment-to-population ratio for prime-age women is already above U.S. levels. In fact, it is at similar levels to those experienced in the U.S. during the boom years of the late 1990s. Thus, the declining likelihood that more women will enter the labor force eliminates a wage-suppressing factor. Chart I-5USD/JPY: A Function Of##br## Real Rate Differentials USD/JPY: A Function Of Real Rate Differentials USD/JPY: A Function Of Real Rate Differentials Chart I-6Japan: Female Labor Participation Now Exceeds ##br##The U.S. Japanese Wages Can Now Rise bca.fes_wr_2016_10_28_s1_c6 bca.fes_wr_2016_10_28_s1_c6 Second, the Japanese shipment-to-inventory ratio is improving. Thanks to lean-inventory techniques, this ratio tends to be most elevated at the bottom of economic slowdowns, reflecting depressed sales rather than bloated inventories. Historically, growing shipments relative to inventories are associated with rising inflation expectations (Chart I-7). Third, the drag from fiscal policy is dissipating. Budget tightening is leveling off, lifting a big brake on domestic demand (Chart I-8). Moreover, we expect fiscal stimulus to gather momentum in 2017, especially in the form of wage policy. This provides an additional support for Japanese inflation expectations. If no further fiscal stimulus comes to fruition in Japan, we expect USD/JPY to rally toward 110-115 in the next 18-months. If aggressive fiscal stimulus and a wage policy are implemented, the upside for USD/JPY could be much greater, in the order of 120 or more. Chart I-7Japanese Shipment-To-Inventory##br## Ratio And CPI Expectations Japanese Shipment-To-Inventory Ratio And CPI Expectations Japanese Shipment-To-Inventory Ratio And CPI Expectations Chart I-8The Dissipating Japanese ##br##Fiscal Drag USD, JPY, AUD: Where Do We Stand? USD, JPY, AUD: Where Do We Stand? Yet, while the cyclical outlook for the yen is bearish, the shorter-term outlook is more nuanced. Any EM-selloff triggered by tightening global liquidity conditions could prompt downward pressures on Japanese inflation expectations. This would mechanically lift Japanese real rates and the yen. Hence, we recommend investors sell the yen on a long-term basis but hedge this position by buying JPY volatility over the next 3-6 months. Australian Dollar The Australian dollar is at a tricky spot. Technically, the AUD has been forming a tapering wedge, a pattern that often heralds a large move in this currency. How will this pattern resolve itself? We expect a bearish outcome. The domestic economy is displaying some worrying signs. Not only is full-time employment contracting, but so are total hours worked (Chart I-9). This is likely to weigh on household income and on consumption. This is especially problematic as Australian gross fixed capital formation continues to contract at a 4.5% annual pace. The result is that inflationary pressures in Australia will be kept at bay. In the process, the RBA could adopt a more dovish bias. Chart I-9Australian Domestic Conditions ##br##Are Deteriorating bca.fes_wr_2016_10_28_s1_c9 bca.fes_wr_2016_10_28_s1_c9 Chart I-10Australian Exports To ##br##China Are Still Falling... Australian Exports To China Are Still Falling... Australian Exports To China Are Still Falling... Additionally, despite a stabilization in Chinese growth, Chinese imports from Australia continue to contract (Chart I-10). Not only has this happened as iron ore prices have rebounded, but also, as economic conditions have improved in EMs that are highly levered to the Chinese cycle (Chart I-11). Our expectation is that the Chinese industrial sector is likely to experience a slowdown in the months ahead, courtesy of a falling fiscal impulse (Chart I-12), which begs a question: What does the future hold for Australian exports? Chart I-11...Despite Rising Taiwanese##br## Industrial Production bca.fes_wr_2016_10_28_s1_c11 bca.fes_wr_2016_10_28_s1_c11 Chart I-12Tightening Global Liquidity Is A Headwind##br## For EM Financial Conditions And Growth Tightening Global Liquidity Is A Headwind For EM Financial Conditions And Growth Tightening Global Liquidity Is A Headwind For EM Financial Conditions And Growth Finally, our bullish U.S. dollar stance is a tough hurdle for commodity prices to overcome (Chart I-13). Weakness in commodities would represent a negative terms-of-trade shock for Australia and the AUD. Moreover, the PBOC continues to use a lower RMB as an engine of reflation, and we stand by our bearish JPY forecast. Because of these two developments KRW, SGD, and TWD, are very likely to experience further downside. Historically, Asian currency weakness correlates closely with a weak AUD (Chart I-14). Chart I-13Commodities And The Dollar:##br## Joined At The Hip bca.fes_wr_2016_10_28_s1_c13 bca.fes_wr_2016_10_28_s1_c13 Chart I-14AUD Performs Poorly When ##br##Asian Currencies Sell Off bca.fes_wr_2016_10_28_s1_c14 bca.fes_wr_2016_10_28_s1_c14 We are already shorting AUD/USD in the context of a short commodity currencies trade. We are considering buying EUR/AUD, as the euro is less sensitive to the dollar, EM spreads, and commodity prices versus the AUD. Also, EUR/AUD is more attractive from a valuation perspective, trading 5% below its PPP fair value. This cross is also supported by a favorable balance-of-payments backdrop, with the euro area registering a 7.7% of GDP current-account differential relative to Australia. Buying EUR/AUD represents a way for investors to bet on a weaker AUD while decreasing their exposure to the U.S. dollar risk factor. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 bca.fes_wr_2016_10_28_s2_c1 bca.fes_wr_2016_10_28_s2_c1 Chart II-2USD Technicals 2 bca.fes_wr_2016_10_28_s2_c2 bca.fes_wr_2016_10_28_s2_c2 Policy Commentary: "There are risks of hanging around zero too long. And if the economy can withstand [a hike], I think it's appropriate to move" - Philadelphia Fed President Patrick Harker (October 26, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Euro Chart II-3EUR Technicals 1 bca.fes_wr_2016_10_28_s2_c3 bca.fes_wr_2016_10_28_s2_c3 Chart II-4EUR Technicals 2 bca.fes_wr_2016_10_28_s2_c4 bca.fes_wr_2016_10_28_s2_c4 Policy Commentary: "In the euro area, we have a long way to go before we exhaust the productivity improvements that have already taken place in the U.S" - ECB President Mario Draghi (October 25, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 The Yen Chart II-5JPY Technicals 1 bca.fes_wr_2016_10_28_s2_c5 bca.fes_wr_2016_10_28_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_10_28_s2_c6 bca.fes_wr_2016_10_28_s2_c6 Policy Commentary: "Since the employment situation has continued to improve, no further easing of monetary policy may be necessary... at any rate, I would like to discuss this thoroughly with other board members at our monetary policy meeting" - BoJ Board Member Yutaka Harada (October 12, 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 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_10_28_s2_c7 bca.fes_wr_2016_10_28_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_10_28_s2_c8 bca.fes_wr_2016_10_28_s2_c8 Policy Commentary: "Our judgment in the summer was that we could have seen another 400,000-500,000 people unemployed over the course of the next few years...So we're willing to tolerate a bit of overshoot in inflation over the course of the next few years in order to avoid that situation, to cushion the blow" - BOE Governor Mark Carney (October 14, 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_10_28_s2_c9 bca.fes_wr_2016_10_28_s2_c9 Chart II-10AUD Technicals 2 bca.fes_wr_2016_10_28_s2_c10 bca.fes_wr_2016_10_28_s2_c10 Policy Commentary: "We have never thought of our job as keeping the year-ended rate of inflation between 2 and 3 percent at all times...Given the uncertainties in the world, something more prescriptive and mechanical is neither possible nor desirable" - RBA Governor Philip Lowe (October 17, 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 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 bca.fes_wr_2016_10_28_s2_c11 bca.fes_wr_2016_10_28_s2_c11 Chart II-12NZD Technicals 2 bca.fes_wr_2016_10_28_s2_c12 bca.fes_wr_2016_10_28_s2_c12 Policy Commentary: "There are several reasons for low inflation - both here and abroad. In New Zealand, tradable inflation, which accounts for almost half of the CPI regimen, has been negative for the past four years. Much of the weakness in inflation can be attributed to global developments that have been reflected in the high New Zealand dollar and low inflation in our import prices" - RBNZ Assistant Governor John McDermott (October 11, 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 bca.fes_wr_2016_10_28_s2_c13 bca.fes_wr_2016_10_28_s2_c13 Chart II-14CAD Technicals 2 bca.fes_wr_2016_10_28_s2_c14 bca.fes_wr_2016_10_28_s2_c14 Policy Commentary: ""Given the downgrade to our outlook, Governing Council actively discussed the possibility of adding more monetary stimulus at this time, in order to speed up the return of the economy to full capacity" - BoC Governor Stephen Poloz (October 19, 2016) Report Links: Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Swiss Franc Chart II-15CHF Technicals 1 bca.fes_wr_2016_10_28_s2_c15 bca.fes_wr_2016_10_28_s2_c15 Chart II-16CHF Technicals 2 bca.fes_wr_2016_10_28_s2_c16 bca.fes_wr_2016_10_28_s2_c16 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 bca.fes_wr_2016_10_28_s2_c17 bca.fes_wr_2016_10_28_s2_c17 Chart II-18NOK Technicals 2 bca.fes_wr_2016_10_28_s2_c18 bca.fes_wr_2016_10_28_s2_c18 Policy Commentary: "A period of low interest rates can engender financial imbalances. The risk that growth in property prices and debt will become unsustainably high over time is increasing. With high debt ratios, households are more vulnerable to cyclical downturns" - Norges Bank Governor Oystein Olsen (October 11, 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 bca.fes_wr_2016_10_28_s2_c19 bca.fes_wr_2016_10_28_s2_c19 Chart II-20SEK Technicals 2 bca.fes_wr_2016_10_28_s2_c20 bca.fes_wr_2016_10_28_s2_c20 Policy Commentary: "[On Sweden's financial stability]...it remains an issue because we are mismanaging out housing market. Our housing market isn't under control in my view" - Riksbank Governor Stefan Ingves (October 17, 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 We expect the U.S. House of Representatives to remain in GOP hands, but the Democrats could take razor-thin control of the Senate if Clinton wins the Presidency. The current, market-bullish status quo of divided government will continue. The chances of cooperation between a Clinton Administration and the House is actually quite good on some issues. We would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. There is now bipartisan support in the U.S. for removing the sequester, opening the door to some fiscal stimulus. A shift in focus from monetary to fiscal policy will be quite bullish for the dollar, which could rise by 10% in trade-weighted terms. The Japanese government appears to be preparing another shot of fiscal stimulus, which would be quite bearish for the yen and bullish for Japanese stocks when combined with the Bank of Japan's new yield curve policy. A number of headwinds that have held back U.S. growth this year will give way, generating 2½-3% real GDP growth in 2017. Positive growth surprises will encourage the FOMC to tighten in December and another five times over 2017/18. However, the speed of rate hikes will depend on how quickly the dollar appreciates. Dollar appreciation will undermine U.S. EPS growth next year. We view this as a headwind for stocks, but not something that will prevent modest gains in the S&P 500 next year. A key risk is that a surging dollar and a more hawkish FOMC sparks a correction in EM assets in the near term, spilling over into developed market bourses. Given elevated valuations, the risk/reward balance still favors a defensive strategy, with no more than a benchmark allocation to stocks. Several trends support our recommendation to maintain slightly below-benchmark duration within fixed- income portfolios. Among them, the annual growth rate in total central bank assets for the U.S., Euro Area, the U.K. and Japan is on the verge of peaking even assuming the ECB extends, which means that the period of maximum downward pressure on global term premia is over. Continue to overweight indexed bonds versus conventional issues. Oil prices should be able to hold up in the face of dollar strength given that we expect the tightening oil market will dominate. However, base metals will struggle. Feature As we go to press, Hillary Clinton is poised to win the Presidency of the United States following a tumultuous and divisive campaign. The key question now is the Senate race, where less controversial Republicans are contesting close elections. The GOP is at high risk of losing four Senate seats, with another three in play. Democrats need only four seats to take the Senate because, assuming that Clinton wins the presidency, Vice-President Tim Kaine would then cast the tie-breaking vote in that body. We expect the GOP to hold onto the House. This means that the current, market-bullish status quo of a divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate, the Clinton White House would be constrained on some of its most left-leaning policies. Unlike Obama, Clinton's victory will not be a popular sweep. She will likely receive less than 50% of the popular vote and will be the first candidate ever elected that has more voters saying they dislike her than like her (Chart I-1). Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting mandate as Obama did in 2008. Chart I-1Clinton And Trump: The Least Charismatic Candidates Ever November 2016 November 2016 Nonetheless, BCA's Geopolitical Strategy service believes that the chances of cooperation between a Clinton Administration and the House is actually quite good on some issues. On corporate tax reform, it is difficult to see a reduction in effective tax rates, but a deal could be struck to broaden the tax base by closing various loopholes. This would be negative for some S&P 500 multinational corporations, but would benefit America's small and medium-sized enterprises. Paul Ryan and moderate Republicans understand that there has been a paradigm shift in America and that the median voter has moved to the left. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. There is now bipartisan support for removing the sequester. Even a modest infrastructure plan could make a substantive difference for the economy given the high fiscal multipliers of government spending in an economy with low interest rates. The political shift to the left means that a Clinton-Ryan coalition will care less about the concerns of America's large corporations than previous governments, leading to policies that will result in higher effective tax rates on major corporations, a dollar bull market (in conjunction with tighter Fed policy, see below), and rising wages over the next four years. The election outcome will also be positive for bombed-out U.S. health care stocks. Even if the Democrats take the Senate, a Republican-held House will make it difficult for Clinton to push through legislation that does serious damage to the sector's pricing power. Health care stocks are oversold and cheap, at a time when consumer demand is solid and our pricing power proxy is rising much more quickly than overall corporate sector pricing. In terms of the macro implications, a shift in focus from monetary to fiscal stimulus will be quite bullish for the dollar. Below we discuss the important changes coming in the global investment landscape stemming from a renewed dollar bull phase. U.S. Growth: Expect Upside Surprises Any boost to U.S. infrastructure spending is unlikely to show up in GDP until the second half of next year. Nonetheless, there are other reasons to be more upbeat than the consensus on growth prospects for the first half as well. It is important to note that U.S. real final sales to private domestic purchasers, a good measure of underlying demand growth, has grown at almost 2½% over the past year, and was up 3.2% in the second quarter sequentially. A number of headwinds conspired to hold back the headline GDP growth figures, but these headwinds should moderate next year (Chart I-2): The five-quarter inventory correction is almost unprecedented in its length, but there are some high-frequency indicators (i.e. durable goods inventories and the inventory component of the ISM manufacturing index) that suggest that the correction is coming to an end (Chart I-3). Inventory destocking only needs to stabilize to boost GDP growth, since it is the change of the change in inventories that affects GDP growth. Chart I-2U.S. 2016 Growth Headwinds To Fade U.S. 2016 Growth Headwinds To Fade U.S. 2016 Growth Headwinds To Fade Chart I-3Inventory Rebuilding Has Commenced bca.bca_mp_2016_11_01_s1_c3 bca.bca_mp_2016_11_01_s1_c3 Some of this year's slowdown reflects a pullback in the contribution of federal and state & local government spending. Nonetheless, this will not last long because state and local government revenues are trending higher and this sector spends all it takes in. As noted above, we also expect a boost from infrastructure spending at the federal level. Housing starts and residential investment hit a soft patch this year. The second quarter dip was mainly due to a warm winter, which pulled forward home-improvement spending. The NAHB homebuilders index heralds a rebound in housing activity in the coming months, in line with the improvement in household formation. Indeed, housing starts are still 20-25% below estimates of the amount of construction necessary to keep up with population growth. We also expect a little more capital spending once the election is out of the way, profits begin to expand again and industrial production growth improves early in the New Year. Moreover, the oil rig count has started to recover, suggesting that energy capex should stabilize and perhaps even improve. Overall corporate capital spending intentions have perked up (Chart I-4). The trade sector will be a drag on growth, especially if the dollar appreciates as we expect. Nonetheless, we believe that the unwinding of the other headwinds that have dogged the economy this year could provide real GDP growth of 2½-3% in 2017. Stronger-than-expected growth will have a positive impact on America's trading partners via import demand, but it is the response of the dollar that could really shake up global financial assets. The reasoning behind our strong dollar view is straightforward: interest rates differentials are the strongest predictor of currency trends on a 12-18 month horizon. Relative economic performance between the U.S. and the rest of the world suggests that interest rate differentials will move even further in favor the U.S. dollar. Chart I-5 highlights that the dollar tends to appreciate when U.S. interest rates are in the upper half of the interest rate distribution of the G10. With few central banks outside of the U.S. in a position to be able to lift interest rates, gently rising U.S. rates will keep the U.S. among the global developed market (DM) high-yielders for many years. Chart I-4Capex Plans Have Improved bca.bca_mp_2016_11_01_s1_c4 bca.bca_mp_2016_11_01_s1_c4 Chart I-5U.S. Sitting Atop The Global Interest Rate Distribution Buoys The Dollar bca.bca_mp_2016_11_01_s1_c5 bca.bca_mp_2016_11_01_s1_c5 Real interest rate differentials may shift even more than nominal rates in favor the dollar. Inflation expectations should rise in Europe and Japan to the extent that their respective currencies weaken and their economies receive a boost from improved U.S. import