Global

II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017.

Highlights Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear as the U.S. equity market breaks out and other stock markets test the upside. Technical conditions are stretched and a correction is overdue, but investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. Upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. History shows that the risk of recession increases when the U.S. unemployment rate falls below its full employment level. Nonetheless, for extended "slow burn" expansions like the current one, inflation pressure accumulates only slowly. These late cycle phases can last for years and can be rewarding for equity investors. Stock markets are also benefiting from an earnings recovery from last year's profit recession in some of the major economies. Importantly, it is not just an energy story and is occurring even in the U.S., where companies are dealing with a strong dollar. The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. The probability of a watered-down border tax being passed as part of a broader tax reform package is higher than the market believes. Overall, tax reform should be positive for growth and profits in the medium term, but is likely to cause near-term turbulence in financial markets. Eurozone breakup risk has re-entered investors' radar screen. Most of the political events this year will end up being red herrings. However, we are quite concerned about Italy, where support for the euro is slipping. Our Duration Checklist supports our short-duration recommendation. The FOMC will hike three times this year, while the European Central Bank and the Bank of England will adopt a more hawkish tone later in 2017 (assuming no political hiccups). The policy divergence backdrop remains positive for the U.S. dollar. Technical and valuation concerns will be a headwind, but will not block another 5-10% appreciation. The Trump Administration is very limited in its ability to engineer a weaker dollar. The robust upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation for a signal to trim risk. Feature U.S. equity markets have broken out and stock indexes in the other major markets are flirting with the top end of their respective trading ranges. Nervousness and uncertainty abound within the investment community, but greed is overwhelming fear. The latter is highlighted by the fact that our Complacency-Anxiety Indictor hit a new high for the cycle (Chart I-1). Chart I-1Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability Complacency Indicator Signals Equity Vulnerability It is disconcerting that there has been no 15-20% equity correction for six years and that technical conditions are stretched. Nonetheless, investors can at least take some comfort that earnings are rebounding and that the economic data are surprising to the upside. As we highlight in this month's Special Report, beginning on page 22, upbeat leading indicators and survey data are now being reflected in a synchronized upturn of the "hard" economic data across the major economies. The economic and profit data are thus providing stocks with a solid tailwind at the moment. Unfortunately, the noise surrounding the Trump/GOP fiscal policy agenda is no less than it was a month ago. Investors are also dealing with another bout of euro breakup jitters ahead of upcoming elections. While most of the European pressure points will turn out to be red herrings in our view, Italy is worrisome (see below). Investors are also concerned that, even if the geopolitical risks fade and Trump's protectionist proposals get watered down, the U.S. is nearing full employment. This means that any growth acceleration this year could show up in rising U.S. wages, a more aggressive Fed and a margin squeeze. In other words, the benefits of growth could go to Main Street rather than to Wall Street. This month we research past cycles to shed some light on this concern. We remain overweight stocks versus bonds, but are watching Italy's political situation, U.S. core inflation and our leading economic indicators for signs to take profits. On a positive note, we are not concerned that the U.S. is "due" for a recession just because it has reached full employment. Late Cycle Economic And Equity Dynamics Previous economic cycles are instructive regarding the recession and margin pressure concerns. In our December 2016 issue, we presented some research in which we split U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from medium and long expansions is the speed at which the most cyclical parts of the economy accelerated, and the time it took unemployment to reach a full employment level. Long expansions were characterized by a drawn-out rise in the cyclical parts of the economy and a very slow return to full employment, similar to what has occurred since the Great Recession. Chart I-2 and Chart I-3 compare the current cycle to the average of two of the long cycles (the 1980s and the 1990s). We excluded the long-running 1960s expansion because the Fed delayed far too long and fell well behind the inflation curve. Chart I-2Long Expansion Comparison (I) Long Expansion Comparison (I) Long Expansion Comparison (I) Chart I-3Long Expansion Comparison (II) Long Expansion Comparison (II) Long Expansion Comparison (II) We define the 'late cycle' phase to be the time period from when the economy first reached full employment to the subsequent recession (shaded portions in Chart I-2 and Chart I-3). The average late-cycle phase for these two expansions lasted almost four years, highlighting that reaching full employment does not necessarily mean that a recession is imminent. Some studies have demonstrated that the probability of recession rises once full employment is reached. We agree with this conclusion when looking across all the post-war cycles.1 However, recessions are almost always triggered by Fed tightening into rising inflationary pressures. Such pressures are slower to emerge in 'slow burn' recoveries, allowing the Fed to proceed gradually. The Fed waited an average of 25 months to tighten policy after reaching full employment in these two long expansions, in part because core CPI inflation was roughly flat (not shown). Wage growth accelerated in both cases, but healthy productivity growth kept unit labor costs in check. The result was an extended late-cycle phase that allowed profits to continue growing. Earnings-per-share for S&P 500 companies expanded by an average of 18% in inflation-adjusted terms during the two late-cycle phases, despite the twin headwinds of narrowing profit margins and a strengthening dollar (the dollar appreciated by an average of 23% in trade-weighted terms). The stock market provided an impressive average real return of 25%. Of course, no two cycles are the same. Both the 1980s and 1990s included a financial crisis in the second half that interrupted the Fed's tightening timetable, which likely extended the expansion phases (the 1987 crash and the 1998 LTCM financial crisis). Today, unit labor costs are under control, but wage and productivity growth rates are significantly lower. The implication is that nominal GDP is expanding at a significantly slower underlying pace in this cycle, limiting the upside for top line growth in the coming years. In terms of valuation, stocks are more expensive today than they were in the second half of the 1980s. Stocks were even more expensive in the late 1990s, but that provides little comfort because the market had entered the 'tech bubble' that did not end well. We are not making the case that the current late-cycle phase will be as long or rewarding for equity holders as it was for the two previous slow-burn expansions. Indeed, fiscal stimulus this year could lead to overheating and a possible recession in late 2018 or 2019. Our point is that reaching full employment does not condemn the equity market to flat or negative returns. Indeed, the previous cycles highlight that earnings growth can be decent even with the twin headwinds of narrowing margins and a strengthening dollar. The Earnings Mini-Cycle Another factor that distinguishes the current late-cycle phase from the previous two is that the main equity markets endured an earnings recession last year that did not coincide with an economic recession. Since the mid-1980s, there have been three similar episodes (shaded periods in Chart I-4). Bottom-up analysts failed to see the profit recession coming in each case, such that actual EPS fell well short of expectations set 12 months before (the 12-month forward EPS is shown with a 12-month lag to facilitate comparison). In each case, forward EPS estimates trended sideways while actual profits contracted. Chart I-4Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) Market Dynamics During Previous Profit Recessions (But No Economic Recession) This was followed by a recovery in profit growth that eventually closed the gap again between actual and (lagged) 12-month forward EPS. This 'catch up' phase coincided with some multiple expansion and a total return to the S&P 500 of about 8% in the late 1990s and 20% in 2013/14.2 The starting point for the forward P/E is elevated today, which means that double-digit returns may be out of reach. Nonetheless, stocks are likely to outperform bonds on a 6-12 month view. A Bird's Eye View Of The Trump Agenda The U.S. Administration and Congressional Republicans are considering some radical changes to the tax code and not all of them are positive for risk assets. We have no doubt that some sort of tax bill will be passed in 2017. The GOP faces few constraints to cutting corporate taxes and there is every reason to believe it will occur quickly. The major question is whether a broader tax reform will be passed. Trying to understand all the moving parts to tax reform is a daunting task. In order to simplify things, Table I-1 lists the main policies that are being considered, along with the economic and financial consequences of each. Some policies on their own, such as ending interest deductibility, would be negative for the economy and risk assets. However, the top three items in the table will likely be combined if a broad tax reform package is passed. Together, these three items define a destination-based cash-flow tax, which some Republicans would like to replace the existing corporate income tax. The aim is to promote domestic over foreign production, stimulate capital spending and remove a bias in the tax system that favors imports over exports. Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Table I-1A Bird's Eye View Of The Implications Of The Trump/GOP Fiscal Policy Agenda March 2017 March 2017 Perhaps the most controversial aspect is the border-adjustment tax (BAT), which would tax the value added of imports and rebate the tax that exporters pay. We will not get into the details of the BAT here, but interested readers should see two recent BCA reports for more details.3 The implications of the BAT for the economy and financial markets depend importantly on the dollar's response. In theory, the dollar would appreciate by enough to offset the tax paid by importers and the tax advantage gained by exporters, leaving the trade balance and the distribution of after-tax corporate profits in the economy largely unchanged. This is because a full dollar adjustment would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits. A 20% border tax, for example, would require an immediate 25% jump in the dollar to level the playing field. In reality, much depends on how the Fed and other countries respond to the BAT. We believe the dollar's rise would be less than fully offsetting, but would still appreciate by a non-trivial 10% in the event of a 20% border tax. If the dollar's adjustment is only partially offsetting, then it would have the effect of boosting exports and curtailing imports, thereby adding to GDP growth and overall corporate profits. It would make it more attractive for U.S. multinational firms to produce in the U.S., rather than produce elsewhere and export to the U.S. A partial dollar adjustment would also be inflationary because import prices would rise. The smaller the dollar appreciation, the more inflationary the impact. The result would be dollar strength coinciding with higher Treasury yields, breaking the typical pattern in recent years. The impact on the U.S. equity market is trickier. To the extent that dollar strength is not fully offsetting, then the resulting economic boost will lift corporate earnings indirectly. However, the BAT will reduce after-tax profits directly. One risk is that the FOMC slams the brakes on the economy in the face of rising inflation. Another is that, with the economy already operating close to full employment, faster growth might be reflected in accelerating wage inflation that eats into profit margins. However, our sense is that the labor market is not tight enough to immediately spark cost-push inflation. As noted above, it usually takes some time for wage inflation to get a head of steam once the labor market gap is closed in a slow-burn expansion. Full employment is not a hard threshold beyond which the economy suddenly changes. Moreover, the Phillips curve has been quite flat in this recovery, suggesting that it will require significant levels of excess demand to move the dial on inflation. More likely, a slow upward creep in core PCE inflation will allow the Fed to err on the side of caution. Unintended Consequences There are a number of risks and unintended consequences associated with the border tax. One major drawback of the BAT is that, to the extent that the dollar appreciates, it reduces the dollar value of the assets that Americans hold abroad. We estimate that a 25% appreciation, for example, would impose a whopping paper loss of about 13% of GDP. Moreover, a partial dollar adjustment could devastate the profits of importers, while generating a substantial negative tax rate for exporters. It would also be disruptive to multinational supply chains and to the structure of corporate balance sheets (debt becomes more expensive relative to equity finance). Partial dollar adjustment would also be bad news for countries that rely heavily on exports to the U.S. to drive growth, especially emerging economies that have piled up a lot of dollar-denominated debt. An EM crisis cannot be ruled out. Finally, it is unclear whether or not a border tax is consistent with World Trade Organization Rules. At a minimum, it will be seen as a protectionist act by America's trading partners and could trigger a trade war. President Trump has sent conflicting views on the BAT and there has been a wave of criticism from sectors that will lose from such legislation. However, the House GOP leaders signaled a greater flexibility in drafting the law so as to win over various stakeholders. Our Geopolitical Strategy team believes that Trump will ultimately hew to the Republican Party leadership on tax reform, largely because his protectionist and mercantilist vision is fundamentally aligned with the chief aims of the BAT. Critics will be won over by the use of carve-outs and/or phased implementation for key imports like food, fuel and clothing. Interestingly, the sectors that suffer the most from the import tax also tend to pay higher effective tax rates and thus stand to benefit from the rate cuts (Chart I-5). Finally, the BAT would raise revenue that can be used to offset the corporate tax cuts, helping to sell the package to Republican deficit hawks. Chart I-5Cuts In Tax Rates Mitigate A New Import Tax Somewhat March 2017 March 2017 But even if the border adjustment never sees the light of day, there will certainly be tax cuts for both corporations and households, along with specific add-ons to deal with concerns like corporate inversions and un-repatriated corporate cash held overseas. An infrastructure plan and cuts to other discretionary non-defense government spending also have a high probability, although the amounts involved may be small. An outsourcing tax has a significant, though less than 50%, chance of occurring in the absence of a border tax. On its own, an outsourcing tax would be negative for growth, profits and equity returns. We place a 50/50 chance on a broad tax reform package that includes the border adjustment. We believe that a broad tax reform package will ultimately be positive for the bottom line for the corporate sector as a whole, although unintended consequences will complicate the path to higher stock prices. Eurozone: Breakup Risk Resurfaces Investors have lots to consider on the other side of the Atlantic as well. The European election timetable is packed and plenty is at stake. Could we see a wave of populism generate game-changing political turmoil in the E.U., as occurred in the U.S. and U.K.? Our geopolitical strategists believe that European risks are largely red-herrings for 2017. Investors are overestimating most of the inherent risks:4 In the Netherlands, the Euroskeptic Party for Freedom is set to capture about 30 out of 150 seats in the March election. However, that is not enough to win a majority. Dutch support for the euro is at a very high level, while voters lack confidence in the country's future outside of the EU. Support for the euro is also elevated in France, limiting the chance that Le Pen will win the upcoming presidential election. Even if she is somehow elected, it is unlikely that she would command a majority of the National Assembly. Exiting the Eurozone and EU would necessitate changing the constitution, possibly requiring a referendum that Le Pen would likely lose. That said, these constraints may not be clear to investors, sparking a market panic if Le Pen wins the election. The German public is not very Euroskeptic either and anti-euro parties are nowhere close to governing. Markets may take a Merkel loss at the hands of the SPD negatively at first. However, the new SPD Chancellor candidate, Martin Schulz, is even more supportive of the euro than Merkel and he would be less insistent on fiscal austerity in the Eurozone. A handover of power to Schulz would ultimately be positive for European stocks. The Catlan independence referendum in September could cause knee-jerk ripples as well. Nonetheless, without recognition from Spain, and no support from EU and NATO member states, Catlonia cannot win independence with a referendum alone. Greece faces a €7 billion payment in July, by which time the funding must be released or the government will run out of cash. The IMF refuses to be involved in any deal that condones Greece's unsustainable debt path. If a crisis emerges, the likely outcome would be early elections. While markets may not like the prospect of an election, the pro-euro and pro-EU New Democratic Party (NDP) is polling well above SYRIZA. The NDP would produce a stable, pro-reform government that would be positive for growth and financial markets. It is a different story in Italy, where an election will occur either in the autumn or early in 2018. Support for the common currency continues to plumb multi-decade lows, while Italian confidence in life outside the EU is perhaps the greatest on the continent (Chart I-6 and Chart I-7). Euroskeptic parties are gaining in popularity as well. The possibility of a referendum on the euro, were a Euroskeptic coalition to win, would obviously be very negative for risk assets in Europe and around the world. Chart I-6Italians Turning Against The Euro Italians Turning Against The Euro Italians Turning Against The Euro Chart I-7Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU Italians Confident In Life Outside The EU The implication is that most of the risks posed by European politics should cause no more than temporary volatility. The main exception is Italy. We will be watching the Italian polls carefully in the coming months, but we believe that the widening in French/German bond spreads presents investors with a short-term opportunity to bet on narrowing.5 Bond Bear