demand. But since neither central bank will allow much of an increase in local bond yields, rising inflation expectations will translate into lower real yields in the Eurozone and Japan. This will reinforce the dollar's bias to appreciate. The ECB could upset this forecast by announcing that it will taper the asset purchase program beginning in March of next year, but we believe it is more likely the central bank will extend the QE program for another six months. In Japan's case, the nominal yield curve is now fixed by the Bank of Japan out to 10-years. How Much Will The Dollar Appreciate? This is a difficult question. A central bank can tighten monetary conditions, but does not have control over how much of the tightening comes via interest rates and how much through currency appreciation. Our sense is that over the next couple of years the fed funds rate will need to rise to 2% in nominal terms (0% in real terms) and the dollar will appreciate by 10% in trade-weighted terms, to avoid an economic overheating and an overshoot of the inflation target. We expect the Fed to tighten in December, followed by two more quarter-point hikes in 2017. But, of course, an outsized dollar response to the initial rate hikes would temper the speed of Fed tightening. A 10% rise seems aggressive, but it would still leave the broad trade-weighted dollar index well below previous peaks. Wouldn't Such A Dollar Surge Kill Any Hopes Of A Recovery In U.S. Profits? Undoubtedly, dollar strength presents a direct and non-trivial risk to the earnings outlook. Our U.S. EPS model foresees a return to positive earnings growth early next year, and a full-year expansion of 5-6% (Chart I-6). This is based on three important assumptions: (1) industrial production returns to modest but positive growth next year; (2) oil prices are roughly unchanged from current levels, allowing profits in the energy patch to recover with a lag; and (3) nominal GDP growth accelerates modestly relative to labor compensation. Chart I-6The U.S. Profit Outlook bca.bca_mp_2016_11_01_s1_c6 bca.bca_mp_2016_11_01_s1_c6 However, we assumed in the base case scenario presented in May that the dollar is unchanged. Re-running the model with a 10% dollar appreciation over the next year would shave about 2-3 percentage points off of EPS growth next year (Chart I-6). In other words, EPS would rise next year, but only modestly. Can The S&P 500 Rally In The Context Of Dollar Strength? Chart I-7Stocks Can Appreciate With The Dollar bca.bca_mp_2016_11_01_s1_c7 bca.bca_mp_2016_11_01_s1_c7 An appreciating dollar is clearly a headwind, but it is the case that the S&P 500 rallied along with the dollar in the last three major dollar bull markets: 1978-1985, 1994-2002, and 2011 to today (Chart I-7). One could point to special factors in each episode. Nonetheless, our point is that if the dollar is appreciating because growth outside the U.S. is deteriorating, then the backdrop is negative for U.S. equities. But if the dollar is appreciating because the U.S. economic growth backdrop has brightened (with no deterioration elsewhere), then U.S. stocks can rally despite the negative impact of the dollar on profits. Indeed, the direction of causation reverses at times: it is the rally in U.S. risk assets (along with higher rates) that attracts foreign capital and pushes the dollar higher. A tax holiday on foreign retained earnings would also be positive for the dollar and risk assets. That said, the currency shifts we expect over the next year will favor Eurozone and Japanese stocks to the U.S. market in local currency terms. This is particularly so for Japan if more aggressive monetary and fiscal policies manage to sharply devalue the yen (see below). According to our models, a 5% depreciation of the euro and a 10% drop in the yen in trade-weighted terms would boost EPS growth next year by 3 and 5 percentage points, respectively, in the Eurozone and Japan (Chart I-8). Monetary policy divergence and relative valuation also support our recommendation to favor Japanese and Eurozone stocks versus the U.S. Chart I-8The Eurozone Profit Outlook The Eurozone Profit Outlook The Eurozone Profit Outlook What Does Our Dollar Outlook Mean For EM Assets? Continuing liquidity injections from the ECB and BoJ are positive for emerging market (EM) assets. Unfortunately, this will not shield emerging markets from a 10% dollar rise, especially if it is accompanied by another downleg in commodity prices (Chart I-9). A stronger greenback is likely to cause distress among over-leveraged EM borrowers given that 80% of EM foreign-currency debt is denominated in dollars. Chart I-10 illustrates that there have been no periods when EM share prices rallied amid strength in the trade-weighted U.S. dollar since the early 1980s. Meanwhile, the gap between EM and U.S. nonfinancials' return on equity (RoE) remains deeply negative, which historically has been associated with EM currency depreciation. Chart I-9Dollar Strength Is Negative For Commodities... bca.bca_mp_2016_11_01_s1_c9 bca.bca_mp_2016_11_01_s1_c9 Chart I-10...And Emerging Markets ...And Emerging Markets ...And Emerging Markets The implication is that the recent rally in EM risk assets and currencies will not last. Investors should avoid this space. A dollar rally would also be a headache for the People's Bank of China (PBoC). Allowing the RMB to depreciate aggressively versus the dollar to avoid an appreciation in trade-weighted terms could ruffle political feathers in the U.S. and spark capital flight. The PBoC will likely manage the RMB's decline versus the dollar and allow it to appreciate in trade-weighted terms, while tightening capital account controls to prevent capital from fleeing the country. This outcome is slightly negative for the economy and could generate some financial market volatility as the process unfolds. We believe that China will be able to maintain GDP growth of around 6½% next year and that there will be no financial crisis related to China's high debt levels. Nonetheless, China's transition away from an investment-led to a consumer-led expansion means that the tailwind for commodity demand and EM exports will not return. FOMC: Some Like It Hot The probability of a Fed rate hike in December eased a little in recent days due to some disappointing economic data, such as the September readings on retail sales and the CPI, along with comments from Fed Chair Yellen on the benefits of allowing the economy to "run hot". Some others on the FOMC share her views, but many do not. As we highlighted in last month's Special Report,1 Yellen will not overrule the consensus on the FOMC. The appetite to test the limits of the supply side of the economy is simply not broad enough, as visions of the inflationary 1970s still loom large in some policymakers' minds. The Fed may end up being too slow in tightening policy and generate an overheated economy by accident, but the idea of purposefully engineering a temporary inflation overshoot is off the table. The hawkish shift in the consensus can be observed in the latest FOMC minutes. Not only did three members vote for a rate hike in September, but "several" members felt that a rate hike was a "close call". The remaining doves often point out that the Fed's preferred measure of inflation, core PCE, is still below the 2% target. However, this measure is an outlier; all other popular measures of underlying inflation are near or above 2% and are in a clear uptrend. Wage growth, although somewhat mixed across the various measures, is also trending up (Chart I-11). The doves already lost two members this year (Williams and Rosengren). More will jump ship if core PCE moves up in the coming months as we expect, although a 10% dollar appreciation by itself could shave almost a half point off of inflation next year (Chart I-12). Chart I-11U.S. Wage Pressure Is Growing bca.bca_mp_2016_11_01_s1_c11 bca.bca_mp_2016_11_01_s1_c11 Chart I-12The Inflation Impact Of Dollar Strength bca.bca_mp_2016_11_01_s1_c12 bca.bca_mp_2016_11_01_s1_c12 Recent data disappointments are a concern, but the bounce in both the ISM manufacturing and nonmanufacturing surveys in September, especially in the new orders components, is a sign that the soft patch will not endure. It would require a significant disappointment in the October and November payroll reports for the FOMC to stand pat at the December meeting. Beyond this year, our base-case outlook calls for five quarter-point rate hikes over 2017 and 2018, compared to only two rate hikes currently discounted in money markets. This forecast is uncertain because an even larger portion of the overall tightening in monetary conditions than we expect could come via the dollar. Indeed, there is a significant risk that dollar strength and Fed tightening sparks a correction in risk assets. The TINA phenomenon (There Is No Alternative) has forced many investors to take more risk they are comfortable holding. Valuations are also rich. This is the main reason why our investment recommendation is cautious, including only a benchmark allocation to equities in a balanced portfolio. We maintain that stocks will outperform bonds and cash on a 1-2 year horizon, although total returns will be depressed by historical standards. Moreover, we would not be surprised to see a 10% correction in the major equity bourses in the coming months. Investors with a short-term horizon should consider buying some insurance against this risk. What would it take for us to upgrade stocks to overweight? We would like to see significant fiscal stimulus in some combination of the U.S., Eurozone and Japan. It would be particularly bullish if the stimulus occurs outside the U.S., because a pickup in global growth would allow the Fed to tighten without driving the dollar significantly higher. This scenario would improve the outlook for equities inside and outside of the U.S. Finally, a 10% equity correction would create enough value that we would be quite tempted to upgrade the sector. Japan Prepares For The Next Step The dollar's ascent will be particularly acute versus the yen if we are right that more aggressive policy action looms in Japan. We argued in last month's Overview that fiscal stimulus will be particularly powerful in the context of the Bank of Japan's (BoJ) new policy framework. Instead of targeting a pace of asset purchases, the central bank is effectively fixing the yield curve by promising to hold the 10-year yield near to zero. By fixing the yield curve and by committing to maintain this policy until Japanese inflation moves above the 2% target, the BoJ is hoping to raise inflation expectations and drive down real bond yields. Fiscal stimulus in this environment would be quite effective because nominal yields would not be allowed to rise in response. Any increase in inflation expectations would flow directly into lower real yields and weaken the yen, thus reinforcing the initial thrust of fiscal policy. The timing and amount of additional fiscal spending is not clear, but the Japanese Diet is currently deliberating the third revision to the second supplementary budget. Government officials have signaled that there will be more coordination between monetary and fiscal policy in the future. The government is also debating ways to boost household income, including raising government wages, lifting the minimum wage and providing tax incentives for the private sector to be more generous on the wage front. Any efforts to boost income will add to upward pressure on actual inflation and inflation expectations. Given that the market is discounting inflation of only 0.26% per year on average over the next 20 years, the balance of risks favors an inflation rate that surprises to the upside. The resulting downward pressure on real interest rates, at a time when U.S. real rates will be rising, will depress the yen. Our currency experts expect the yen to weaken to 125 versus the dollar, representing a decline of roughly 10% in trade-weighted terms. We estimate that this would add about a half point to Japanese headline consumer price inflation next year (Chart I-12). A successful policy push would ultimately be quite bearish for JGBs. However, a critical element in the plan is that the BoJ prevents a premature rise in nominal yields. We do not expect any JGB selloff for at least a year. This means that, while total returns for JGBs will be poor (or negative for some maturities), the market will outperform the other major government bond markets in currency hedged terms if global yields rise in the coming months as we expect. The implication is that investors should favor JGBs over Bunds and, especially, Treasuries within global hedged bond portfolios. Also, stay long inflation protection in Japan, overweight the Nikkei and underweight the yen. Reason To Be Bond Bearish Chart I-13Reasons To Keep Duration Short bca.bca_mp_2016_11_01_s1_c13 bca.bca_mp_2016_11_01_s1_c13 Our fairly hawkish view on the Fed is a key factor behind our recommendation to keep duration slightly short of benchmark within bond portfolios. More broadly, the global deflation beast is far from tamed, but the firming in selected commodity prices is reducing some of the downward pressure on inflation in the advanced economies. Oil prices have breached $50/bbl on hopes that OPEC-Russia talks will result in production cuts. Our commodity strategists do not expect any agreement to have much of a lasting impact on oil prices. Indeed, there is a risk that oil prices correct if the talks ultimately fail. However, we still expect WTI to trade between $40 and $65/bbl until 2020. The annual growth rate for the continuous commodity index has reached positive territory for the first time since 2014, which is translating into a more positive pricing environment for manufactured goods and overall headline inflation rates for both developed and emerging economies (Chart I-13, bottom panel). This has given inflation expectations a boost in the major markets, at a time when output gaps in developed countries are narrowing (the gap is near to being fully closed in the U.S.). Several other factors favor a below-benchmark duration stance at least for the near term (Chart I-13): Global growth is improving slowly. The global leading economic indicator (LEI) is rising and our diffusion index shows that 10 of 15 countries have rising LEIs. We expect the U.S. economy, in particular, to surprise to the upside. The prospect of even a little fiscal stimulus is bond bearish, following years of austerity in the major developed countries. The downward pressure on global term premia is dissipating as the BoJ has switched away from quantitative targets for asset purchases to fixing the yield curve. The ECB is likely to extend the QE program by another six months, but the central bank is unlikely to lift the pace of purchases from the current level. The annual percent change in total central bank assets for the U.S., Euro Area, the U.K. and Japan is on the verge of peaking even assuming the ECB extends, which means that the period of maximum downward pressure on global term premia is over (Chart I-14). Chart I-14Liquidity Growth Peaking Out bca.bca_mp_2016_11_01_s1_c14 bca.bca_mp_2016_11_01_s1_c14 The market expects that real short-term interest rates will stay in negative territory until at least the middle of the next decade, even in the U.S. There is plenty of room for the forward yield curve to reprice higher if growth turns out to be better than expected. This is particularly the case in the U.K., where fears of a post-Brexit economic bust and a fresh shot of stimulus from Bank of England sent the pound and gilt yields to extremely low levels. Our global bond and currency services recommend taking profits on overweight gilt/underweight sterling positions, and shifting in the opposite direction. Finally, bond sentiment indicators are still bullish, particularly in the U.S. Treasury market. Nonetheless, we are far from frothing bond bears. We do not believe that the fixed income market has moved into a secular bear phase, and would likely shift to benchmark or even above-benchmark duration if the 10-year Treasury yield reached 2%. Yields could eventually re-test the year's lows if there is a sharp equity correction. This is a market to be traded for now. Conclusions A more upbeat view on global and, especially, U.S. growth prospects is positive for risk assets, but the adjustment process could be painful as investors come to grips with what this means for the Fed. Extremely low Treasury yields imply that the consensus has "bought into" the Secular Stagnation thesis for the U.S., or at least to the view that America will never again be able to grow above 2%. The pickup in growth we expect will arrive at a time when there is accumulating evidence of an acceleration in wages, signaling that the labor market has reached full employment. A shift in focus away from monetary and toward fiscal stimulus, both inside and outside the U.S., is also bond-bearish. The bond market appears to be ignoring these trends so far, although rising inflation expectations suggest that we may be at the edge of a change in market expectations for growth, inflation and the Fed outlook. A significant shift up in the dollar would limit the bond market selloff, and it would be positive for the major economies outside of the U.S. Nonetheless, a 10% dollar appreciation would carry its own risks, including a hit to the U.S. profit outlook. On its own, dollar strength would not prevent the S&P 500 from rising, but there is a non-trivial risk that it wreaks havoc in the EM and commodity space for a time, reverberating back into developed markets. The bottom line is that investors should remain focused on capital preservation, with no more than an overall benchmark weighting in equities with a bias toward defensive sectors. Within bond portfolios, keep duration on the short side and favor high-quality spread product to government bonds in the major countries. High-yield bonds would benefit from stronger-than-expected economic growth in the U.S., but value is poor and balance sheets are deteriorating; the risk/reward balance is unattractive. European investment-grade bonds issued by domestic issuers are more attractive than the U.S. market because of improving balance sheet health. Favor real-return bonds to conventional issues in the major countries and add exposure to floating-rate notes. Our dollar view means that base metals should be avoided, despite the fact that we expect that China will be able to stabilize growth at around 6-7%. Oil should be able to hold up in the face of dollar strength given that we expect a tightening oil supply/demand backdrop. Both gold and silver would weaken if the dollar continues to appreciate and real bond yields rise in the near term. Nonetheless, rising inflation should overwhelm these negatives in the medium term. This implies that precious metals deserve a strategic place in investors' portfolios, although the near-term could be rough. Finally, we have received many questions on the risks posed by mushrooming U.S. student debt. This month's Special Report, beginning on page 19, takes an in-depth look. We conclude that student debt is a modest economic drag, but is not a source of risk to the government's finances and does not represent the next "subprime" crisis. Mark McClellan Senior Vice President The Bank Credit Analyst October 27, 2016 Next Report: November 24, 2016 1 Please see The Bank Credit Analyst, "Herding Cats at the Fed," October 2016, available at bca.bcaresearch.com II. Student Loan Blues: Can't Repay What I Borrowed Incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages. Some are comparing this trend to the housing subprime crisis, arguing that student debt is a major drag on growth at a minimum, and the source of another financial crisis at worst. Delinquency rates have surged and the 5-year cumulative default rate on student debt has reached almost 30%. Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%. Sticker prices at most institutions have mushroomed, although few students pay the full fare. Rising tuition fees only explain about half of the surge in student debt. Education still pays, although the benefits have waned versus the costs. Moreover, students with debt lag significantly those with no debt in terms of wealth accumulation and home ownership after graduation. The rise in default rates have been due to the influx of non-traditional student borrowers after 2007, who come from lower income families and have had poorer educational and employment outcomes. However, the wave of such borrowers has faded, which means that overall delinquency and default rates will decline in the coming years. Debt service payments, while onerous for many families, are not a major drag on overall real GDP growth. The increased propensity of 18-35 year-olds to live with their parents has trimmed annual real GDP growth by 0.14% per year since 2007, although student debt is only one of many underlying causes. The student loan program is at worst only a minor drain on the Federal government's coffer because of the high recovery rate. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Student debt is not the next subprime. "We are not doing these young people any favors by giving them loans that they cannot afford, that they cannot discharge in bankruptcy, and that could be a drag on their financial well-being even into retirement". - Sheila Bair, former FDIC chief, Bloomberg interview, September 26, 2016 Ms. Bair was one of the first to warn about the risks posed by the U.S. subprime MBS market, well before Lehman went bust. Few were listening then, but more are listening now as she sounds the alarm bell regarding student loans. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages (Chart II-1). Ms. Bair notes that, like the MBS market before 2007, cheap and freely available credit is fueling prices (tuition in this case). Banks handed out mortgage loans to many who could not afford them in the 2000s, just as the Department of Education (DoE) is doing today with student loans. It is difficult to assess borrowers' ability to repay student loans. Some argue that the DoE is not even trying. The trajectory of student debt is indeed alarming (Chart II-2). In inflation-adjusted terms, the total value of loans outstanding has quadrupled since 2000, representing an annual average compound rate of 9.4%. The rise reflects both an increase in the number of borrowers and more borrowing per person. Average debt/person has jumped from $17,300 in 2007 to almost $28,000 in 2015 (amounts vary across data sources). Rising debt levels occurred across the family income distribution. Chart II-1Student Debt: The Next Subprime? bca.bca_mp_2016_11_01_s2_c1 bca.bca_mp_2016_11_01_s2_c1 Chart II-2Student Loan Statistics bca.bca_mp_2016_11_01_s2_c2 bca.bca_mp_2016_11_01_s2_c2 These figures understate the true debt levels because they include only loans that are made under the federal loan program, representing 81% of the total. The remainder are private loans, mostly originated by banks. Private loans do not enjoy the same borrower protection afforded to federal loans, and carry a significantly higher interest rate (average of almost 14% in 2016, compared to federal loan rates of 3.76%). The data on private loans are sparse due to limited reporting, but a study based on 2012 data showed that the average amount of debt for students with private loans was almost $40,000 at that time.1 Sticker Shock It is easy to blame rising tuition fees given soaring "sticker prices" at most institutions. The average posted fee for tuition and room & board has increased by 30% in inflation-adjusted terms since 2007 at public universities, and by 23% at private non-profit institutions (Charts II-3A & II-3B). However, due to grants, tuition discounts and tax credits for education, only a small fraction of students pay the posted rate. For the 2015/16 school year, the net price that the average student paid at a private non-profit institution was $26,400, far less than the almost $44,000 sticker price. Chart II-3ATuition & Fees: Public Institutions bca.bca_mp_2016_11_01_s2_c3a bca.bca_mp_2016_11_01_s2_c3a Chart II-3BTuition & Fees: Private Institutions bca.bca_mp_2016_11_01_s2_c3b bca.bca_mp_2016_11_01_s2_c3b Chart II-4The Distribution Of Student Debt November 2016 November 2016 The Brookings Institute estimates that only about 50% of the escalation in student debt in the past two decades can be explained by rising tuition costs.2 Another quarter reflects rising educational attainment; kids are staying in school longer to get a leg up in the highly competitive workplace. The remainder of the total rise in debt was left unexplained in the study. Other possible contributing factors include policy changes that expanded eligibility for federal loans programs, and the housing bust that made it more difficult for families to borrow against the value of their homes for education purposes. There was also a change in the background characteristics of borrowers after the Great Financial Crisis (see below). The share of students suffering with an extraordinary amount of debt is growing, although they still represent a small portion of the total for federal loans (Chart II-4). Five percent of student debtors owe more than $100,000 each, up from 2% in 2007. Another 10% hold between $50,000 and $100,000. About two-thirds of student borrowers owe less than $25,000. A Student Debt Crisis? Another Brookings paper provides estimates for the debt service burden associated with federal student loans. The burden is calculated as the median debt service payment divided by median earnings of employed borrowers for two years after entering the repayment period (Chart II-5).3 This ratio rose from about 4½% in 2004 to 7.1% in 2013. Unfortunately, more recent data are not available. The average interest rate on the outstanding loans has moderated since 2011, although not nearly as quickly as the drop in market interest rates.4 Nonetheless, the continued escalation in the stock of debt per person in recent years means that the debt service-to-income ratio has likely continued to escalate since 2013, despite the moderation in the average interest rate paid. The jump in student loan delinquencies has raised red flags regarding the number of borrowers in financial distress, feeding concerns that a student loan debt crisis is on the horizon. The 90-day delinquency rate for student loans has increased from about 7% in 2007 to 11% in 2012, where it has hovered ever since according to the Federal Reserve Bank of NY data (Chart II-1). However, since only about 55% of all loans are in the repayment period, the actual delinquency rate among those in repayment is almost double the official figures. Loans are considered to be in default when they are more than 270 days past due. Brookings estimates that the 5-year default rate for student loans entering the repayment period five years earlier reached 28% in 2014, up from 16% for the five-year period ending in 2007 (Chart II-6).5 Perhaps surprisingly, the default rate is still far below the peak rate of more than 40% in the late 1990s. Chart II-5Debt Service Burden Is Rising bca.bca_mp_2016_11_01_s2_c5 bca.bca_mp_2016_11_01_s2_c5 Chart II-6Defaults Are Rising bca.bca_mp_2016_11_01_s2_c6 bca.bca_mp_2016_11_01_s2_c6 Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%.6 This is because borrowers are not able to discharge federal student debts during bankruptcy. Congress has passed legislation making it very difficult for borrowers to avoid repaying. The DoE has the authority to use a number of extraordinary collection means. These include garnishing a portion of borrower's wages or seizing any payment a borrower may receive from the federal government. Education Still Pays, But Not For Everyone Chart II-7Debt And Wages For 20-40 Year Olds bca.bca_mp_2016_11_01_s2_c7 bca.bca_mp_2016_11_01_s2_c7 The good news is that education still pays for the average or median borrower. Chart II-7 shows that, while the average amount of student loans has escalated, it is still well below the average wage for those borrowers in the 20 to 40-year age group.7 The gap between wages and debt has narrowed over the past 15 years, but the increase in lifetime earnings potential still far exceeds the rise in accumulated debt for the average or median student. Of course, student loans have not paid off for everyone. News reports have highlighted plenty of examples of students that have graduated with crushing debt burdens and poor job prospects. Nonetheless, the Brookings study found that, for the vast majority, "the increase in borrowing would be made up for relatively early in the career of a worker with mean earnings".8 The Digest of Education Statistics show that, in 2013, the median annual earnings for full-time workers with a Bachelor's degree in the 25 to 34 age group was $48,530, compared with $30,000 for workers with just a high-school diploma. The bad news is that it is taking much longer to repay these debts. The mean term of repayment has increased from 7½% in 1992 to about 13½ years in 2010.9 Extended repayment and income-driven repayment plans can increase the loan term to 20, 25 or even 30 years. In some cases, borrowers will still be paying for their education when their children enter college!10 There is also evidence that the debt burden is causing some young adults to delay marriage and live with their parents for longer than they otherwise would. More Debt And Less Wealth Young student debtors also lag significantly relative to their peers in terms of wealth accumulation. A Pew Research Center study found that households headed by a young, college-educated adult without any student debt obligations have about seven times the typical net worth ($64,700) of households headed by a young, college-educated adult with student debt ($8,700; Chart II-8).11 Net worth is lower for those with student loans not just because their overall debt levels are higher; the value of their assets trailed as well. This gap is despite the fact that those households with a degree had almost double the annual income of those in the study that did not. Even comparing only households headed by young adults that did not attain a degree, accumulated wealth for those with student debt fell far short of those who avoided debt. One explanation is that money being absorbed by student debt repayment is unavailable to accumulate assets. A Federal Reserve Bank (FRB) of Boston study12 estimated that a 10% increase in student loan debt per household is associated with a 0.9% decline in the value of total wealth. Student loan burdens also mean that households end up relying more on other types of debt, such as auto loans and credit cards, according to the Pew study. Chart II-8Higher Debt, Lower Wealth... November 2016 November 2016 Table II-1...And Lower Homeownership November 2016 November 2016 Student debtors are also less likely to own a home after 2009 (Table II-1). Before 2009, the FRB of Boston study found that 30-year olds with a history of student loans had a higher homeownership rate than those without student debt. This makes sense because the boost to household income from obtaining more education should make it easier to quality for a mortgage. However, the relationship between student debt and homeownership switched after the Great Recession. The economy-wide homeownership rate has fallen sharply since home prices peaked in 2006, but the drop was more severe for those with student loans. This is probably due to the erosion in future income expectations following the recession for those with student debt, as well as more limited access to additional credit based on these individuals' existing debt loads (i.e. lower credit scores). Alternatively, student debtors may simply be reluctant to add to their overall leverage in light of the more uncertain economic outlook. A Fed study estimated that every 10% increase in student debt per person now results in a 1 percentage point drop in the homeownership rate for the first five years after graduation.13 Non-Traditional Borrowers Led The Surge In Delinquencies... While student debt burdens are unlikely to ameliorate anytime soon, the default rate should moderate in the coming years. Brookings (2015) conducted a detailed assessment of the characteristics of student loan borrowers and how they changed after 2007, by matching administrative data on federal student borrowers with earnings data from tax records. The study split the sample into "traditional" and "non-traditional" borrowers. Traditional borrowers are defined to be those attending 4-year public and private institutions because they tend to be typical in nature; they start college in their late teens, soon after completing high school, are dependent on their parents for aid purposes, pursue 4-year degrees and, frequently, head on to graduate study. This group historically represented the majority of federal borrowers and loan amounts. Non-traditional borrowers historically made up only a small portion of the total. These are defined to be those borrowing for 2-year programs (primarily community college) or to attend for-profit schools. The study found that non-traditional borrowers have largely come from lower-income families, tended to be older (i.e. not supported by parents), attended institutions with relatively low completion rates and faced poor labor market outcomes after leaving school (Chart II-9). Lower median wages and higher rates of unemployment meant that non-traditional borrowers tended to default on their student loans at a higher rate than traditional students. Student borrowing is counter cyclical; it tends to accelerate during recessions as unfavorable labor market conditions encourage people to return to school or to stay in school longer. The flow of new borrowers accelerated particularly sharply during the Great Recession, as intense pressure on State budgets led to cuts in scholarships by public institutions. Access to alternative credit markets was also curtailed during and after the Great Financial Crisis. Chart II-9Non-Traditional Students Had Poor Labor Market Experience November 2016 November 2016 Chart II-10Surge In Non-Traditional ##br##Borrowers After 2007 bca.bca_mp_2016_11_01_s2_c10 bca.bca_mp_2016_11_01_s2_c10 Student loan inflows (i.e. the number of new borrowers) and outflows (the number paying off loans) are shown in Chart II-10. Inflows trended higher from 2000 to 2007, while outflows were fairly flat, leading to an upward trend in the net inflows. Inflows subsequently surged during the recession, reaching a peak in 2010. The jump in new borrowers was concentrated among non-traditional students. The number of non-traditional borrowers grew to represent almost half of all new borrowers soon after the recession. The wave of students who had begun to borrow during the recession entered the repayment period in increasingly large numbers from 2011 to 2014. The early years of repayment are the most precarious because debtors are just starting their careers and their earnings are the most variable. The rise in the share of non-traditional borrowers largely explains the surge in the overall default rate since 2011. In contrast, the majority of traditional borrowers have experienced strong labor market outcomes and relatively low rates of default. Of all the students who left school, started to repay federal loans in 2011, and had fallen into default by 2013, about 70% were non-traditional borrowers. ...But The Worst Is Over The situation has since begun to reverse. Inflows and the net change in the number of borrowers has declined since 2012, particularly at 2-year and for-profit institutions. The moderation of the pace of inflows, the change in the composition of borrowers (less non-traditional), and efforts by the DoE to expand the use of income-based repayment programs will put downward pressure on delinquency and default rates in the coming years. Economic Impact Of Student Debt There are several channels through which rising student debt can affect overall economic growth. Spending by households with student debt will be curtailed both by the need to service the loans and by the fact that these households have lower levels of net worth. They are also less likely to own a home or form a small business. (1)Debt Service Burden And The Wealth Effect Table II-2 presents estimates of the value of aggregate debt service payments as a percent of GDP. This is based on the median debt service-to-earnings estimates from the Brookings Institute and median income for households where the head is less than 35 years of age in the Survey of Consumer Finances. If we assume that every dollar paid to service student loans is a dollar not spent on goods and services, then Table II-2 implies that the resulting drag on the level of real GDP has doubled from 0.17% of GDP in 2004 to 0.34% in 2013 (latest year available). However, it is the increase over time that matters for GDP growth, not the level. The rise of 0.17% was spread over nine years, suggesting that the drag on GDP growth was minimal. Moreover, this represents an overestimate of the actual drag, because households with student debt have leaned more heavily on other types of debt in an attempt to maintain their living standards. Table II-2The Debt Service Drag On GDP November 2016 November 2016 Lower levels of asset accumulation and net worth will also undermine consumer spending. However, we believe that accounting for both the "wealth effect" and the debt-service effect on GDP would be double counting. Chart II-11Spending On Education ##br##Not A Growth Driver bca.bca_mp_2016_11_01_s2_c11 bca.bca_mp_2016_11_01_s2_c11 Education spending also provides a possible offset to the negative impact of debt service on GDP growth. However, in terms of household spending on education, in inflation-adjusted terms there has been virtually no growth in consumer spending on higher education over the past 15 years despite all the extra spending in nominal dollars (Chart II-11). Data on government spending specifically on higher education is not available, but spending on all levels of education including primary and secondary schools has declined as a fraction of real GDP since the early 2000's. The implication is that total spending on higher education by households and governments has not provided any offset to the drag on GDP growth from student debt since 2007. (2)Housing Market Earlier, we cited Fed estimates that every 10% increase in student debt per person results in a 1 percentage point drop in the homeownership rate for the first five years after graduation. The economy-wide homeownership rate has fallen by 5.5 percentage points since the beginning of 2007, reaching 62.9% in the second quarter of 2016. We estimate that rising student indebtedness could account for as much as 1½ percentage points of the total 5½ percentage point drop. This is based on the Fed's estimates, the rise in the share of student loan borrowers among the total number of households and the increase in student debt-per-person. Again, this estimate likely overstates the impact because we are implicitly assuming that every new student borrower since 2007 ultimately forms a new household upon graduation. Undoubtedly, a portion of student borrowers formed a household with