Market Is Intact These geopolitical concerns and uncertainty over President Trump's policy priorities put the cyclical bond bear market on hold early in the New Year, despite continued positive economic surprises. Even Fed Chair Yellen's hawkish tone in her recent Congressional testimony failed to move long-term Treasury yields sustainably higher, after warning that "waiting too long to remove accommodation would be unwise." In the money markets, expectations priced into the overnight index swap curve have returned to levels last seen on the day of the December 2016 FOMC meeting (Chart I-8). The market is priced for 53 basis points of rate increases between now and the end of the year, with a 26% chance that the next rate hike occurs in March. March is too early to expect the next FOMC rate hike. One reason is that core PCE inflation has been stuck near 1.7% and we believe it will rise only slowly in the coming months. Even though the strong January core CPI print seemed to strengthen the case for a March hike, the details of the report show that only a few components accounted for most of the gains. In fact, our CPI diffusion index fell even further below the zero line. With both our CPI and PCE diffusion indexes in negative territory, inflation may even soften temporarily in the coming months. This would take some heat off of the FOMC (Chart I-9). Chart I-8Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Fed Rate Expectations Shift Toward Dots Chart I-9U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily U.S. Inflation May Soften Temporarily Second, Fed policymakers will want to see how the Trump policy agenda shakes out in the next few months before moving. We still expect three rate hikes this year, beginning in June. The stance of central bank policy is on our Duration Checklist, as set out by BCA's Global Fixed Income Strategy service (Table I-2). We will not go through all the items on the checklist, but interested readers are encouraged to see our Special Report.6 Table I-2Stay Bearish On Bonds March 2017 March 2017 Naturally, leading and coincident indicators for global growth feature prominently in the Checklist. And, as we highlight in this month's Special Report, a synchronized global growth acceleration is underway that is broadly based across economies, consumer and business sectors, and manufacturing and services industries. Our indicators for private spending suggest that real GDP growth in the major countries accelerated sharply between 2016Q3 and the first quarter of 2017, to well above a trend pace. In the Euro Area, jobless rate has been declining quickly and reached 9.6% in January, the lowest level in nearly eight years. Even if economic growth is only 1½% in 2017 (i.e. below our base case), the unemployment rate could reach 9% by year-end, which would be close to full employment. Core inflation already appears to be bottoming and broad disinflationary pressures are abating. When the ECB re-evaluates its asset purchase program around the middle of this year, policymakers could be faced with rising inflation and an economy that has exhausted most of its excess slack. At that point, possibly around September, ECB members will begin to hint that the asset purchases will be tapered at the beginning of 2018. Moreover, the annual growth rate of the ECB's balance sheet will peak by around mid-year and then trend lower (Chart I-10). This inflection point, along with expectations that the ECB will taper further in 2018, will place upward pressure on both European and global bond yields. The Bank of England (BoE) may become more hawkish as well. At the February BoE meeting, policymakers re-iterated that they are willing to look through a temporary overshoot of the inflation target that is related to pass-through from the weak pound and higher oil prices. However, the BoE has its limits. The Statement warned that tighter policy may be necessary if wage growth accelerates and/or consumer spending growth does not moderate in line with the BoE's projection. In the absence of Brexit-related shocks, the BoE is unlikely to see the growth slowdown it is expecting, given healthy Eurozone economic activity and the stimulus provided by the weak pound. Investors should remain positioned for Gilt underperformance of global currency-hedged benchmarks (Chart I-11). Chart I-10Bond Strategy And ##br## The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Bond Strategy And The ECB Balance Sheet Chart I-11Gilts To Underperform Gilts To Underperform Gilts To Underperform Outside of central bank policy, a majority of items on the Duration Checklist are checked at the moment, indicating that investors with a 3-12 month view should maintain below-benchmark duration within bond portfolios. That said, technical conditions are a headwind to higher yields in the very near term. Oversold conditions and heavy short positioning suggest that yields will have a tough time rising quickly as the market continues to consolidate last year's sharp selloff. Can Trump Force Dollar Weakness? Chart I-12Trump Can't Weaken ##br## Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long Trump Can't Weaken Dollar With Tweets For Long The U.S. dollar appears to have recently decoupled from shifts in both nominal and real interest rate differentials this year (Chart I-12). The dollar is expensive, but we do not believe that valuation is a barrier to an extended overshoot given the backdrop of diverging monetary policies between the U.S. and the other major central banks. The dollar's recent stickiness appears to be driven by recent comments from the new Administration that the previous 'strong dollar' policy is a relic of the past. Let us put aside for the moment the fact that expansionary fiscal policy, higher import tariffs and/or a border tax would likely push the dollar even higher. "Tweeting" that the U.S. now has a 'weak dollar' policy will have little effect beyond the near term. A lasting dollar depreciation would require changes in the underlying macro fundamentals and policies. President Trump would have to do one of the following: Force the Fed to ease policy rather than tighten. However, the impact may be short-lived because accelerating inflation would soon force the Fed to tighten aggressively. Convince the other major central banks to tighten their monetary policies at a faster pace than the Fed (principally, the People's Bank of China, the BoJ, the ECB, Banco de Mexico, and the Bank of Canada). Again, the impact on the dollar would be fleeting because premature tightening in any of these economies would undermine growth and investors would conclude that policy tightening is unsustainable. Convince these same countries to implement very expansionary fiscal policies. This has a better chance of sustainably suppressing the dollar, but foreign policy would have to be significantly more stimulative than U.S. fiscal policy. The U.S. Administration will not be able to force the Fed's hand or convince other countries to change tack. President Trump has an opportunity to stack the FOMC with doves if he wishes next year, given so many vacant positions. Nonetheless, Trump's public pronouncements on monetary policy have generally been hawkish. It will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans would likely resist. This means that the path of least resistance for the dollar remains up. Dollar valuation is stretched and market technicals are a headwind to the rally. However, valuation signals in the currency market have a poor track record at making money on a less than 2-year horizon. The dollar is currently about 8% overvalued by our measure, which is far from the 20-25% overvaluation level that would justify short positions on valuation grounds alone (Chart I-13). What is more concerning for dollar bulls is that there is near universal unanimity on the trade. Nonetheless, both sentiment and net speculative positions are not nearly as stretched as they were at the top of the Clinton USD bull market (Chart I-14). Moreover, it took six years of elevated bullishness and long positioning to prompt the end of the bull market in 2002. We believe that the dollar will appreciate by another 5-to-10% in real trade-weighted terms by the end of the year, despite lopsided market positioning. The appreciation will be even greater if a border tax is implemented. Chart I-13Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Dollar is Overvalued, But Far From an Extreme Chart I-14In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right In The 1990s, The Concensus Was Right Conclusions Many investors, including us, have been expecting an equity market correction for some time. But the longer that the market goes without a correction, the "fear of missing out" forces more investors to throw in the towel and buy. This market backdrop means that now is not the best time to commit fresh money to stocks, but we would not recommend taking profits either. On a positive note, the U.S. economy is not poised on the edge of recession just because it has reached full employment. Indeed, a synchronized growth acceleration is underway across the major countries that is broadly based across industries. Inflationary pressure is building only slowly in the U.S., which gives the Fed room to maneuver. Moreover, the Trump Administration has not labelled China a currency manipulator, and has sounded more conciliatory toward NATO and the European Union in recent days. This is all good news, but the direction of U.S. fiscal policy remains highly uncertain. Moreover, investors must navigate a host of geopolitical landmines in Europe this year, most important of which is an Italian election that may occur in the autumn. The ECB and the BoE will likely become more hawkish in tone later this year. The impressive upturn in the economic and profit data keeps us positive on the stock-to-bond total return ratio for the near term. Investors should maintain an overweight allocation to stocks versus bonds within global portfolios. The