other student borrowers. Even if this estimate is close to the truth, it is not clear that there is a large impact on GDP growth. The formation of new households will result in an expansion in the housing stock one-for-one (assuming no change in inventories). Whether they decide to rent or buy, this will boost the residential investment portion of GDP. Buying a home or condo often results in home renovation and purchases of new furnishings, thus providing the economy with a larger boost compared to new households that rent. Nonetheless, the difference is difficult to estimate and is probably small enough to ignore. Another way to approach the issue is to gauge the impact on the housing market of the greater propensity of 18-35 year olds to live with their parents. Those living at home jumped from 19.2 million in 2007 to 23.0 million in 2015. The proportion of those living at home of the total population of 18-35 year olds rose from 28% to 32%. If the ratio had not increased over the period, it would have resulted in an extra 2½ million young people leaving home. If we assume that one-quarter of them move in with someone else who is also leaving home, then it would result in an increase in the housing stock of more than 1.8 million units since 2007 (condos or single family homes). We estimate that the resulting boost to residential construction growth would have added an average 0.14 percentage points to real GDP growth each year since 2007. Of course, it is not clear how much of the "living at home" trend is due to student loans as opposed to low earnings or poor job prospects. This estimate thus overstates the direct impact of student loans on the housing market. Nonetheless, it is instructive that the living-at-home phenomenon has been a non-trivial drag on economic growth via new home construction. (3) New Business Creation Academic research has also linked rising student indebtedness to a slower pace of new business creation. Research by the Federal Reserve Bank of Philadelphia points out that approximately 60% of new jobs in the private sector are created by small business.14 The U.S. Small Business Administration states that small firms receive approximately three-quarters of their capital needs in the form of loans, credit cards and lines of credit, which often have a personal liability attached. Having student loans reduces one's debt capacity and thus the ability to obtain small business loans. The Fed study compared student loan data and new business formation across U.S. counties. The Fed estimates that an increase of one standard deviation in student debt results in a decrease of 70 in the annual pace of new small business creation, representing a decline of approximately 14½%. Chart II-12 shows the inverse correlation between student debt and new business formation across U.S. states. Chart II-12Student Debt Hinders Small Business Creation November 2016 November 2016 The impact of a slower pace of new business creation on overall economic growth is unclear. A student that does not create a new business for whatever reason will likely end up working for an already existing company that is growing, expanding the supply side of the economy anyway. True, small businesses create a lot of jobs, but they lose a lot too because the failure rate for these firms is high in the early years. Some claim that the less vibrant new business environment since 2007 reflects a less dynamic economy, helping to explain the dismal productivity record since that time. However, this flies in the face of the fact that the small business sector is less productive overall than large businesses. Chart II-13 demonstrates that there is a rough correlation between the new firm creation rate and real GDP growth per capita at the state level. However, it is not clear which one is driving the other. Our sense is that, while a less vibrant new business backdrop likely contributed to the poor post-Lehman economic record, it is far from the major driving factor. Chart II-13GDP Growth And Small Business Creation: Which One Is The Driver? bca.bca_mp_2016_11_01_s2_c13 bca.bca_mp_2016_11_01_s2_c13 (4) The Federal Budget Could the surge in delinquency rates wind up costing the taxpayer a bundle? Eighty percent of all student loans are either made directly by or are backed by the federal government, generating a potentially large contingent liability. Fortunately for the taxpayer, the recovery rate on student loans is extremely high. Moreover, the Federal government makes money on the spread between the student loan rate and the rate at which it finances these loans (Treasury yields). Congress sets the loan rates and they are kept well above Treasury yields. Under Congressional accounting rules, the cost of a student loan is recorded in the federal budget during the year the loan is disbursed, taking into account the amount of the loan, expected payments to the government over the life of the loan, and other cash flows, all discounted to the present value using interest rates on U.S. Treasury securities. By this accounting rule, the Congressional Budget Office estimates that the Federal government will make a net profit of almost $200 billion over the 2013-2023 period.15 However, a more reasonable "fair value" accounting method, which includes the costs of collection and other items, shows that the student loan program will cost the taxpayer roughly $100 billion over the same period. Either way, the bottom line is that the student loan program is at worst only a minor drain on the Federal government's coffer. Delinquency and default rates are likely to moderate in the coming years. But even if default rates were to surge to new highs for some reason, the recovery rate is so elevated that the impact on the Federal budget balance would be lost in the rounding. Conclusion It seems clear that incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. There has been a vicious circle in which increased federal loan limits supported institutions' ability to raise tuition fees, resulting in a greater need for federal loans. Some for-profit institutions have been criticized for offering shoddy education, for graduating too many students in disciplines for which job prospects are poor, and for encouraging students to load up on high-cost debt. The U.S. spends almost 80% more per pupil on higher education than the OECD average, and yet some argue that this has not resulted in better educational outcomes. The social impact of student leveraging is clearly negative. The benefits of education have narrowed relative to the costs. Financial stress has increased along with debt service burdens, especially for non-traditional borrowers, and repayment periods have been extended to an average of over 13 years. These trends have caused young people to delay marriage and home purchases. This is a serious political and social issue that needs to be addressed. That said, we do not agree with Ms. Bair that student debt is the next "subprime" crisis. Delinquency and default rates are likely to fall in the coming years. These loans have not been packaged into opaque financial instruments and distributed throughout the investment world. The vast majority of the loans are federally backed and the recovery rate is very high. Even if there is a wave of mass defaults, the federal deficit might rise slightly but there is no channel through which the shock can propagate through the financial system. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Mark McClellan Senior Vice President The Bank Credit Analyst 1 "Student Debt and the Class of 2015," Annual Report of the Institute for College Access & Success, October 2016. 2 Beth Akers and Matthew Chingos, "Is a Student Loan Crisis on the Horizon?" Brown Center on Education Policy at Brookings, June 2014. 3 Adam Looney and Constantine Yannelis, "A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults," Brookings Papers on Economic Activity, Fall 2015. 4 Most federal student loans are at a fixed rate set by Congress. 5 Brookings (2015). 6 http://www.edcentral.org/edcyclopedia/federal-student-loan-default-rate… 7 The data are only available to 2010, but we have estimated figures to 2013. 8 Brookings (2014). 9 Brookings (2014). 10 Student loans generally have a 10-year term, but loans consolidated with the federal government are eligible for extended repayment terms based on the outstanding balance, with larger debts eligible for longer repayment terms. 11 "Young Adults, Student Debt and Economic Well-Being," Pew Research Center, May 14, 2014. 12 Daniel Cooper and J.Christina Wang, "Student Loan Debt and Economic Outcomes," Federal Reserve Bank of Boston, October 2014. 13 Alvaro Mezza, Daniel Ringo, Shane Sherlund and Kamila Sommer, "On the Effect of Student Loans on Access to Homeownership," Finance and Economic Discussion Series of the Federal Reserve Board. 2016-2010. 14 Brent Ambrose, Larry Cordell, and Shuwei Ma, "The Impact of Student Loan Debt on Small Business Formation," Federal Reserve Bank of Philadelphia Working Paper, July 2015. III. Indicators And Reference Charts Equity markets ended the month slightly lower as investors come to grips with the economic and profit implications of the pending Fed rate hike and Brexit. While TINA is still in play, caution abounds, as highlighted by waning investor sentiment and continued weakness in our Equity Technical indictor. Rising bond yields and a stronger dollar contributed to a weakening in our Monetary Indictor, trends that no doubt contributed to the overall diminished appetite for risk over the month. Our Equity Valuation Indicators have improved somewhat, but still remain in overvalued territory. Net earnings revisions have become constructive and positive earnings surprises increasingly outpaced negative ones. Despite this, we would need to see a close to 10% price depreciation for U.S. equities to appear attractive, as outlined in Section 1. Our Willingness-to-Pay (WTP) indicators continue to send a positive message for stock markets. These indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors often say they are bullish but remain conservative in their asset allocation. At the moment, the low levels of the WTP indicators suggest that flows have been stronger into bonds than into stocks. From a contrary perspective, this means that there is "dry powder" available if investors decide to move more aggressively into equity markets. The U.S. and Eurozone indicators appear to have bottomed out last month and continue their ascent. This should be bullish for both U.S. and Eurozone equities. The U.S. dollar notched a strong month with a gain of more than 3%. This has tightened financial conditions as can be seen in the decline of our Financial Conditions Index. The deviation from its 12-month moving average is even more pronounced, turning negative after several months of treading water in "easing" territory. Our Dollar Composite Technical indicator displayed a violent move higher, but has yet to breach a level consistent with previous episodes of overextension; the USD can rally further. The yen is showing signs of entering an extended period of depreciation. Net speculative positions are extremely elevated and the 40-week rate of change appears to have formed a trough, rebounding from all-time lows. In a similar vein, the euro is also displaying weakness as its 40-week rate of change is crossing into negative territory. As outlined in Section 1, we expect a 10% appreciation in the U.S. dollar, a 10% depreciation in the yen and a 5% depreciation of the euro in trade-weighted terms. The commodity complex ended the month flat, with a more robust global growth backdrop offsetting the negative impact of a strong U.S. dollar and higher rates. While the advance/decline line ticked up, a positive sign for a potential broad-based gain across currencies, gold had a less than stellar month. The outsized impact of financial variables (U.S. dollar strength and higher real rates) on the yellow metal led to a more than 5% price decline. Our Commodity Composite Technical Indicator surged deeper into overbought territory, indicating that it might be time to take some risk off the table. The balance of risks for commodities excluding oil is to the downside. As mentioned in Section 1, an appreciating U.S. dollar and elevated yields will eventually feed through to weakness in the space. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-5U.S. Earnings U.S. Earnings U.S. Earnings Chart III-6Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-7Global Stock Market ##br##And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-8U.S. Treasurys And Valuations U.S. Treasurys and Valuations U.S. Treasurys and Valuations Chart III-9U.S. Treasury Indicators U.S. Treasury Indicators U.S. Treasury Indicators Chart III-10Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1110-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-12U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-13Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-14Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-15U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-16U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-17U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-18Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-19Euro Technicals Euro Technicals Euro Technicals Chart III-20Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-21Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-22Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-23Commodity Prices Commodity Prices Commodity Prices Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-26Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-27U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-28U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-29U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-30U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-31U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-32U.S. Consumption U.S. Consumption U.S. Consumption Chart III-33U.S. Housing U.S. Housing U.S. Housing Chart III-34U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-35U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-36Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-37Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China

Highlights The perceived shape of Brexit is the single most important driver of the pound and most U.K. assets. The U.K. Courts are due to deliver landmark legal rulings, which have huge implications for the perceived shape of Brexit. Expect an eventual soft Brexit if the Courts decide against the U.K. government and deem that triggering Article 50 requires parliamentary approval. Expect a much harder Brexit if the Courts decide in favour of the U.K. government. Tactical investors should consider owning some very short-term call options on pound/dollar or a combination of call and put options. Feature Within the next two weeks, the U.K. High Court will deliver a landmark legal ruling which will have huge implications for the future of the U.K. and Europe. Chart of the WeekDifferent Levels Of Brexit Mean Different Levels Of The Pound bca.eis_wr_2016_10_27_s1_c1 bca.eis_wr_2016_10_27_s1_c1 The U.K. High Court will rule whether Prime Minister Theresa May can start the legal process to exit the EU using the so-called 'royal prerogative' - the power granted to governments to make decisions without a vote from parliament. If May cannot use the royal prerogative, she will require an Act of Parliament to trigger Article 50 of the Lisbon Treaty. The High Court judgement hinges on a fundamental issue. Triggering Article 50 necessarily means that the current government will overturn previous parliamentary decisions - the European Communities Act (1972) and European Union Act (2011). Does the constitution permit a government to overturn parliamentary decisions, take away treaties, and remove the population's legal rights without obtaining parliamentary approval? Although we are not legal experts, the court could regard that as overstretching government authority. If the High Court's judgement does go against the U.K. government, expect pound/dollar to rally immediately by about 4-5 cents. Conversely, a judgement in favour of the government could see the pound sell off by about 1-2 cents. Given the possibility of this gapping, tactical investors should consider owning some very short-term call options on pound/dollar, or a combination of call and put options. Nevertheless, the story will not end with the High Court. Whichever side loses will appeal the decision and take the case to the Supreme Court, which is expected to respond by the end of the year. This ultimate pronouncement of law will have a landmark bearing on the shape of Brexit and, thereby, the future of the U.K. and the other EU 27. Where Is The Pound Headed Longer-Term? For investors, the spectrum of Brexit possibilities - no Brexit, 'soft' Brexit, 'hard' Brexit, or 'very hard' Brexit - will be the single-most important driver of the pound, and by extension, other U.K. assets. Of course, U.K. asset prices ultimately depend on economic and financial fundamentals. But Chart I-2, Chart I-3, Chart I-4, Chart I-5, Chart I-6, Chart I-7 illustrate that by far the most important fundamental for all U.K. assets right now is the perceived hardness of Brexit, as captured in the pound's value. Chart I-2Harder Brexit Means The Eurostoxx600 ##br##Underperforms The FTSE100... bca.eis_wr_2016_10_27_s1_c2 bca.eis_wr_2016_10_27_s1_c2 Chart I-3...And The FTSE250 ##br##Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 ...And The FTSE250 Underperforms The FTSE100 Chart I-4Harder Brexit Means U.K. ##br##Goods Exporters Outperform... bca.eis_wr_2016_10_27_s1_c4 bca.eis_wr_2016_10_27_s1_c4 Chart I-5Harder Brexit Means ##br##Retailers Underperform... bca.eis_wr_2016_10_27_s1_c5 bca.eis_wr_2016_10_27_s1_c5 Chart I-6...Travel And Leisure Underperforms... bca.eis_wr_2016_10_27_s1_c6 bca.eis_wr_2016_10_27_s1_c6 Chart I-7...And Real Estate Underperforms bca.eis_wr_2016_10_27_s1_c7 bca.eis_wr_2016_10_27_s1_c7 Pound/dollar has (so far) traded at three distinct levels, based on three distinct levels of perceived Brexit severity: near 1.50 before the Brexit vote; near 1.30 after the Brexit vote but perceiving a soft Brexit; and near 1.20 after Theresa May announced that she would trigger Article 50 by next March and was contemplating a hard Brexit (Chart of the Week). Hence the (post-appeal) outcome of the legal case against the government carries great significance. If the government loses, and requires a parliamentary vote to trigger Article 50, several consequences follow. Theresa May's end-March deadline for firing the Brexit starting gun would become very difficult to meet, severely delaying the whole process. Would the government even win a parliamentary majority? If in doubt, would the government call a snap General Election to try and beef up its majority? The current batch of parliamentarians has a strong bias for staying in the EU, but it would be difficult to fly in the face of the referendum result. On the other hand, the checks and balances of parliament are there precisely to stop the country walking over the cliff-edge that a very hard Brexit would be. All the while, with investment slowing and higher inflation from the weaker pound squeezing household real incomes, the economic headwinds from the U.K.s limbo status would be becoming more apparent. Given the high stakes and likely irreversibility of the formal legal process, parliamentarians would rightfully want to examine and approve the U.K.'s negotiating hand. It seems that Parliament would almost certainly water down or delay Brexit before voting it through. Hence, if the government loses its legal case after appeal, Brexit will likely end up in a soft form. And pound/dollar will ultimately elevate to 1.35. Conversely, if the government wins its legal case after appeal, Theresa May will be on course to trigger Article 50 early next year, as promised. At which point, the EU 27's optimal game-theoretical first play is to be very aggressive - effectively opening with a very hard Brexit offer as described in the next section. Whereupon, pound/dollar would find its fourth, even lower, new level: near 1.10. Two Myths About Brexit It is important to debunk a couple of common myths about Brexit. First, that the U.K.'s current position as the EU 28's second largest economy will force the remaining EU 27 to give the U.K. a special status - allowing access to the three freedoms of goods, services, and capital but with controls on the fourth freedom of movement: people. This belief is misplaced. The biggest worry for the EU 27 is that a special status for Britain could catalyse other countries, under populist pressure, to ask for equivalent deals. The EU 27 does not want to give Marine Le Pen the opportunity to say "let's follow the Brits, they've negotiated a great deal." Hence, the U.K. will not get special treatment. Quite the contrary, it must be seen to be paying a substantial price for Brexit. Even for Anglophile Angela Merkel, protecting the indivisibility of the four freedoms and the integrity of the EU is the overriding priority. If the U.K. restricts free movement of people, it almost certainly means a hard Brexit: substantially restricted access to the single market. The U.K. would then have to negotiate a free trade agreement (FTA) with the EU. Given the current difficulty that Canada is experiencing in negotiating a FTA, this might not be a straightforward process for the U.K either. Furthermore, as a FTA does not usually cover services, it would handicap the services-heavy U.K. economy, while perfectly suiting the goods-heavy German economy. A second common belief is that the pound will act as an automatic economic stabilizer. That irrespective of a very tough deal from the EU 27, a weaker sterling will soothe the pain of a very hard Brexit by making British exports more competitive. Granted, the weaker pound will boost the demand for the U.K.'s goods exports. But total U.K exports are much less sensitive to devaluations compared to when the pound tumbled out of the Exchange Rate Mechanism in 1992. Then, just a quarter of the U.K's exports were services; today that proportion is approaching a half (Chart I-8) With the exception of tourism, these services tend to be high value-added financial and business services. Cutting their price will not significantly boost the demand for them. Chart I-8Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Almost Half Of U.K. Exports Are Services Meanwhile, U.K. consumers will feel distinctly poorer as the sterling prices of food and energy rise (Chart I-9), squeezing real household incomes and spending. In turn, this will leave the Bank of England with a major headache. How best to support real spending: defend the plunging pound to keep a lid on food and energy prices, or cut interest rates? Chart I-9Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Higher Sterling Prices For Food And Energy Will Squeeze Real Incomes Investment Reductionism For U.K. Assets The charts throughout this report show that the strategy for many U.K. investments reduces to an overriding question. Will the U.K largely retain access to the single market, defining a soft Brexit? Or will the U.K. largely lose access to the single market, defining a hard Brexit? In a soft Brexit: Sterling would rally 10%, taking pound/dollar to 1.35. The Eurostoxx600 and S&P500 would outperform the FTSE100. Within U.K. equities, sterling earners would outperform dollar earners, favouring small and mid-cap over large cap. The FTSE250 would outperform the FTSE100. The heavily domestic-focused retailers, travel and leisure, and real estate sectors would outperform the market. Goods exporters, such as the apparel sector would become less competitive and underperform the market. In a hard Brexit, expect the exact opposite of the above. Pound/dollar would slump 10% to 1.10, and so on. To determine which strategy to follow, await the post-appeal Supreme Court judgement on how Article 50 must be triggered, due at the end of the year. If Article 50 requires parliamentary approval, expect a soft Brexit. If it doesn't require parliamentary approval, expect the Brexit game theory to become hard and aggressive. Right now this is a coin toss, but forced to choose, we expect events may eventually prevent a damaging hard Brexit. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com Fractal Trading Model* This week's trade is another commodity pair trade: long copper / short tin. 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 10 Long Copper / Short Tin Long Copper / Short Tin * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c1 bca.eis_wr_2016_10_27_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c2 bca.eis_wr_2016_10_27_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c3 bca.eis_wr_2016_10_27_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_10_27_s2_c4 bca.eis_wr_2016_10_27_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c5 bca.eis_wr_2016_10_27_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c6 bca.eis_wr_2016_10_27_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c7 bca.eis_wr_2016_10_27_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_10_27_s2_c8 bca.eis_wr_2016_10_27_s2_c8

Dear Client, I am on the road visiting clients in Toronto, Chicago, and Wisconsin this week, and as such there will be no regular Weekly Report. Instead, we are sending you a Special Report written by my colleague Marko Papic, Chief Strategist of BCA's Geopolitical Strategy service. In this report, Marko argues that Hillary Clinton has not yet sealed the election, despite her high odds of winning. I hope you will find this report both interesting and informative. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights Clinton has a 65.5% chance of winning the presidency. A Trump win requires a surprise - such as in voter turnout. Still, we doubt Trump can punch more than 3% above his polling. Regardless of the outcome, multinational corporate profits will suffer. Go long the USD. Feature With the conclusion of the final presidential debate on October 19, the U.S. election is now in its final inning. Donald Trump's chances of mounting a comeback are slipping away (Chart 1). Could there be a Brexit-like surprise for the markets on November 8? And what are the investment implications of this year's unprecedented election? Chart 1 How Trump Can Still Win... Paddy Power, one of the world's biggest bookies, has begun to pay out bets to people who had wagered on Secretary Hillary Clinton winning the election. Meanwhile, according to Nate Silver, America's statistical Geek-in-Chief, Donald Trump has a meager 13.7% chance of winning the election.1 While our own model gives Clinton a 65.5% chance of winning, we have not forgotten Yogi Berra's wisdom: "It ain't over till it's over." There are three reasons why we would have held onto the pay-outs if we ran Paddy Power: Turnout assumptions could be wrong: Silver's quant model - and ours - is based on the assumption that the publically available opinion polls are high-quality data points. To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." The problem is that this method is mathematically the same as combining bad mortgages into securities. The idea 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.2 If there is a bias that is common to a large part of the data, then you are in real trouble. And why would there be a bias in election polls? For one, polling is not a science. It is an art. To extrapolate the results of an opinion survey of ~1,000 individuals to the general election of ~130 million people, polling professionals have to make turnout assumptions that are based partly on previous elections and partly on guesswork. This year, these assumptions are notoriously difficult to make as both candidates are extremely unpopular (Chart 2). This is bound to throw off pollsters' assumptions and may partially explain the regular gyrations that can be gleaned in Chart 1. For Secretary Hillary Clinton, the problem is compounded by the fact that she requires a high turnout to win. She needs the "Obama Coalition" of minorities and Millennial voters to show up as they did for President Barack Obama in 2008 and 2012. But we know that she struggled with the latter, with Senator Bernie Sanders picking up 70% of the youth vote in the Democratic primaries (Chart 3). If the 2016 turnout resembles the turnout from mid-term elections - which Republicans have generally won this century - then Trump could still have a chance. Chart 2 Chart 3 People may be lying: Another concern for Clinton is that she may be the 21st century Tom Bradley. Bradley was an African-American Mayor of Los Angeles who lost the 1982 California governor's race despite being ahead in the polls right up until election day. The "Bradley effect" theory goes that white voters lied when answering the polls in 1982 for fear of appearing racially prejudiced. Today, voters may be telling pollsters what they think is "politically correct," thus favoring Clinton in the polls. In the same vein - but ideologically opposite - the former Imperial Wizard of the Knights of the Ku Klux Klan, David Duke, outperformed expectations in both the 1996 U.S. Senate election and the 1999 special election for Louisiana's First Congressional District. He lost both elections, but he managed to garner double-digit support both times. More recently, the June 23 Brexit vote surprised markets. In our view, investors and betting markets underestimated Brexit largely in spite of polls, which had been close throughout the campaign stage (Charts 4 and 5). BCA's Geopolitical Strategy outlined the case for why the probability of Brexit was much higher than the market assumption as early as March.3 Our concerns began to manifest in the polls with the "Leave" camp comfortably ahead throughout June. And then, from June 16 (one week before the vote) to June 23, the "Stay" vote surged ahead in the polls, garnering a 4% lead the day before the election. This surge in the last week was clearly false, as the "Leave" camp won by a 3.8% margin, a 7.8% swing on the day of the election. So, what happened? The vertical line in Chart 5 shows the day that Member of Parliament Jo Cox was murdered by a British ultra-nationalist. Our guess is that the stunning political assassination - an extremely rare event in the U.K. - created a "Cox effect" in the Brexit polling. Those who were polled may have mourned for Cox, or resisted being associated with the extreme views of a self-professed neo-Nazi, yet they silently stuck to their legitimate concerns regarding EU membership on the day of the referendum. Chart 4Online Betting Got Brexit Wrong... bca.gps_sr_2016_10_21_c4 bca.gps_sr_2016_10_21_c4 Chart 5...So Did Prominent Opinion Polls bca.gps_sr_2016_10_21_c5 bca.gps_sr_2016_10_21_c5 The Brexit example illustrates that lying to pollsters is not something that only happens in the past. It has happened as recently as June. Given Donald Trump's controversial statements - and particularly his misogynist rants going back to 2005 - American voters may be lying to pollsters when it comes to their choice for president. Chart 6Media Narratives Are Cyclical bca.gps_sr_2016_10_21_c6 bca.gps_sr_2016_10_21_c6 Media narratives: As our geopolitical team has stressed throughout this election, the news media work through narratives (Chart 6). These narratives appear to have influenced polls, leading to regular gyrations in support levels for the two candidates. Will the media have another "comeback kid" narrative for Trump in store ahead of the election? It cannot be discounted. And if the polls tighten to the 0-3% range again, the turnout concerns and the "Bradley/Cox effect" from above could be enough to swing the election for Trump. Bottom Line: Clinton remains the favorite to win the election, but her probability of winning is closer to 65.5% than the 85% that appears to be "priced in the market." ...And Why He Will Not Win While we are not comfortable calling the election a "done deal," we do believe that Clinton is a favorite. The BCA Geopolitical Strategy quantitative model predicts that she has about a 65.5% probability of winning.4 And the team's qualitative analysis of Trump's electoral strategy suggests that the hurdles to his victory are considerable, particularly in swing states Virginia and Colorado. Before we introduce the quantitative and qualitative models that underpin our election forecast, let us address the above concerns about turnout and the "Bradley/Cox effect" head on. In our view, the polls are telling the truth. We concede that Trump's support level may be underestimated by approximately 3%, which would not be out of line with the last five presidential elections (Chart 7). However, a Clinton lead greater than ~3% the day of the election will be insurmountable for four reasons: Chart 7 GOP primary: It was not the polling that got Trump wrong during the Republican primary race, but the pundits. The polls were generally accurate, particularly those in the swing states where polls tend to be frequent and sophisticated (Chart 8). Polls only underestimated Trump by more than 3% in Illinois, Massachusetts, New York and Pennsylvania. Some of Trump's most controversial statements were made in late 2015 and early 2016 and yet they prompted no shame from his supporters when answering pollsters' questions. Turnout seesaw: Trump's strategy - which we dubbed "The Great White Hype" back in March - is a serious and mathematically viable electoral strategy.5 The effort focuses on boosting the GOP share and overall turnout of the white, blue-collar voter. The problem with this strategy, as executed by Trump, is that its effect could be a seesaw. Trump's rhetoric and policy proposals may appeal to less-educated, lower-income white voters, but may also reduce his support among well-educated, upper-income voters. This is a serious problem for Trump given that the 2012 exit polls indicate that Romney won college graduates by 4 points and voters earning $100k or above by 10 points. In other words, upper-income, well-educated voters are a key constituency of the Republican Party. And just as Clinton may have trouble getting Millennials and minorities to vote for her by the same margin as they did for Obama, Trump could be struggling to get key conservative constituencies out as well. Debates: All scientific polls taken after the debates have Hillary Clinton as a clear winner (Chart 9). This may seem surprising given the reaction of many pundits that Trump outperformed the very low expectations for him in the debates. Many analysts scored the debates close, but voters did not. Why? Because independent and undecided voters are just now tuning into the election and want to see candidates discuss serious policy issues and show leadership. Chart 8 Chart 9 Political science research shows that the direct influence of party identification decreases in presidential elections over time, but issues gain importance, especially after the presidential debates.6 As such, voters tuning into the debates were not discounting Trump's fiery rhetoric and behavior, they were appalled by it. We can't say we were surprised, as we have been showing Chart 10 to clients since February. Chart 10 Senate: If voters are hiding their true support level for Donald Trump, then their genuine preference should be revealed in Senate races where less controversial Republicans are contesting close elections. Instead, Republicans are on a path to lose four of their Senate seats, with another three in play (Democrats need four to take the Senate, assuming that Clinton wins the presidency, since Vice-President Tim Kaine would then cast the tie-breaking vote in that body). Democrats are ahead in Indiana, Illinois, Wisconsin, and Colorado. Nevada is also expected to stay blue. Missouri, New Hampshire, North Carolina, and Pennsylvania are all still in contention, despite the GOP incumbent advantage in all three. Bottom Line: Despite the challenges that this election presents - two highly disliked candidates, questions about turnout, and concerns about polling quality - we doubt that Donald Trump can surprise his poll numbers by more than ~3%. With Hillary Clinton up by 6.4% in the latest RealClearPolitics poll of polls, this means that Trump has to start rallying now if he is going to have a chance on November 8. What Do Our Quantitative & Qualitative Models Say? Our geopolitical team's quantitative model predicts that Hillary Clinton will win the election with 335 electoral votes. The model, built using historical macroeconomic and election data since 1980, has been projecting a strong Clinton victory for some time.7 It currently shows that Clinton already has 279 electoral votes from states where she has more than a 70% chance of winning (Chart 11). These results mean that even under the unlikely scenario in which the GOP wins all the remaining swing states (North Carolina, Arizona, Florida, Ohio, and Iowa), Clinton will still win the election, all other things being equal. Chart 11 Meanwhile, our qualitative model relies on testing Trump's electoral strategy - boosting the share of the white vote accruing to the GOP - in the real world. We concluded in March that Trump did have a path to victory, albeit a very narrow one. Our research showed that Trump's strategy is mathematically viable, at least in 2016 when the white share of the total population remains large enough. We specifically showed that Trump would only need to increase white voters' support by 1.7% and 2.9% in Florida and Ohio, respectively, to flip those states, which seems quite reasonable. We also pointed out that getting a 5.7% swing in Iowa could be feasible. On the other hand, we showed that "flipping" Midwest states like Michigan, Pennsylvania, and Wisconsin would require a very large swing of white voters in Trump's favor: 13.9%, 7.8%, and 8.1%, respectively. With those numbers, Trump would have to win nearly 70% of Michigan's white voters, 65% of Pennsylvania's, and 58% of Wisconsin's. Of the three, Wisconsin looks the most achievable. On the other hand, the GOP only managed to pick up 52% of the state's white share in 2004, the last time a Republican candidate for president won an actual majority of the popular vote since 1988. So, getting to 58% is a high bar given Wisconsin's recent electoral history. How did our qualitative model hold up in terms of state-by-state polling? It did really well! As we predicted, Trump has led the race or nearly led the race in Iowa, Florida, and Ohio (Chart 12). In Michigan, Pennsylvania, and Wisconsin, Clinton's lead has remained higher than 5% through most of the election cycle, even when the media narrative shifted against her (Chart 13). Chart 12The 'White Hype' Model Works Here bca.gps_sr_2016_10_21_c12 bca.gps_sr_2016_10_21_c12 Chart 13White Hype' Does Not Work Here bca.gps_sr_2016_10_21_c13 bca.gps_sr_2016_10_21_c13 If Trump were to win all the states that our White Hype model predicts as competitive, he would still be short of the necessary 270 electoral votes. Map 1 shows the ideal distribution of states for Trump, one that ignores the polls and assigns swing states to Trump or Clinton based on whether the White Hype model is feasible or