backdrop could become rockier for risk assets in the second half of the year. We will be watching political trends in Italy, our leading economic indicators, and U.S. core inflation among other factors for a signal to trim risk. Our other recommendations include: Maintain below-benchmark duration within bond portfolios. Overweight Eurozone government bonds relative to the U.S. and U.K. in currency-hedged portfolios. Overweight European and Japanese equities versus the U.S. in currency-hedged portfolios. Be defensively positioned within equity sectors to temper the risk associated with overweighting stocks versus bonds. In U.S. equities, maintain a preference for exporting companies over those that rely heavily on imports. Overweight investment-grade corporate bonds relative to government issues, but stay underweight high-yield where value is very stretched. Within European government bond portfolios, continue to avoid the Periphery in favor of the core markets. Fade the widening in French/German spreads. Overweight the dollar relative to the other major currencies. Stay cautious on EM bonds, stocks and currencies. Overweight small cap stocks versus large in the U.S. market, on expected policy changes that will disproportionately favor small companies. We are bullish on oil prices in absolute terms on a 12-month horizon, and recommend favoring this commodity relative to base metals. Mark McClellan Senior Vice President The Bank Credit Analyst February 23, 2017 Next Report: March 30, 2017 1 Indeed, this must be true by definition. 2 The S&P 500 contracted during 1987 because of the market crash. 3 Please see BCA Global Investment Strategy "U.S. Border Adjustment Tax: A Potential Monster Issue for 2017," dated January 20, 2017. Also see: BCA Geopolitical Strategy "Will Congress Pass The Border Adjustment Tax?", dated February 8, 2017. 4 Please see Global Political Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017. 5 Please see Global Political Strategy Special Report, "Our Views On French Government Bonds," dated February 7, 2017. 6 Please see Global Fixed Income Strategy Special Report, "A Duration Checklist For U.S. Treasurys And German Bunds," dated February 15, 2017. II. Global Growth Pickup: Fact Or Fiction? Risk assets have discounted a lot of good economic news. There is concern that the growth impulse evident in surveys of business activity and confidence has been slow to show up clearly in the "hard" economic data related to final demand. If the optimism displayed in the survey data is simply reflecting "hope" for less government red tape, tax cuts and infrastructure spending in the U.S., then risk assets are highly vulnerable to policy disappointment. After a deep dive into the economic data for the major countries, we have little doubt that a tangible growth acceleration is underway. Momentum in job creation has ebbed, but retail sales, industrial production and capital spending are all showing more dynamism in the advanced economies. Evidence of improving activity is broadly-based across countries and industrial sectors (including services). Orders and production are gaining strength for goods related to both business and household final demand. Inventory rebuilding will add to growth this year, but this is not the main story. The energy revival is not the main driver either. Indeed, energy production has lagged the overall pick-up in industrial production growth. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our models, based largely on survey data, point to a significant acceleration in G7 real GDP growth in early 2017. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. A return of animal spirits could prolong a period of robust growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts. This economic backdrop is positive for risk assets and bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this current cyclical upturn will be any more resilient and enduring than previous mini-cycles in this lackluster expansion. Much depends on U.S. policy and European politics in 2017. The so-called Trump reflation trades lost momentum in January, but the dollar and equity indexes are on the rise again as we go to press. A lot of recent volatility is related to the news flow out of Washington, as investors gauge whether President Trump will prioritize the growth-enhancing aspects of his policy agenda over the ones that will hinder economic activity. Much is at stake because it appears that risk assets have discounted a lot of good economic news. Investors have taken some comfort from the fact that leading indicators are trending up across most of the Developed Markets (DM) and Emerging Markets (EM) economies. In the major advanced economies, only the Australian leading indicator is not above the boom/bust mark and rising. Our Global Leading Economic Indicator is trending higher and it will climb further in the coming months given that its diffusion index is well above 50 (Chart II-1). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook (although the former ticked down in February). Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart II-2). The improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Surveys (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. Chart II-1A Consistent, Positive ##br## Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Chart II-2Surging Confidence, ##br## Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. Could it be that the bounce in confidence is simply based on faith that U.S. fiscal policy will be the catalyst for a global growth acceleration? Could it be that, beyond this hope, there is really nothing else to support a brighter economic outlook? Is it the case that the improved tone in the survey data only reflects the end of an inventory correction and a rebound in energy production? If the answer is 'yes' to any of these questions, then equity and corporate bond markets are highly vulnerable to U.S. policy disappointment. This month we take deep dive into the economic data for the major economies. The good news is that there is more to the cyclical upturn than hope, inventories or energy production. The improved tone in the forward-looking data is now clearly showing up in measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, the bad news. There has been a worrying loss of momentum in job creation, although the data releases lag by several months in the U.K. and the Eurozone, making it difficult to get an overall read on payrolls into year-end (Charts II-3 and II-4).1 Job gains have accelerated in recent months in Japan, Canada and Australia. The payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart II-3Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Global Employment Growth Cooling Off (I) Chart II-4Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) Global Employment Growth Cooling Off (II) On the positive side, households are opening their wallets a little wider according to the retail sales data (Chart II-5 and Chart II-6). Year-over-year growth of a weighted average of nominal retail sales for the major advanced economies (AE) has accelerated to about 3%, and the 3-month rate of change has surged to 8%. Sales growth has accelerated sharply in all the major economies except Australia. The retail picture is less impressive in volume terms given the recent pickup in headline inflation, but the consumer spending backdrop is nonetheless improving. The major exception is the U.K., where inflation-adjusted retail sales have lost momentum in recent months. Chart II-5On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) On Your Mark, Get Set, Shop!! (I) Chart II-6On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) On Your Mark, Get Set, Shop!! (II) Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart II-7). Order books began to fill up in the second half of 2016 and the year-over-year growth rate appears headed for double digits in the coming months. The pickup is fairly widespread across industries in Germany and the U.S., although less so in Japan. The acceleration of imported capital goods for our 20 country aggregate corroborates the stronger new orders reports (Chart II-7, bottom panel). Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across most of the major advanced economies (Chart II-8 and Chart II-9). Chart II-7Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Global Capex Cycle Turning Positive... Chart II-8...Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn ... Driving A Global Manufacturing Upturn Chart II-9Global Manufacturing Upturn Global Manufacturing Upturn Global Manufacturing Upturn The fading of the negative impacts of the oil shock and last year's inventory correction are playing some role in the manufacturing rebound, but there is more to it than that. The production upturn is broadly-based across sectors in Japan and the U.K., although less so in the Eurozone and the U.S. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart II-10). Interestingly, energy-related production is not a driving force. Indeed, energy production is lagging the overall improvement in industrial output growth, even in the U.S. where the shale oil & gas sector is tooling up again (Chart II-11). Chart II-10A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration Chart II-11Energy Is Not The Main Driver Energy Is Not The Main Driver Energy Is Not The Main Driver The Boost From Inventories And Energy Some inventory rebuilding will undoubtedly contribute to the rebound in industrial production and real GDP growth in 2017. The inventory contribution has been negative for 6 quarters in a row for the major advanced economies, which is long for a non-recessionary period (Chart II-12). We estimate that U.S. industrial production growth will easily grow in the 4-5% range this year given a conservative estimate of manufacturing shipments and a flattening off in the inventory/shipments ratio (which will require some inventory restocking; Chart II-13). Chart II-12Global Inventory Correction Is Over Global Inventory Correction Is Over Global Inventory Correction Is Over Chart II-13U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish U.S. Manufacturing Outlook Is Bullish Nonetheless, the inventory cycle is not the main story for 2017. The swing in inventories seldom contributes to annual real GDP growth by more than a tenth of a percentage point for the major countries as a whole outside of recessions. Moreover, inventory swings generally do not lead the cycle; they only reinforce cyclical upturns and downturns in final demand. U.S. industrial production growth this year will undoubtedly exceed the 4-5% rate discussed above because that estimate does not include a resurgence of capital spending in the energy patch. BCA's Energy Sector Strategy service predicts that energy-related capex will surge by 40% in 2017, largely in the shale sector (Chart II-13, bottom panel). Even if energy capital spending outside the U.S. is roughly flat, as we expect, this would be a major improvement relative to the 15-20% contraction last year. According to Stern/NYU data, energy-related investment spending currently represents about a quarter of total U.S. capital spending.3 Thus, a 40% jump in energy capex would boost overall U.S. business investment in the national accounts by an impressive 10 percentage points. This is a significant contribution, but at the moment the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. Soft Survey Data Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey all include measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. We analyzed a wide variety of survey data and combined the ones that best lead (if only slightly) consumer and capital spending into indicators of private final demand (Chart II-14 and Chart II-15). A wide swath of confidence and survey data are rising at the moment, with few exceptions. Moreover, the improvement is observed in both the manufacturing and services sectors, and for both households and businesses. We employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart II-16). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter, from 1½% in 2016 Q3. We expect growth of close to 3% in the U.S. and about 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 1.7% in the first quarter based on these indicators. Chart II-14Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Our Consumer Indicators Have Turned Up... Chart II-15...Our Capex Indicators Too ...Our Capex Indicators Too ...Our Capex Indicators Too Chart II-16Real Growth To Accelerate Real Growth To Accelerate Real Growth To Accelerate The outlook is less impressive for the U.K. While the survey data have revealed the biggest jump of the major countries in recent months, this represents a rebound from last years' Brexit-driven plunge. Nonetheless, current survey levels are consistent with continued solid growth. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Infrastructure spending in the state-owned sector is slowing, but overall industrial capital spending growth has turned up because of private sector activity. An easing in monetary conditions last year is lifting growth and profitability which, in turn, is generating an incentive for the business sector to invest. There are also budding signs of recovery in housing-related investment. Stronger Chinese capital spending in 2017 will encourage imports and thereby support activity in China's trading partners, particularly in Asia. Will The Growth Impulse Have Legs? The cyclical dynamics so far appear a lot like the rebound in global growth following the 2011/12 economic soft patch and inventory correction (Chart II-17). That mini cycle was caused by a second installment of the Eurozone financial crisis. The damage to confidence and the tightening in financial conditions sparked a recession on the European continent and a loss of economic momentum globally. The financial situation in Europe began to improve in 2013. Consumer spending growth in the major advanced economies was the first to turn up, followed by capital spending, industrial production and, finally, hiring. Then, as now, the upturn in the surveys led the hard data. Unfortunately, the growth surge was short-lived because the 2014/15 collapse in oil prices undermined confidence and tightened financial conditions once again. The result was a manufacturing recession and inventory correction in 2016. There are reasons to believe that the cyclical upturn will have legs this time. It is good news that the growth impetus is observed in both the manufacturing and service sectors, and that it is widespread across the major advanced economies. Fiscal policy will likely be less restrictive this year than in 2014/15, and our sense is that some of the lingering scar tissue from the Great Recession is beginning to fade. The latter is probably most evident in the case of the U.S.; a Special Report from BCA's U.S. Investment Strategy service highlighted that the U.S. expansion has become more self-reinforcing.4 In the U.S. business sector, it appears that "animal spirits" have been stirred by the promise of less government red tape, lower taxes and protection from external competitive pressures. Regional Fed surveys herald a surge in capital spending plans in the next six months (Chart II-18). The rebound in corporate profitability also bodes well for capital spending. Chart II-17Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Consumers Usually Lead At Turning Points... Chart II-18...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now ...But Capex Appears To Be Leading Now Conclusions: We have little doubt that a meaningful global growth acceleration is underway. It is possible that consumer and business confidence measures are contaminated by hopes of policy stimulus in the U.S., but there is widespread verification from survey data of current spending that real final demand growth accelerated in 2016Q4 and 2017Q1. In terms of the hard data, evidence of improving manufacturing output and capital spending is broadly-based across industrial sectors and countries, suggesting that there is more going on than the end of an inventory correction and energy rebound. The bottom line is that investors should not dismiss the improved tone to the global economic data as mere "hope". Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, which would be positive for risk assets and the dollar, but bearish for bonds. Admittedly, however, we cannot point to concrete evidence that this cyclical upturn will be any more enduring than previous mini-cycles in this lackluster expansion. The economy may be just as vulnerable to shocks as was the case in 2014. As discussed in the Overview, there are numerous risks that could truncate the economic and profit upswing. On the U.S. policy front, tax cuts and some more infrastructure spending would be positive for risk assets on their own. However, the addition of the border tax or the implementation of other trade restrictions would disrupt international supply chains, abruptly shift relative prices and possibly generate a host of unintended consequences. And in Europe, markets have to navigate a minefield of potentially disruptive elections this year. Any resulting damage to household and business confidence could short-circuit the upturn in growth. For now, we remain overweight equities and corporate bonds relative to government bonds in the major countries, but political dynamics may force a shift in asset allocation as we move through the year. Mark McClellan Senior Vice President The Bank Credit Analyst 1 Note that where only non-seasonally adjusted data is available, we have seasonally-adjusted the data so that we can get a sense of short-term momentum via the annualized 3-month rate of change. 2 Machinery orders used for Japan. 3 Please see http://www.stern.nyu.edu/ 4 Please see U.S. Investment Strategy Special Report "The State Of The Economy In Pictures," dated January 30, 2017. III. Indicators And Reference Charts The breakout in the S&P 500 over the past month has further stretched valuation metrics. The Shiller P/E is very elevated, and the price/sales ratio is almost back to the tech bubble peak. However, our composite valuation indicator is still slightly below the one sigma level that marks significant overvaluation. This composite indicator comprises 11 different measures of value. The monetary indicator is slightly negative, but not dangerously so for stocks. Technical momentum is positive, although several indicators suggest that the equity rally is stretched and long overdue for a correction. These include our speculation indicator, composite sentiment and the VIX. Forward earnings estimates are still rising, although it may be a warning sign that the net earnings revisions ratio has rolled over. 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. The WTP indicators have turned up for the Japanese, Eurozone and U.S. markets, although only the latter is sending a particularly bullish message at the moment. The U.S. WTP has risen above the 0.95 level that historically provides the strongest bullish signal for the stock-to-bond total return ratio. The WTP indicator suggests that, after loading up on bonds last year, investors still have "dry powder" available to buy stocks as risk tolerance improves. Bond valuation is roughly unchanged from last month at close to fair value, as long-term yields have been stuck in a trading range. The Treasury technical indicator suggests that oversold conditions have not yet been fully unwound, suggesting that the next leg of the bear market may take some time to develop. The dollar is extremely expensive based on the PPP measure shown in this section. However, other measures suggest that valuation is not yet at an extreme (see the Overview). Technically overbought conditions are still being unwound according to our dollar technical indictor. 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 Markets are facing large tail risks - both negative and positive; Donald Trump is a "Fat-Tail" president; European politics offer both a right-tail risk - German Europhile turn ... ... And a left-tail risk - Italian election and a shock in France; Investors should turn to the options market for opportunities. Feature "Stock market hits new high with longest winning streak in decades. Great level of confidence and optimism - even before tax plan rollout!" President Donald Trump "tweet" - February 16, 2017 Global stocks continue their tear as the market shrugs off President Trump's tweets, European Black Swans, saber-rattling in the South China Sea, and fears of de-globalization. Some of the optimism is backed by economic data, but mostly by the "soft data," or survey-based indicators (Chart 1).1 Chart 1Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits Not Much Behind The Optimism Aside From Animal Spirits So, why the party? It's the Animal Spirits. The bears are in retreat ... or facing deportation! We think investors are betting that the combination of the Brexit referendum and election of Donald Trump has forced policymakers to take their heads out of the sand. The market believes that policymakers have heard the angry electorate whose message is that dithering over economic policies must stop. BCA has been in this camp since last summer, when our colleague Peter Berezin penned an optimistic missive titled "The Upside To Populism."2 The hope that urgency will translate to expediency is what we think has propelled the S&P 500 to one of its best post-election performances (Chart 2). Trump's market performance is in the 83rd percentile of post-election outcomes. As promised, Trump has delivered a win. Chart 2Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest Trump Is Winning The S&P 500 Contest The danger is that the market is extrapolating from the Trump presidency all the "right-tail" or super-positive policy outcomes without accounting for any left-tail events. Trump is a "Fat-Tails" president, an unorthodox politician that could break the gridlock and deliver positive change, but whose brand of nationalist populism may also produce paradigm-shifting crises along the way. Several indicators suggest that caution is warranted. Our U.S. Equity Strategy colleagues offer two measures of complacency, the valuation-to-volatility ratio (Chart 3) and "Complacency-Anxiety Index" (Chart 4).3 Both are stretched and suggest that the market has never been as engrossed by the right-tail narrative as today. Given our constraints-based methodology, we are concerned by how certain the market appears. It seems to believe that all the wonderful things that Trump has promised will face no constraints, while his nationalism and mercantilism will be discarded. Chart 3Market Sees Only Right Tails Market Sees Only Right Tails Market Sees Only Right Tails Chart 4Complacency Reigns Complacency Reigns Complacency Reigns First, on the domestic front, Trump faces several mounting constraints: Political capital: Trump is an unpopular president (Chart 5), at least by the standards of his peers who enjoyed a post-election "honeymoon." This could affect his relationship with the GOP-controlled Congress that hardly warmed up to him in the first place. Precedent: Congress is struggling to produce Obamacare-replacement legislation, which the GOP had six years to prepare for. This bodes poorly for the timeliness of other legislation, like tax reform. Paying for stimulus: Republicans and the White House appear to be at odds over how to pay for the coming household and corporate tax cuts. The former want to pass the controversial border adjustment tax (BAT),4 while the Trump administration may not care how tax cuts are paid for. The BAT proposal is also facing opposition from major retailers and its legality under the WTO is still in question. Infrastructure: Spending on infrastructure, which is a no-brainer and has broad public support (Chart 6), has not seen a concrete plan despite Trump's emphasis on it during his inaugural address and campaign. Chart 5Trump's Approval Ratings Dismal A Fat-Tails World A Fat-Tails World Chart 6Everyone Loves New Roads A Fat-Tails World A Fat-Tails World In addition to the domestic political agenda, investors must deal with a packed European political calendar that we elucidated in last week's report5 (Table 1) and a potential U.S.-China trade war that could spill over into military tensions in the South China Sea.6 Table 1Busy Calendar For Europe This Year A Fat-Tails World A Fat-Tails World Investors may have been lulled into complacency by the February 10 phone call between presidents Xi and Trump. During the call, Trump committed to uphold the "One China" policy that has formed the bedrock of the Beijing-Washington rapprochement since 1972. A week later, on February 16, China suspended all imports of coal from North Korea - 50% of the country's entire export haul - until the end of the year. The move was a big nod to Donald Trump, a message by Beijing that China can play the role of an indispensable partner - if not outright ally - in the region. These moves have put fears of trade protectionism, our main candidate for a catalyst of a market correction, on the backburner. Investors can certainly be disappointed by smaller-than-expected tax cuts and tepid infrastructure spending, but such policy reversals will only encourage the Fed to stay easy and thus prolong the party. In the context of a synchronized global growth recovery - with both the global (Chart 7) and U.S. (Chart 8) economies looking decent - investors will not be deterred from bullishness merely by congressional intrigue. Chart 7Global Growth Looks Solid ... Global Growth Looks Solid ... Global Growth Looks Solid ... Chart 8... And So Does U.S. Growth ... And So Does U.S. Growth ... And So Does U.S. Growth The problem for investors is that the main two risks to global markets in 2017 have no set timeline. Last week, we pointed out that the main political risk in Europe is the Italian election whose date could be in autumn, or even as late as spring 2018. Today we add the French election to the list, where Marine Le Pen is mounting a furious rally on the back of rioting in the banlieue of Aulnay-sous-Bois. Similarly, Trump's mercantilism may remain dormant as he focuses on immigration, the "dishonest media," and cabinet appointees, even though it is very real. His administration is laser-focused on correcting a major perceived ill of the U.S. economy: the current account deficit. Therefore, investors should certainly welcome the Xi-Trump phone call, but the fact that the two leaders spent valuable time reaffirming a policy set 45 years ago should not be encouraging. In fact, the Trump administration has since asked the U.S. Trade Representative's office to consider changing how it calculates the U.S. trade deficit. According to the Wall Street Journal, Trump's White House is looking to exclude "re-exports" - goods imported into the U.S. merely so they can be assembled and then exported - from the calculation of U.S. exports.7 This would naturally balloon the U.S. trade deficit and give the Trump administration greater political ammunition - particularly against Mexico - for retaliation. Given solid global growth data, extremely positive surveys, and a market narrative still focused on the "Upside of Populism," it is tempting for investors to throw caution to the wind. Every time we encounter a bear in a client meeting or conference, we ask if he or she would "buy on dips" in case a correction happened. Their answer is almost universally "yes." It is difficult to see how a correction occurs in such an environment, where nobody actually expects a bear market. Although we are throwing in the towel with our two hedges - both the S&P 500 and Eurostoxx hedges have stopped out, we continue to stress that the market has priced in none of the left-tail risks that remain. We have a Fat-Tail President in the White House and an increasingly binary resolution to the euro area saga in the making in Europe. Fat Tails In Europe Since late 2016, we have suspected that Merkel's rule is unsustainable.8 However, while most investors fretted that Merkel would be replaced by a Euroskeptic, we considered that outcome extremely unlikely (at least in the current electoral cycle). For one, the refugee crisis that befell Europe would be short-lived, and indeed it is now over (Chart 9). For another, Germans are not Euroskeptics. What is astonishing is how quickly the German political establishment has realized and sought to profit from these facts. Instead of opposing Merkel with a cautious choice, the center-left Social Democratic Party (SPD) has turned to an unabashed Europhile, former President of the European Parliament Martin Schulz. Schulz is a relative unknown in Germany and was perceived by Merkel's coterie as a lightweight. On the surface, this made sense. Schulz has no university education and worked as a bookseller before becoming a politician. However, he knows EU politics extremely well, as he has been a member of the European Parliament since 1994. He has therefore heard every Euroskeptic argument on the continent and has learned to counter it emphatically. And he seems to understand the benefits that euro area membership has bestowed upon Germany, a view he appears to share with 80% of the German public, if the latest polls are to be believed (Chart 10)! Chart 9Migrant Crisis Waning Migrant Crisis Waning Migrant Crisis Waning Chart 10Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Germans See The Euro As A Great Deal Thus far, Schulz's campaign has focused on three main lines of attack: the traditional SPD call for greater economic redistribution, general appeal for European solidarity, and blaming Merkel for the rise of populists. To everyone's surprise - other than folks who understand how Germany works - this has been a successful approach. In just three weeks, the SPD has gone from trailing Merkel's Christian Democratic Union (CDU) by double digits