not. Notice that the two remaining major states are Virginia and Colorado. For Trump to win this election, we believe that he needs to win one of the two (Colorado in combination with either Nevada or New Hampshire), in addition to all of Florida, Ohio, North Carolina, and Iowa. This is a tall order! Particularly given that his polling in Virginia and Colorado is poor (Chart 14). Chart Chart 14Two Critical Swing States bca.gps_sr_2016_10_21_c14 bca.gps_sr_2016_10_21_c14 Bottom Line: BCA's Geopolitical Strategy quantitative and qualitative models both show that Hillary Clinton is a clear favorite to win the election, a view we have held since December 2015.8 Investment Implications: MNCs Vs. SMEs Our colleague Peter Berezin has already discussed the implications of a Trump victory: a stronger USD and a sell-off in stocks.9 We agree and would add that a rally in Treasurys would be likely in the event of a surprise Trump win (Chart 15). Chart 15Trump's Success Helps Safe-Haven Assets bca.gps_sr_2016_10_21_c15 bca.gps_sr_2016_10_21_c15 The rally in safe-haven assets would eventually give way, however, to a bear market in Treasurys as investors realized that Trump has no intention of controlling public spending or reining in the (already growing) budget deficit. Growth, and likely inflation, would surprise to the upside, allowing the Fed to hike rates beyond the 48 bps expected by the market through the end of 2018. We do not foresee that a Republican-held Congress would stand in Trump's way, despite the clear dislike between the Speaker of the House, Representative Paul Ryan, and Trump. Ryan would not go against a sitting president from the same party who just pulled off a revolutionary election. The entire House will face re-election in 2018 and moderate Republicans will be wary of standing up to Trump, lest he campaign against them in GOP primaries in a short two years. Investors are putting way too much faith in America's checks-and-balances to keep Trump from enacting his policies, at least in the short term. These are constitutional, legal, and technical checks, and political expediency often overrules all three. In case of a Clinton win, we would expect the House to remain controlled by the GOP. There are only about 38 truly competitive electoral districts in this race, according to The Cook Political Report.10 Given that the Republicans have a 60-seat majority in the House, a Democratic takeover would require Democratic candidates to defeat Republican Representatives in 30 out of 38 competitive districts. At best, this means that the current, market- bullish status quo of divided government will continue. With the House remaining in Republican hands, and Democrats clinging to a potential razor-thin control of the Senate (vulnerable to a post-Trump Republican comeback in 2018), the Clinton White House would be constrained on some of its most left-leaning policies.11 And what are the chances of cooperation on modest reforms? We think they are actually quite good. Unlike Obama, Clinton's victory will not be a popular sweep. She will not control Congress, she will likely receive less than 50% of the popular vote (due to the presence of two notable third-party candidates), and she will be the first candidate ever elected that has more voters saying they dislike her than like her. Therefore, the odds are slim that Clinton will come to power with the same level of confidence and agenda-setting vision as Obama did in 2008. Instead, we see two potential avenues for modest cooperation with the GOP-controlled House: Chart 16Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate Taxes Have Bottomed Corporate tax reform: It is unlikely that we will see reform that lowers the already historically-low effective tax rates (Chart 16). However, broadening the tax base by closing various loopholes could be feasible. This will hurt S&P 500 multi-national corporations that have been able to lobby for special treatment over the past three decades. However, it will benefit America's SMEs, which are the backbone of employment and growth. Fiscal spending: Paul Ryan and moderate Republicans understand that there is a paradigm shift in America and that the median voter is moving to the left.12 After all, Donald Trump won the GOP primary with an unorthodox economic message that combined both left- and right-wing economic policies. As such, we would expect House Republicans to give in to a modest infrastructure spending plan from Clinton, in exchange for corporate tax reform. Even a modest plan could make a substantive difference for the economy given the high fiscal multipliers of infrastructure spending in an economy with low interest rates. This in turn would allow the Fed to surprise the markets with more than two rate hikes by the end of 2018 and thus sustain the USD bull market. If there is one trend that we are certain will end with the 2016 U.S. election, it is the dominance of American economic policy by the S&P 500, or perhaps the S&P 100. What Trump and Senator Bernie Sanders have shown is that challenging for the presidency no longer requires a cozy relationship with either Wall Street or the large multinational corporations (MNCs). We therefore do not expect a Clinton-Ryan coalition to care as much about the concerns of America's large corporations as otherwise might be the case. Policies that lead to higher effective corporate tax rates on major S&P 500 corporations, a dollar bull market, and higher wages are likely over the course of the next four years. The political pendulum is shifting in the U.S. and it should marginally favor growth, inflation, the USD, and SMEs.13 Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com 1 Please see FiveThirtyEight, "Who Will Win The Presidency?" dated October 20, 2016, available at fiverthirtyeight.com. 2 "You mean like the 2008 Global Financial Crisis?" Yes. Like that. 3 Please see BCA Geopolitical Strategy Special Report, "With Or Without You: The U.K. And The EU," dated March 17, 2016, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 5 Please see BCA Geopolitical Strategy and Global Investment Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 6 Please see Andreas Graefe, "Issues and Leader Voting in U.S. Presidential Elections,"Electoral Studies 32:4 (2013), pp.644-657. 7 For the assumptions underpinning our model, we encourage clients to read BCA Geopolitical Strategy Special Report, "U.S. Election: Final Forecast & Implications," dated October 12, 2016, available at gps.bcaresearch.com. 8 Please see The Bank Credit Analyst Strategy Outlook, "Stuck In A Rut," dated December 17, 2015, available at bca.bcaresearch.com. 9 Please see BCA Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. 10 Please see "House: Recent Updates," accessed October 20, 2016, available at cookpolitical.com 11 We believe that it will be very difficult, if not impossible, for the Democrats to retain a razor-thin majority in the Senate if they get one in November. First, Democrats will have to defend 25 Senate seats (including two allied independent seats) out of 33 in contention in 2018. Second, Democrats always see a drop-off in voter turnout and enthusiasm in mid-term elections. 12 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Monthly Report, "King Dollar: The Agent Of Righteous Retribution," dated October 12, 2016, available at gps.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights EM tech stocks are overbought while banks are fundamentally vulnerable due to bad-loan overhang. EM stocks have never decoupled from the U.S. dollar and commodities prices. There has been no recovery in EM corporate profitability and EPS. We reiterate two equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. Upgrade Thai stocks to overweight within the EM equity benchmark and go long THB versus KRW. Feature Our Reflation Confirming Indicator - an equal-weighted aggregate of platinum prices (a proxy for global reflation), industrial metals prices (a proxy for China growth) and U.S. lumber prices (a proxy for U.S. reflation) - has decisively rolled over, and is spelling trouble for emerging market (EM) equities (Chart I-1). In particular, platinum prices have relapsed after hitting a major resistance at their 800-day moving average (Chart I-2). Such a technical pattern often leads to new lows. If so, it could presage a major selloff in EM markets in the months ahead. Chart I-1A Red Flag From ##br##Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator A Red Flag From Reflation Confirming Indicator Chart I-2Platinum: A Canary##br## In A Coal Mine? bca.ems_wr_2016_10_19_s1_c2 bca.ems_wr_2016_10_19_s1_c2 The rationale behind using platinum rather than gold or silver prices is because platinum is a precious metal that also has industrial uses. Besides, we have found that platinum prices correlate with EM stocks better than gold or silver. The latter two sometimes rally due to global demand for safety, even as EM markets tank. Finally, platinum seems to be the most high-beta precious metal in the sense that it "catches a cold" sooner and, thus, might be leading other reflationary plays. In short, EM share prices have been flat since August 15, and odds are that they are topping out and the next large move will be to the downside. Can EM De-Couple From The U.S. Dollar? Many investors are asking whether EM risk assets can rally if the greenback continues to rebound. Chart I-3 illustrates that since the early 1980s, there have been no periods when EM share prices rallied amid strength in the real broad trade-weighted U.S. dollar (the dollar is shown inverted on this and the proceeding charts). The same holds true if one uses the nominal narrow trade-weighted U.S. dollar1 (Chart I-4). Chart I-3Real Trade-Weighted ##br##U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Real Trade-Weighted U.S. Dollar And EM Stocks Chart I-4Nominal Trade-Weighted ##br##U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks Nominal Trade-Weighted U.S. Dollar And EM Stocks One could disregard these charts and argue that this time around is different. We don't quite see it that way. Chart I-5Nominal Trade-Weighted ##br##U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Nominal Trade-Weighted U.S. Dollar And Commodities Notably, the narrative behind the EM rally since February's lows has been based on the Federal Reserve backing off from rate hikes and the U.S. dollar weakening - with the latter propelling a rally in commodities prices. These arguments appear to be reversing: the U.S. dollar is already firming up and commodities prices are at best mixed. The broad index for commodities prices always drops when the U.S. dollar rallies (Chart I-5). In recent months, the advance in commodities prices has been uneven and narrow based. While oil prices have spiked substantially, industrial metals prices have advanced very little. The current oil price rally is proving a bit more durable and lasting than we thought a few months ago. Nevertheless, China's apparent consumption of petroleum products is beginning to contract (Chart I-6). Consequently, resurfacing worries about EM/China's demand for commodities will lead to a meaningful pullback in crude prices in the months ahead, especially since the likelihood that oil producers act to restrain supply at the current prices is very low. As for commodities trading in China such as steel, iron ore, rubber, plate glass and others, they have been on a roller-coaster ride in recent months (Chart I-7). Chart I-6China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak China's Demand For Oil Products Is Very Weak Chart I-7Commodities Prices In China Commodities Prices In China Commodities Prices In China Bottom Line: There are reasonably high odds that as the U.S. dollar strengthens and commodities prices roll over, EM risk assets (stocks, currencies and credit markets) will start to relapse. EM Beyond Commodities: Still Shrinking Profits Table I-1EM Sectors Weights: In 2011 And Now The EM Rally: Running Out Of Steam? The EM Rally: Running Out Of Steam? Another question that many investors have been asking is as follows: Is there not a positive story in EM beyond commodities? Given that the weight of the EM equity market benchmark in commodities stocks - energy and materials - has drastically declined in recent years, from 29.2% in 2011 to 13.7% now (Table I-1), and the weight in technology stocks has risen substantially (from 12.9% in 2011 to 23.9% now), couldn't non-commodities stocks drive the index higher? In this regard, we have the following observations: Information technology stocks are overbought. The EM information technology equity index has surged to its previous highs (Chart I-8, top panel). This sector is dominated by five companies that have a very large weight also in the overall EM benchmark: Samsung (3.6% weight in the EM equity benchmark), TMSC (3.5%), Alibaba (2.9%), Hon Hai Precision (1%) and Tencent (3.8%). Their share price performance has been spectacular, and some of them have gone ballistic (Chart I-9). TMSC and to a lesser extent Samsung have benefited from the rising prices of semiconductors (Chart I-9, second panel from top). However, it is not assured that semiconductor prices will continue soaring from these levels as global aggregate demand remains very weak. In short, the outlook for semi stocks is by and large a semiconductor industry call, not a macro one. As for Alibaba and Tencent, they are bottom-up stories - not macro bets at all. At the macro level, we reassert that EM/China demand for technology goods and services as well as for health care will stay robust. Hence, from a revenue perspective, technology and health care companies will outperform other EM sectors. This still warrants an overweight allocation to technology and health care stocks, a recommendation that we have had in place since June 2010 (Chart I-8, bottom panel). Odds are that tech outperformance will persist, but we are not sure about absolute performance, given overbought conditions and not-so-cheap valuations. Excluding information technology, the EM benchmark is somewhat weaker (Chart I-10). Chart I-8EM Technology Stocks: Sky Is Limit? bca.ems_wr_2016_10_19_s1_c8 bca.ems_wr_2016_10_19_s1_c8 Chart I-9Individual Tech Names Are Overbought Individual Tech Names Are Overbought Individual Tech Names Are Overbought Chart I-10EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech EM Equities: Overall And Excluding Tech There is no improvement in EM corporate profitability The return on equity (RoE) for EM non-financial listed companies has stabilized at very low levels, but it has not improved at all (Chart I-11, top panel). The reason we use non-financials' RoE rather than overall RoE is because in EM the latter is artificially inflated at the moment, as banks are originating a lot of new loans but are not sufficiently provisioning for bad loans. Among the three components of non-financials RoE, net profit margins have stabilized but asset turnover is falling and leverage continues to mushroom (Chart I-11, bottom two panels). Remarkably, the relative performance between EM and U.S. stocks has historically been driven by relative RoE. When non-financial RoE in EM is above that of the U.S., EM stocks outperform U.S. ones, and vice-versa (Chart I-12). This relationships argues for EM stocks underperformance versus the S&P 500. Chart I-11EM Non-Financials: ##br##RoE And Its Components EM Non-Financials: RoE And Its Components EM Non-Financials: RoE And Its Components Chart I-12EM Versus U.S.: ##br##Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices EM Versus U.S.: Relative RoE And Share Prices Overall EM EPS is still contracting in both local currency and U.S. dollar terms (Chart I-13). Even though the rate of contraction is easing for EPS in U.S. dollar terms, it is due to EM exchange rate appreciation versus the greenback this year. Furthermore, EPS in U.S. dollars is contracting in a majority of non-commodities sectors (Chart I-13A, Chart I-13B). The exceptions are utilities and industrials, which both exhibit strong EPS growth despite poor share price performance. The latter could be a sign that strong industrials and utilities EPS have been due to temporary factors and are not sustainable. Chart I-13AEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Chart I-13BEM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector EM EPS Growth: Overall And By Sector Banks hold the key. Apart from commodities/the U.S. dollar and tech stocks, EM banks' share prices are probably the most important precursor to the direction of the overall EM benchmark. Financials are the second-largest sector in the EM equity benchmark (26.4% weight), so if bank share prices break down, the broader EM index will likely relapse. Our analysis of bank health in various EM countries leads us to believe that banks are under-provisioned for non-performing loans (NPL) (Chart I-14A, Chart I-14B). As EM growth disappointments resurface, investors will question the quality of banks' balance sheets and push down bank equity valuation. Hence, odds are bank share prices will drop sooner than later. Chart I-14AEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned Chart I-14BEM NPLs Are Unrecognized ##br##And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned EM NPLs Are Unrecognized And Under-Provisioned In turn, concerns about EM banks will heighten doubts about overall EM growth and the EM equity benchmark will sell off. Bottom Line: EM tech stocks are overbought, while banks are fundamentally vulnerable due to the bad-loan overhang. As commodities prices relapse anew and worries about the EM credit cycle resurface, the EM benchmark will drop considerably. An Update On Two Relative Equity Trades We reiterate two relative equity trades: short EM banks / long U.S. banks, and short Chinese property developers / long U.S. homebuilders. For investors who do not have these positions, now is a good time to initiate them. Short EM banks / long U.S. banks (Chart I-15). The credit cycle in EM/China will undergo a further downturn: credit growth is set to decelerate as banks recognize NPLs and seek to raise capital. Even if a crisis is avoided, the need to raise substantial amounts of equity will considerably erode the value of EM bank shares. Meanwhile, risks to U.S. banks such as a flat yield curve and a possible spillover effect from European banking tremors are considerably less severe than the problems faced by EM banks. Importantly, unlike EM banks, U.S. banks' balance sheets are very healthy. Short Chinese property developers / long U.S. homebuilders (Chart I-16). Chart I-15Stay Short EM Banks##br## Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Stay Short EM Banks Versus U.S. Banks Chart I-16Stay Short Chinese Property ##br##Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Stay Short Chinese Property Developers Versus U.S. Homebuilders Chinese property developers are on the verge of another downturn, as the authorities have tightened policy surrounding housing. Residential and non-residential property sales have boomed in the past 12 months, but starts have been less robust (Chart I-17). The upshot could still be high shadow inventories. Going forward, as speculative demand for housing cools off, property developers' chronic malaise - high leverage and lack of cash flow - will come back to play. Remarkably, property stocks trading in Hong Kong have failed to break out amid the buoyant residential market frenzy in the past 12 months, and are likely to break down as demand growth falters in the coming months (Chart I-18). Chart I-17China's Real Estate: ##br##Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract China's Real Estate: Sales And Starts Will Contract Chart I-18Chinese Property Developers: ##br##On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Chinese Property Developers: On A Verge Of Breakdown? Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW The death of King Bhumibol Adulyadej marks the end of an era not only because he symbolized national unity but also because his entire generation is passing. This generational shift has far-reaching consequences for Thailand's political establishment: in the long run it could hurt the Thai military's - and its allies' - attempt to cement their dominance over parliament. However, as Box II-1 (on page 17) explains, there is a low probability of serious domestic instability over the next 12 months2 - although beyond that risks will be heating up. For now, the military junta faces no major political or economic constraints: The junta has already consolidated control over all major organs of government and has purged or intimidated political enemies. The military will have to turn power back to parliament, or make a major policy mistake, for the opposition movement to rise again. The government's fiscal deficit has been stable (around 3% of GDP) over the past few years, public debt is at 33% of GDP, government bond yields are low and debt servicing costs are at 5% of total expenditures (Chart II-1). Hence, the military government can ramp up expenditures further to appease the disaffected. Indeed, the military junta has already accelerated public capital expenditures (Chart II-2) and investments have poured into the Northeast, a populous base of opposition to the junta. Chart II-1Thailand: More Room ##br##For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Thailand: More Room For Fiscal Stimulus Chart II-2Thailand: Government ##br##Capex Has Been Booming bca.ems_wr_2016_10_19_s2_c2 bca.ems_wr_2016_10_19_s2_c2 Likewise, fiscal expenditure has also accelerated in areas such as general public services, defense, and social protection (Chart II-3). Additionally, the Bank of Thailand (BoT) has scope to cut interest rates as the policy rate is still above a very low inflation rate (Chart II-4). This will limit the downside for credit growth and contribute to economic and political stability. Chart II-3Rising Public Spending bca.ems_wr_2016_10_19_s2_c3 bca.ems_wr_2016_10_19_s2_c3 Chart II-4Thailand: No Inflation; Room To Cut Rates bca.ems_wr_2016_10_19_s2_c4 bca.ems_wr_2016_10_19_s2_c4 The large current account surplus - standing at 11% of GDP - provides the authorities with plenty of fiscal and monetary maneuverability without having to worry about a major depreciation in the Thai baht (Chart II-5). Amid this sensitive political transition, the central bank will likely defend the currency if downward pressure on the baht emerges due to U.S. dollar strength. Therefore, we recommend traders to go long the Thai baht versus the Korean won (Chart II-6). Despite Korea's enormous current account, the won is at risk from depreciation in the RMB and the Japanese yen. Chart II-5Enormous Current Account ##br##Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Enormous Current Account Surplus Will Support The Baht Chart II-6Go Long THB Against KRW bca.ems_wr_2016_10_19_s2_c6 bca.ems_wr_2016_10_19_s2_c6 On the whole, although the Thai economy has been stagnant (Chart II-7), fiscal spending and low interest rates will limit the downside in growth. Bottom Line: We expect relative calm on the political surface in Thailand over the next 12 months and a stable macro backdrop. Therefore, we are using the latest weakness to upgrade this bourse from neutral to overweight within an EM equity portfolio (Chart II-8). Chart II-7Thai Growth Has Been Stagnant bca.ems_wr_2016_10_19_s2_c7 bca.ems_wr_2016_10_19_s2_c7 Chart II-8Upgrade Thai Stocks ##br##From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight Upgrade Thai Stocks From Neutral To Overweight In addition, currency traders should go long THB versus KRW. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com BOX 1 The Military Coup In 2014 Pre-empted The King's Death... The May 2014 military coup was timed to pre-empt this event. The king's health had been declining for years and it was only a matter of time until he died. This raised the prospect of an intense political struggle that could have escalated into a full-blown succession crisis. Thus the military moved preemptively so that it would be in control of the country ahead of the king's death and could reshape the constitutional system in the military's favor before his death, as it has done. ... And This Means Stability For Now If the populist, anti-royalist faction had been in control of government at the time of the king's death, it could have attempted to manipulate the less popular new king and take advantage of the vacuum of royal authority in order to reduce the role of the military and their allies. That in turn could have sparked a wave of mass protests from royalists, pressuring the government to collapse, or a military coup that would not have carried the king's implicit approval like the 2014 coup. That would have fed the narrative that a final showdown between the factions was finally emerging, and would have been highly alarming to foreign investors. But Risks Still Linger Make no mistake: a new long-term cycle of political instability is now emerging. Potential military mistakes and the return to parliamentary rule are potential dangers. The country's deep divisions - between (1) the Bangkok-centered royalist bureaucratic and military establishment and (2) the provincial opposition -have not been healed but aggravated since the 2014 coup and the new pro-military constitution: The junta's constitutional and electoral reforms will weaken the representation of the largest opposition party, the Pheu Thai Party, and will marginalize a large share of the 65% of the country's population that lives in the opposition-sympathetic provinces. It is also conceivable that the new king could trigger conflict by lending support to the populist opposition. For instance, he could pardon the exiled leader of the rural opposition movement, or he could transform the powerful Privy Council. However, we do not expect discontent to flare up significantly until late 2017 or 2018 when the military steps back and a new election cycle begins.3 We will reassess and alert investors if we foresee a rapid deterioration in the palace-military network, or in the military's ability to prevent seething resistance in the provinces. 1 The narrow U.S. dollar is a trade-weighted exchange rate versus the euro, Canadian dollar, Japanese yen, British pound, Swiss franc, Australian dollar, and Swedish krona. Source: The Federal Reserve. 2 The exception is that isolated acts of terrorism remain likely and could well strike key areas in Bangkok, signaling the reality that the underground opposition to military dictatorship remains alive and well. 3 The junta will use the one-year national period of mourning to its advantage and opposition forces will not want to be targeted for causing any trouble during a time of mourning. The junta could very easily delay the transition to nominal civilian rule, including the elections slated for November 2017. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Muni Credit Cycle: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. Issuance: State & local government investment spending will increase in 2017, as will muni issuance for new capital. Pensions: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. Election: Muni/Treasury yield ratios have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Feature The financial crisis marked a major inflection point in the municipal bond market. Not only did the economic fall-out from the housing crash lead to historically large state & local government budget gaps, but the end of bond insurance and a growing realization that municipal default is possible have focused investor attention on credit quality more than ever before. In this Special Report we zero-in on the Municipal/Treasury (M/T) yield ratio.1 We identify its major short-run and long-run drivers, and assess where it is headed in the context of the municipal bond credit cycle. The Longer-Run Outlook For Yield Ratios An important input to our understanding of the municipal credit cycle is our Muni Health Monitor (MHM). The MHM is a composite of eight indicators of state & local government budget health. Full details of the indicator and its components can be found in the Appendix to this report. The MHM has an excellent track record of signaling the major inflection points in muni ratings migration (Chart 1). We observe that the MHM bottomed in 2006, one year before the previous trough in ratings migration. The MHM also crossed into "deteriorating health" territory six months before municipal downgrades started to outpace upgrades in 2008. More recently, the MHM crossed back into "improving health" territory in Q4 2012. Muni ratings migration also peaked in Q4 2012 and upgrades began outpacing downgrades in Q4 2014. Chart 1The Municipal Health Monitor Leads Ratings bca.usbs_sr_2016_10_18_c1 bca.usbs_sr_2016_10_18_c1 We pay attention to the trends in muni ratings because ratings and state & local government net borrowing explain more than 50% of the variation in the average M/T yield ratio since 1997 (Chart 2). Further, increased investor focus on the creditworthiness of municipal issues has made the yield ratio even more responsive to ratings and net borrowing since the Great Recession. So where are we currently situated in the muni credit cycle? The MHM remains in "improving health" territory, but appears to have entered an extended bottoming-out phase. Given the re-leveraging that has already occurred in the corporate sector, it would be extremely unusual for the MHM to improve further during this cycle. In fact, our Corporate Health Monitor tends to lead the MHM by about two years (Chart 3). This squares with what we know about the behavior of state & local governments throughout the economic cycle. Chart 2The Muni Credit Cycle Illustrated I bca.usbs_sr_2016_10_18_c2 bca.usbs_sr_2016_10_18_c2 Chart 3The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II The Muni Credit Cycle Illustrated II Typically, the corporate sector will increase debt loads when times are good and will then be forced to de-lever when the economy enters recession, profits contract and those debt loads become unsustainable. State & local government budget gaps, on the other hand, will tend to narrow during an economic recovery as rapid income growth translates into increased tax revenue. It is only during a recession that state & local government budget gaps widen, since tax revenue plummets while expenditure growth - particularly for social benefits - remains firm. The end result is that the municipal credit cycle tends to lag the corporate credit cycle. This is also apparent in the ratings data (Chart 3, bottom panel), which suggest that we should expect to see muni downgrades (and hence yield ratios) head higher near the end of next year. The typical lag between the corporate credit cycle and the municipal credit cycle suggests that M/T yield ratios should remain well behaved until late-2017, and then begin to move higher. However, the extraordinary length of the current economic recovery gives us some cause to believe that the lags in this cycle may be somewhat longer. We turn to a macro analysis of net state & local government borrowing to shed some further light on this issue. Net borrowing is simply the difference between revenues and expenditures. On the revenue side of the ledger, state & local governments have already seen a significant deceleration in tax receipts during the past year (Chart 4). Every source of tax revenue - except for property taxes - has slowed alongside what has been disappointing overall economic growth so far in 2016. While a return to the 10% revenue growth that was seen in the mid-2000s is unlikely, we expect most of the recent deceleration will soon be reversed. Aggregate weekly hours bounced sharply in September (Chart 5), and federal income tax withholdings also continue to grow rapidly. Both indicators suggest that income growth will be stronger during the next few months, which will support state & local tax receipts. On the expenditures side, while spending on social benefit programs has increased, state & local governments have largely dealt with budget gaps by cutting back severely on discretionary spending (Chart 6). Investment spending has also collapsed and, as a result, gross municipal bond issuance has been dominated by refinancing (Chart 6, bottom two panels). Chart 4S&L Government Revenue S&L Government Revenue S&L Government Revenue Chart 5Income Growth Will Rebound bca.usbs_sr_2016_10_18_c5 bca.usbs_sr_2016_10_18_c5 Chart 6S&L Government Expenditures bca.usbs_sr_2016_10_18_c6 bca.usbs_sr_2016_10_18_c6 This could all be about to change. Both U.S. Presidential candidates have prioritized infrastructure spending as part of their platforms. Hillary Clinton plans to increase infrastructure spending by $500 billion. This consists of $250 billion of federal infrastructure spending over the next five years and $25 billion of seed money to create a national infrastructure bank. The bank would also accept an additional $225 billion in direct loans. Clinton's plan would also bring back the Build America Bonds (BABs) program. Donald Trump has also expressed a desire to invest heavily in infrastructure, and has floated figures in the range of $1 trillion, although he has been less specific about the details. Historically, about 70% of public investment has occurred at the state & local government level (Chart 7). This suggests that if infrastructure spending became a priority it would lead to a large increase in state & local government investment and hence municipal bond issuance. However, with Clinton's plan it is still unclear whether the bulk of infrastructure spending would be financed through the Treasury market or the muni market. Certainly, to the extent that increased spending is financed through the BABs program, then tax-exempt muni issuance would not be impacted. In our view, state & local government investment spending will head higher in 2017 even without any support from the new President. The need for state & local governments to invest in infrastructure has been evident for some time, but only recently have budgets become healthy enough for governments to consider it. There is a strong correlation between state & local government investment spending and the net percentage of states with a total balance (general fund plus rainy day fund) that exceeds 5% of expenditures (Chart 8). This figure has just recently moved into positive territory and, not coincidentally, more than $200 billion worth of infrastructure spending will be on ballots requesting voter approval in November.2 Chart 7State & Local Government ##br##Drives Investment bca.usbs_sr_2016_10_18_c7 bca.usbs_sr_2016_10_18_c7 Chart 8Healthy Enough##br## To Invest bca.usbs_sr_2016_10_18_c8 bca.usbs_sr_2016_10_18_c8 The combination of resilient, but not surging, revenue growth and increased investment spending in 2017 is consistent with the idea that the muni credit cycle will follow the lead of the corporate cycle and start to turn near the end of next year. Bottom Line: The reading from our Municipal Health Monitor supports low Muni/Treasury yield ratios for now, but will become less supportive near the end of 2017. This is consistent with historical lags between the muni and corporate credit cycles. The Pension Problem Of course, the elephant in the room with regards to the long-run outlook for municipal credit quality is pensions. So far pensions have only entered our discussion of the muni credit cycle tangentially, since the pension funded ratio is a component of the MHM (see Appendix). However, large unfunded pension liabilities - should they persist - have the potential to be severely destabilizing for the muni market at some point in the future. According to the U.S. National Accounts, aggregate defined benefit pension entitlements at the state & local government level total $5.6 trillion, only 65% of which are currently funded by assets. However, this aggregate figure masks large divergences between a few municipalities with unsustainable pension liabilities and the majority of municipalities where pension liabilities are probably manageable. Chart 9Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions Low Returns Put Pressure On Pensions In a recent report,3 the Center for Retirement Research at Boston College found that 36 states should be able to fund their existing liabilities by making annual payments that total less than 15% of revenue. However, five states - Illinois, New Jersey, Connecticut, Hawaii and Kentucky - require annual payments in excess of 25% of revenue. The breakdown is found to be similar at the city level, where pension costs were found to be manageable for the majority of cities, although Chicago, Detroit, San Jose, Miami, Houston, Baltimore, Wichita and Portland all face annual pension costs that exceed 40% of revenue. Unfortunately, while the pension situations of most municipalities are currently manageable, they are only likely to get worse. Changes in the aggregate pension funded ratio closely track returns from a portfolio that is 50% invested in the S&P 500 and 50% invested in the Barclays Treasury index (Chart 9). Based on current equity valuations, it is probably only reasonable to expect 6% annual nominal returns from the equity market during the next 10 years,4 and the 10-year Treasury yield suggests that 1.8% is a reasonable expectation for annual nominal Treasury returns. Taken together, annual nominal investment returns from a 50/50 portfolio during the next decade could be close to 4%, far below the historical average of 8.9% and also below the 7.6% average return assumed by state & local pension plans in 2014. The two main points are that: The pension problem is likely to get worse, not better Given that large under-funded pensions are concentrated in only a few states, inter-state muni allocations are very important On this second point, we observe that states with lower pension funded ratios have higher General Obligation (GO) bond yields (Chart 10), and also that not all of the difference is reflected in credit ratings. We ran a cross-sectional regression of GO bond yields against credit rating and found that a correlation remains between the residual from that regression and the pension funded ratio (Chart 11). In other words, credit rating does not adequately control for the risk presented by under-funded pensions. Chart 10Municipal Bond Yields Vs. Pension Funded Ratios Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Chart 11Municipal Bond Yields Vs. Pension Funded Ratios: Controlling For Credit Rating Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle Bottom Line: The pension funding problem will only get worse in the coming years. Credit ratings do not adequately reflect the risk from under-funded pensions. The Short-Run Outlook For Yield Ratios So far we have discussed the muni credit cycle and noted that M/T yield ratios should begin to move higher on a sustained basis at some point near the end of 2017. However, the near-term drivers of M/T yield ratios suggest that an overweight allocation to municipal bonds remains appropriate for the time being. We have found that the bulk of near-term volatility in M/T ratios can be explained by four factors (Chart 12): The Global Policy Uncertainty Index5 Gross municipal bond issuance Net municipal