to leading in the polls for the first time since 2001 (Chart 11). What should investors make of Schulz's meteoric rise? For one, nobody should get too excited, as the election is still a long seven months away. However, the SPD's resurrection suggests that the German political marketplace has been demanding a genuinely pro- euro area political alternative to the overly cautious Angela Merkel for some time. In other words, Schulz has realized that the median voter in Germany is far more Europhile than the conventional wisdom and Merkel have thought. Again... Chart 10 says it all! Unfortunately for the euro, Germany's Europhile turn may be too little too late. Italy's election is a major risk. As with the threat of American mercantilism, Italian elections are a risk that we cannot properly time. Furthermore, polls remain extremely close in Italy, suggesting that the election could go either way between the establishment and Euroskeptic parties. At this point, the best outcome may be a hung parliament. Meanwhile, the ongoing unrest in the northeast suburb of Paris, Aulnay-sous-Bois, appears to have given Marine Le Pen some wind in her sails (Chart 12). She has closed her head-to-head polling gap against Francois Fillon and Emmanuel Macron to just 12% and 20% respectively. Our net assessment is that she is not going to win, but our conviction level is declining. Her subjective probability has climbed to well over 20% at this point. Chart 11Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Pro-Europe Sentiment Drives SPD Revival Chart 12Le Pen Lags By 12-20% In Second Round A Fat-Tails World A Fat-Tails World Similar rioting in 2005 launched the political career of one Nicolas Sarkozy, who, as the country's Minister of Interior, took a hard line approach to the unrest, which launched him into the presidency. The lesson from Sarkozy's rise is important for two reasons. First, unrest in France's banlieues is politically relevant. These frequent bursts of violence support the National Front (FN) narrative that the integration of migrants has failed, that the country needs full control over its borders, and that the elites in Paris are not serious about law and order. The second lesson is that centrist, establishment politicians have no problem with being tough on crime, minorities, or immigrants. Sarkozy's rhetoric in 2007 mirrored much of the FN electoral platform. There is enough time, in other words, for Macron and Fillon to do the same in 2017. This will be particularly easy for Fillon, whose immigration policies already echo those of the FN. Chart 13ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe ECB Policy Will Stimulate Core Europe Macron, however, could be in trouble in the second round. And at the moment, he is more likely to face Le Pen in the second round than Fillon. As we pointed out in last week's missive, Macron could struggle to get right-wing voters to support him in the second round. We still do not have a historical case where right-wing voters were the ones who swung against the FN. In both the 2002 presidential election and the 2015 regional elections, it was mostly left-wing voters who swung to the center-right to keep the FN out of power. Will French conservative voters come out and support a centrist candidate like Macron who may be perceived as "soft" on crime? Time will tell. His polling appears to be holding up well against Le Pen, but her momentum is now rising. Bottom Line: Europe faces its own version of Fat Tails in 2017. On the one hand, we expect the ECB to remain easier than consensus would have it, given the mounting political risks in the periphery. We expect the ECB to ignore the broad euro area economy and focus on the interest rates that the periphery - namely Italy - needs (very low for very long time) (Chart 13). When combined with a Europhile turn in Germany and a positive fiscal thrust as the EU Commission turns against austerity, we see a Goldilocks scenario for euro area assets over the short and medium term. We are betting that this right-tail risk will ultimately prevail. On the other hand, Italian elections could knock the train off the rails at any time. Due to the announced leadership race in the ruling Democratic Party (PD), the election will most likely have to take place after the summer. Or, it may have to be put off until Q1 2018. But whenever it is announced, it will become the risk to European and global assets. For now, we continue to recommend that clients remain overweight euro area equities. However, vigilance will be needed as the market climbs the wall of worry. Investment Implications - Trading Fat Tails In A Low-Vol World What should investors do in a world that is increasingly exemplified by our Fat-Tails thesis? Current levels of the VIX suggest that the market is not pricing in a potentially higher level of volatility, which we would intuitively expect to rise in a Fat-Tail world (Chart 14). On the other hand, current low levels of volatility may merely be the calm before the storm. Investors may be "frozen" by the high probability of both left- and right-tail outcomes and thus choosing to sit on the sidelines instead of committing to any one narrative. Chart 14Volatility Extremely Low Volatility Extremely Low Volatility Extremely Low One way to think about investing in this world is to turn to the options market. The options market is unique in that it allows investors to take a view on the dispersion of the expected returns of the asset against which the option is written.9 This is because one of the critical components of a call or put option's value is the expected volatility of returns for the asset underlying the option itself. Volatility is trading-market shorthand for the annualized standard deviation of expected returns for the underlying asset. Volatility is a calculated value, whereas the other components of an option's price - i.e. the underlying asset's price, the strike price, time to expiration, and interest rates - are known inputs. Volatility, like the price of the underlying asset, is "discovered" when a trade occurs. After an option trades and its premium is known, an option-pricing model - e.g., the Black-Scholes-Merton model - can be run backwards, so to speak, to see what level of volatility solves the pricing model for the value that cleared the market. This is known as the option's implied volatility, because it is the expected standard deviation of returns implied by the price at which the option clears the market. One reason investors and traders buy and sell options is to express a view on implied volatility. Option buyers who think the market is underestimating the likelihood of sharply higher returns can express this view by buying out-of-the-money options. This can arise for any number of reasons, but they all boil down to one essential point: option buyers think there is a higher probability that returns will be higher or lower during the life of an option than what is being priced in the options market.10 Option sellers, on the other hand, are expressing the opposite view. We believe the geopolitical tail risks we have discussed in this report are not being fully reflected in the options markets most sensitive to this information, among them the gold market. Our own assessment of these risks implies much fatter tails than we currently observe in out-of-the-money gold options. For this reason, we are recommending investors consider buying $1,200/oz gold puts and $1,300/oz gold calls expiring in either June or December of this year. This is a strategic recommendation. We leave it to investors to set their own stop-loss, if they are not comfortable foregoing the full premium paid to hold these options to expiry, possibly expiring worthless. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Robert Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see Global Investment Strategy Weekly Report, "The Downside To Full Employment," dated February 3, 2017, available at gis.bcaresearch.com. 2 Please see Global Investment Strategy Special Report, "The Upside To Populism," dated August 19, 2016, available at gis.bcaresearch.com. 3 Please see U.S. Equity Strategy Weekly Report, "Bridging The Gap," dated February 6, 2017, available at uses.bcaresearch.com. 4 Please see Geopolitical Strategy Weekly Report, "Will Congress Pass The Border Adjustment Tax?" dated February 8, 2017, available at gps.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Climbing The Wall Of Worry In Europe," dated February 15, 2017, available at gps.bcaresearch.com. 6 Please see Geopolitical Strategy Weekly Report, "The 'What Can You Do For Me' World?," dated January 25, 2017, and "Trump, Day One: Let The Trade War Begin," dated January 18, 2017, available at gps.bcaresearch.com. 7 "Please see William Mauldin and Devlin Barrett, "Trump Administration Considers Change In Calculating U.S. Trade Deficit," Wall Street Journal, February 19, 2017, available at www.wsj.com. 8 Please see Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 9 Call options give the buyer the right to go long an underlying asset at the price at which an option contract is struck - i.e. the option's strike price. Puts give option buyers the right to go short the underlying asset at the price at which the contract is struck. While an option buyer is not required to ever exercise an option, option sellers must take the other side of the deal if the buyer chooses to exercise. Option buyers pay a premium for the put or call they purchase. 10 This probability also can be expressed in terms of price levels, which allows investors to take an explicit view of the likelihood of a particular price being realized during the life of the option being purchased. Please see Bob Ryan and Tancred Lidderdale, "Energy Price Volatility and Forecast Uncertainty," published by the U.S. Energy Information Administration (2009), for a discussion of options markets and implied volatility. "Appendix II: Derivation of the Cumulative Normal Density for Futures Prices" beginning on p. 22 shows how to transform the returns distribution into a price distribution. It is available at https://www.eia.gov/outlooks/steo/special/pdf/2009_sp_05.pdf. Geopolitical Calendar