mutual fund flows Ratings migration The Brexit shock to policy uncertainty has now mostly been reversed. Meanwhile, our Muni Excess Supply Indicator (Chart 12, panel 4) shows that gross issuance has been outpacing fund inflows of late. This should put upward pressure on yield ratios, although this pressure has been largely offset by still supportive ratings migration (Chart 12, bottom panel). Considering all factors, this short-term model shows that the average M/T yield ratio is close to fair value. A reading close to fair value is consistent with muni returns that should exceed those from duration-equivalent Treasuries most of the time (Table 1), even before adjusting for the muni tax advantage. In fact, Table 1 shows that the odds of muni underperformance only really increase once the M/T ratio appears more than one half standard deviation expensive on our model. Chart 12A Short-Term Muni Model A Short-Term Muni Model A Short-Term Muni Model Table 1Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Trading The Municipal Credit Cycle Trading The Municipal Credit Cycle The other near-term factor that supports a continued overweight allocation to municipal debt is the prospect of a Clinton victory in next month's election. Since the beginning of the year, the average M/T ratio has closely tracked the probability of a Trump election victory (Chart 13). The reasoning is entirely logical. Trump has promised large tax cuts for the highest earners. Such tax cuts would significantly de-value the tax advantage of municipal bonds and pressure yield ratios higher. In contrast, Clinton promises to raise taxes on high income individuals. This would make the tax advantage of municipal debt more valuable, and pressure yield ratios lower. Chart 13Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios Trump Is Bad For Yield Ratios The average M/T yield ratio has not yet discounted Trump's recent plunge in the polls. This argues for the maintenance of an overweight allocation to municipal debt in the near term. Bottom Line: M/T yield ratios appear fairly valued in the near-term, and have not yet discounted Donald Trump's recent plunge in the polls. Maintain an overweight allocation to municipal bonds for the time being, but stand prepared to gradually reduce exposure as the muni credit cycle starts to turn in late 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com Appendix: The BCA Municipal Health Monitor The BCA Municipal Health Monitor is an equal-weighted composite of eight indicators meant to quantify trends in state & local government budget gaps and debt service capability. The components consist entirely of data that are publicly available from the Bureau of Economic Analysis, Federal Reserve, Bureau of Labor Statistics and the National Association of State Budget Officers. The eight components are described below, and shown graphically in Charts A1 & A2. Chart A1Muni Health Monitor Components I Muni Health Monitor Components I Muni Health Monitor Components I Chart A2Muni Health Monitor Components II bca.usbs_sr_2016_10_18_c15 bca.usbs_sr_2016_10_18_c15 Leverage: The ratio of total state & local government liabilities (excluding unfunded pension liabilities) to total financial assets. Interest Coverage: State & local government current budget surplus (excluding interest expenditures) divided by interest expenditures. The current surplus is calculated as the difference between current revenues and current expenditures (i.e. investment spending is excluded). Pension Funded Ratio: Total assets of state & local government pension funds divided by total pension liabilities. Revenue: State & local government current revenue in nominal terms, as a deviation from its 18-quarter trend. Surplus Margin: State & local government current budget surplus as a % of current revenue. Liquidity: State & local government total financial assets less short-term liabilities, as a % of total financial assets. Employment Growth: Year-over-year % change in state and local government employment. Total Balance: Aggregate state government total year-end balance. The total balance is the general fund balance plus the rainy day fund, as a % of total expenditures. 1 The average M/T yield ratio shown in this report is calculated by taking an equal-weighted average of M/T yield ratios for 2-year, 5-year, 10-year and 30-year maturities. For each maturity point the yield ratio is calculated as the ratio between the Bloomberg Fair Value Aaa Municipal bond yield and the Federal Reserve's constant maturity Treasury yield. 2 http://www.bloomberg.com/news/articles/2016-09-13/mega-deals-lead-ballo… 3 http://crr.bc.edu/briefs/will-pensions-and-opebs-break-state-and-local-… 4 Please see Global Investment Strategy Special Report, "Global Equity Valuations: Risks And Opportunities", dated July 1, 2016, available at gis.bcaresearch.com 5 The index was created by Professors Scott Baker, Nick Bloom and Steven Davis and is driven by the number of times terms related to economic and policy uncertainty are found in newspaper articles. Full details of the methodology are available at www.policyuncertainty.com

Highlights Our protector portfolio is a combination of assets that have a low or negative correlation with equities that give investors some downside protection. Replacing cash and/or Treasuries with our protector portfolio in 60-30-10 or 60-40 benchmark portfolios would have produced superior returns since 2011. We continue to advocate allocating investments to our protector portfolio in the near term as it represents an effective hedge against immediate risks such as a negative market reaction to the upcoming elections and/or disappointing third quarter profits. Feature Both equities and bonds are under pressure, as a higher likelihood of a December interest rate hike is beginning to be priced in at the same time as nervousness about Q3 earnings results has intensified. This confluence of factors - less liquidity and earnings disappointment - has been the central argument of our defensive portfolio stance for some time: any handoff from liquidity to growth would be shaky, and potentially premature. Indeed, as we wrote in the September 26 Weekly Report, liquidity conditions will largely remain favorable for risk assets for some time because even with a December rate hike, interest rates are well below equilibrium, i.e. are not restrictive. However, equity investors will suffer through bouts of earnings disappointments, similar to the chronic disappointment in GDP growth. As we show in Chart 1, throughout the economic recovery, expectations for economic growth have been revised lower and are only now finally in line with what we expect is close to reality. As highlighted in last week's report, investors' expectations about earnings are most likely to undergo the same fate because profit margins will remain a lasting headwind: investors have not yet adjusted to this new reality (Chart 2). That will hold equity gains to low single digits, at best. Chart 1Years Of One-Way (Down) Revisions bca.usis_wr_2016_10_17_c1 bca.usis_wr_2016_10_17_c1 Chart 2Earnings Set To Disappoint? bca.usis_wr_2016_10_17_c2 bca.usis_wr_2016_10_17_c2 Overall, our view is that the economic backdrop is stable as there are low odds of a recession-inducing monetary tightening occurring, and we do not see any other negative shocks that are concerning enough to trigger a recession. Still, above and beyond our worry about profit disappointments, many client queries are currently focused on U.S. election risks. On September 26, we warned of market volatility leading up to the election, since investors may continue to assign too low odds of a Trump Presidential win. However, we would expect markets to quickly recover - at least until Trump reveals his true policy colors. We took a page from the market reaction to Brexit as a possible guideline to the outcome of Trump winning the election, i.e. the election is ultimately won by a non-status quo candidate. Investors will recall that the post-vote U.K. equity market reaction to Brexit was short-lived but savage. However, the uncertainty around the upheaval of institutions and structures in the euro area and the U.K. are far greater than the election of a non-conformist U.S. President within an institutionally sound system with checks and balances. All of that said, we recognize that we could be wrong and that the U.S. election has taken over the pole position on investors' list of concerns. More specifically, investors are worried about negative financial market fallout from a Trump win.1 So, how should investors hedge the downside risk of these election results? And for that matter, what about other near-term risks? Protector Portfolio Explained This publication has been advocating for some time that investors hold some portion of their capital in a protector portfolio (currently a combination of TIPS, gold and the U.S. dollar). The goal is to find assets with a low or negative correlation to U.S. equities and offer a measure of protection against a steep selloff in stocks. As Chart 3 shows, a portfolio of 60/30/10, where 10% is placed in the protector portfolio, would have outperformed a traditional 60/30/10 allocation in which the 10% is held in straight cash since 2011 (in a ZIRP world). A 60/40 allocation where 40% is placed in the protector portfolio also beats a 60/40 stock/Treasury allocation since 2011. Chart 3Protector Portfolio Enhances Performance ##br## Since 2011 Protector Portfolio Enhances Performance Since 2011 Protector Portfolio Enhances Performance Since 2011 Chart 4Protector Components Are ##br## Negatively Correlated With S&P 500 bca.usis_wr_2016_10_17_c4 bca.usis_wr_2016_10_17_c4 The three assets included in our protector portfolio were chosen with specific risks in mind: USD: As the main global reserve currency, the U.S. dollar benefits when global risk aversion is on the rise. Admittedly, when fears have emanated from U.S. soil, the dollar has performed less well compared to other safe-haven assets, such as the Swiss franc and/or Swiss bonds. Nonetheless, for U.S. investors, investing in one's home currency can provide a natural hedge/advantage. In Chart 4, we show the one-year correlation between USD and S&P 500 equity returns. Since 2009, the correlation has been negative and the implication is that by holding USD, investors are already implicitly defensive. Gold: Gold traditionally does well in times of extreme geopolitical uncertainty and also as a hedge against inflation. More recently, gold has done less well as a hedge because the negative correlation between equity prices and gold broke down from 2011 until earlier this year (Chart 4). Gold has once again become negatively correlated with equity prices and we believe it will be an effective safe-haven asset should inflation become a concern. TIPS: Both 10-year TIPS and nominal Treasuries are negatively correlated with U.S. equity returns and both provide some measure of insurance in risk-off periods/phases of economic disappointment. Nonetheless, we prefer TIPS at the moment since they offer a measure of protection against a back-up in inflation expectations (also Chart 4). In sum, our protector portfolio is a combination of assets that are uncorrelated enough with equities to give investors some protection against a range of downside risks. Protector Portfolio: But Beware Buy And Hold Chart 5Protector Buy And Hold Will Not Work bca.usis_wr_2016_10_17_c5 bca.usis_wr_2016_10_17_c5 As Chart 2 has shown, our protector portfolio has outperformed both a 60-30-10 and 60-40 portfolio in recent years. However, longer -term performance has been less outstanding (Chart 5). Indeed, adding a constant proportion of safe-haven assets to a balanced portfolio over an extended period underperforms the balanced portfolio benchmark for long stretches of time: there are non-negligible costs associated with holding safe-haven assets over prolonged periods. The bottom line is that timing plays a critical part in investing in safe-haven assets. Owning a fixed share of protector portfolio assets over long horizons will not beat a traditional buy and hold strategy, although superior returns over cash offer a compelling case in a NIRP world. We continue to recommend that investors hedge against downside risk in the form of the protector portfolio - or simply by choosing the safe haven that most closely corresponds as a hedge to the specific risk at hand. However, it is important to know that safe-haven assets fall in and out of favor through time and the protector portfolio will at some point no longer be justified, and/or its components will need to be adjusted. For example, only after 2000 did Treasuries start providing a good hedge against equity corrections. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but then became correlated with S&P 500 total returns from 2012-early 2016. That said, gold's coefficient has turned negative again, and it should be viewed as an all-weather safe haven, especially if deflation risks begin to dissipate. The Most Relevant Safe Haven In Case Of A Policy Mistake Chart 6Fed Policy Mistake? Buy Protector Portfolio bca.usis_wr_2016_10_17_c6 bca.usis_wr_2016_10_17_c6 As we wrote above, our base investment case is that the prospect of less liquidity and the risk of an earnings disappointment mean that investors should keep a defensive portfolio stance and be prepared for pullbacks in equities in the single digits. However, the Minutes of the latest FOMC meeting highlight that a fairly low threshold has been set for a December interest rate rise. If financial market participants interpret incoming economic information more bearishly than the Fed, then a December rate hike risks being perceived by investors as a policy mistake. Under this scenario, risk assets could be set for a much greater fall, buoying the case for further portfolio insurance. Which safe havens will outperform? We take our cue from the market reaction to the December, 2015 rate hike. In that episode, equity prices fell 12%. The protector portfolio in its current configuration2 increased 10%. The bulk of the appreciation was due to a strong run in gold prices (surely helped in part by massive woes in China) and TIPS (Chart 6). We believe that this basket of assets would once again offer an important buffer against equity losses associated with a policy mistake. The Most Relevant Safe Haven For A Trump Win If a Trump win triggers a correction in risk assets, we would expect the U.S. dollar to rally due to Trump policy uncertainty and heightened geopolitical risk. We noted above that USD does not always rally when a stress event occurs on U.S. soil. However, in the past several weeks, the performance of the dollar as well as Treasury yields has been linked to Trump's probability of winning the election. Whenever the odds of a Trump presidency rise, these risk-off assets have appreciated. And The Most Relevant Lessons From The Election Cycle This month's Geopolitical Strategy Special Report 3 provides a final forecast and implications for the elections. As we note above, we agree that a Trump win is a red herring in terms of the key issues investors face. But we also agree with our geopolitical strategists that there are several important lessons from the election cycle that may have long term ramifications for investors. Below, we highlight the most relevant for financial market participants: The median voter has moved to the left on economic policy. Trump's victory over an army of seasoned, relatively orthodox GOP contenders in the primary exposed the fact that the party's grassroots voters no longer care deeply about fiscal austerity and no longer wish to tolerate the corporate incentive for importing cheap labor. Similarly, demographic trends favoring millennials and minorities (who tend to vote left on economic policies), portends a shift by which the GOP attempts to capture left-leaning voters. Fiscal conservatism (and social conservatism, for that matter) will have less to show by way of official party machinery. The 2016 election campaign has amplified the notion that the news media works in narratives. These narratives work as a filter that preempts and distorts the presentation and, to some extent, reception of facts. This phenomenon was influential in Trump's rise - the first "Twitter" candidacy - as well as his recent decline. Investors cannot be too wary of what the mainstream press or financial "smart money" says about any particular political trend or event. It is essential to separate the wheat from the chaff by using empirics and looking at macro and structural factors to identify the constraints rather than the preferences of candidates or politicians. U.S. Economy: Neither Hot Nor Cold The NFIB survey of small business survey ranks as one of our preferred indicators of U.S. business confidence. The employment related indicators serve as a key input into our payroll model; questions about the pricing environment often provide a good leading/coincident gauge about inflation trends, and; as Chart 7 shows, the labor cost versus pricing series provides an excellent leading indicator for the profit margin outlook. The latter remains in a downtrend, reinforcing our message that profit margins will remain a headwind to earnings growth for still some time. Overall, small business optimism has been generally flat this year, after peaking in late 2014. It is somewhat discouraging that "demand" as a most important problem is no longer falling. Consumption has been one of the more robust areas of growth in the past several years and we expect consumption to continue to outshine other areas of the economy. However, even here, the data should be monitored closely. Chart 7Small Business Concerns (Part 1) bca.usis_wr_2016_10_17_c7 bca.usis_wr_2016_10_17_c7 Chart 8Small Business Concerns (Part 2) bca.usis_wr_2016_10_17_c8 bca.usis_wr_2016_10_17_c8 Retail sales (excluding gasoline and autos) growth has been slowing throughout 2016 and September data did not buck this trend (Chart 8). Results among retailers varied substantially, with growth strongest at building supply stores, sporting goods stores, vehicle dealers and furniture stores. Laggards include electronics and appliance stores - segments that are still under siege from falling prices. The bottom line is that in aggregate, consumption is holding up reasonably well and should continue to do so, as long as employment gains and modest wage growth remain intact. Stay tuned. Lenka Martinek Vice President, U.S. Investment Strategy lenka@bcaresearch.com 1 Our Geopolitical Strategy service concurs that a Trump win is a red herring, i.e. is unlikely to occur and is a distraction from more relevant issues. For more insight, please see Geopolitical Strategy Monthly Report "King Dollar: The Agent Of Righteous Retribution", dated October, 2016, available at gps.bcaresearch.com 2 At the time, the protector portfolio performed slightly less well, as 30-year government bonds were used instead of TIPS. 3 Please see Geopolitical Strategy Special Report "U.S. Election: Final Forecast & Implications", dated October 12, 2016, available at gps.bcaresearch.com Market Calls

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Hillary Clinton has a 65% chance of winning the election; she receives 334 electoral college votes according to our model. Trump still requires an exogenous shock to win. Meanwhile, the USD is poised to rally - and leftward-moving policymakers will applaud its redistributive effects while MNCs suffer the consequences.

Our Treasury yield fair value model suggests that the 10-year Treasury yield has an additional +19bps of upside. Stay at below benchmark duration.