Highlights Global manufacturing inventories are low but this does not guarantee higher share prices for global cyclical stocks. If an increase in inventories is accompanied by strengthening final demand, it will be very bullish for the global business cycle. If final demand growth falters, global cyclical plays will relapse amid rising inventories. China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out raising the odds of a reversal in EM/China plays sooner than later. The risk/reward of EM/China plays remains unattractive. Feature Global Manufacturing Inventories Global manufacturing inventories have been depleted over the past 12 months, and inventory levels are generally low (Chart I-1 and Chart I-2). Chart I-1Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Chart I-2Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Global Manufacturing Inventories Are Low Could inventory re-stocking extend the current manufacturing cycle recovery worldwide? Will low inventories and re-stocking in China lengthen the nation's business cycle upswing? Chart I-3 demonstrates inventory cycles and manufacturing production within manufacturing-intensive economies. The correlation is not stable. Currently, this entails that low manufacturing inventories and a potential rise in inventories over the course of this year do not guarantee acceleration in industrial output growth. Having reviewed manufacturing inventory cycles and their correlation with share prices, we conclude that the key to share prices is final demand - not inventory swings. Manufacturing inventories have dropped in the past 12 months because final demand has been robust (Chart I-4). Historically, periods of re-stocking have often coincided with poor equity market performance. Indeed, Taiwanese, Korean, Japanese and German non-financial share prices have no stable correlation with their respective manufacturing inventory cycles (Chart I-5). In short, manufacturing inventories could rise in the months ahead, but this does not guarantee higher share prices in cyclical industries. Chart I-3Inventories And Production ##br##Are Not Always Correlated Inventories And Production Are Not Always Correlated Inventories And Production Are Not Always Correlated Chart I-4Robust Demand Has Led ##br##To Inventory Depletion Robust Demand Has Led To Inventory Depletion Robust Demand Has Led To Inventory Depletion Chart I-5Non-Financial Share Prices And##br## Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation Non-Financial Share Prices And Inventories: Little Correlation By and large, the outlook for corporate profits is contingent on final demand rather than re-stocking. All of the above confirms that inventories are a residual of demand and supply. Stronger-than-expected demand is bullish for share prices, though it also often coincides with declining inventories. By contrast, rising inventories typically reflect demand falling behind output growth (one can define it as involuntary re-stocking) and these periods are not favorable for share price gains in cyclical industries. One caveat is that there could be a re-stocking cycle amid strengthening demand or, in other words, voluntary re-stocking. If this transpires in the coming months, it will be extremely bullish for share prices as it will supercharge output growth. While the latter scenario - inventory re-stocking amid strengthening final demand - could very well occur within the advanced economies this year, odds of such positive dynamics are low in EM/China. Bottom Line: Share prices in global cyclical sectors are driven by swings in final demand - not in inventories. Going forward, global manufacturing inventories will rise. If this rise is accompanied by strengthening demand, it will be very bullish for the global business cycle. Otherwise, global cyclical plays will relapse as inventories rise. What Drives China's Inventory Cycles Chart I-6 shows that China's manufacturing inventories typically deplete when the credit and fiscal impulse is rising, and vice versa. China's manufacturing inventories have been exhausted because demand has been strong in the past 12 months. In turn, demand strength has originated from the country's massive fiscal and credit stimulus push from the first half of 2016. Chart I-6China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction China: Strong Policy Stimulus Led To Manufacturing Inventories Reduction That said, China's aggregate fiscal and credit impulse seems to have recently rolled over, pointing to a top in its manufacturing mini-cycle and commodities prices (Chart I-7). This signals a potential deceleration in final demand. On the whole, the ongoing modest tightening by the People's Bank of China and by the bank regulator (the China Banking Regulatory Commission) amid a lingering credit bubble is raising the odds of a moderate credit slowdown in the months ahead. Even modest credit growth deceleration will result in a negative credit impulse (Chart I-8, top panel). Meanwhile, the mainland's fiscal impulse has already dropped (Chart I-8, bottom panel). Chart I-7China: Aggregate Credit And Fiscal##br## Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out China: Aggregate Credit And Fiscal Stimulus Has Topped Out Chart I-8China: A Breakdown Of Credit ##br##And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses China: A Breakdown Of Credit And Fiscal Impulses On the whole, these developments are leading us to maintain our negative bias toward EM risk assets and China plays. What has gone wrong in our view/analysis on China in the past 12 months is that the nation's credit growth has stayed much stronger than we expected. In our April 13, 2016 report,1 we did a scenario analysis and argued that China's large fiscal stimulus push would be offset by a negative credit impulse if credit growth slowed from 11.5% to below 10%. In reality, credit growth has been between 11.5-12.5%, producing a positive credit impulse. Barring tightening by the central bank or bank regulators, mainland banks can continue originating loans/money at a double-digit pace, as they have been doing for many years (Chart I-9). In general, commercial banks do not need savings to create money/loans and there are few limits on Chinese banks originating loans "out of thin air," as we argued in our Trilogy of Special Reports on money/loan creation, savings and investment.2 Chart I-9China's Credit/Money Growth##br## Remains Rampant China's Credit/Money Growth Remains Rampant China's Credit/Money Growth Remains Rampant Therefore, if credit growth does not slow, our negative view on China's growth will be off-the-mark again. The pressure point in such a case will be the exchange rate. Unlimited money creation/oversupply of local currency is bearish for the value of the RMB. The RMB will continue depreciating, but it is not certain if it will hurt EM risk assets. It is a major consensus view nowadays that the Chinese authorities will not allow growth to suffer ahead of the Party Congress in autumn of this year. Yet, the PBoC and bank regulators are modestly tightening to "normalize" credit growth. Some clients may wonder why we are placing so much emphasis on the rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend that unwinds excesses. Similarly, moderate tightening in a healthy credit system should not be feared. From a big picture perspective, we turned bearish on China's growth several years ago due to the formation of a credit bubble. The bubble has only gotten larger and an adjustment has not yet even started. This does not justify altering our fundamental assessment of China's growth outlook. It would have been ideal to turn positive tactically on EM/China plays a year ago. Unfortunately, we did not do that. Presently, chasing the market higher might not be the best investment idea. Based on all this and given: the sharp rally in EM/China plays and widespread investor complacency and consensus that "everything" will be fine before the end of this year; modest tightening in Chinese monetary policy amid lingering credit and asset (property and the corporate bond market) bubbles; our outlook for higher U.S. bond yields and a stronger U.S. dollar; the fact that financial markets are forward looking, and timing is impossible; We believe the risk/reward of EM/China plays remains unattractive. In regard to EM ex-China, as we documented in last week's report, domestic demand in the developing economies has not recovered at all, or is mixed at best. DM final demand strength and global manufacturing inventory rebuilding will certainly help Korea and Taiwan, but not other emerging economies. The most important variables for other EM economies including China are domestic demand and/or commodities prices. If commodities prices relapse along with China's credit and fiscal impulse (Chart I-7, bottom panel), EM financial markets will suffer regardless of the growth trends within advanced economies. In fact, strong U.S. growth could lead to higher U.S. interest rate expectations and prop up the U.S. dollar. This will also be a bad omen for EM and commodities. Bottom Line: China's inventory depletion has been due to the large fiscal and credit impulse in the past 12 months - i.e., improving final demand has been instrumental to inventory shedding. Looking forward, the mainland's aggregate credit and fiscal impulse seems to have topped out, raising the odds of a reversal in EM/China plays sooner than later. Industrial Metals Inventories And Prices There is no good data reflecting industrial metals inventories globally. London Metal Exchange and Shanghai Futures Exchange data are likely not indicative of global metals stockpiles. China accounts for close to 50% of global demand for industrial metals, and its demand is critical to prices. Given that the large spike in metals prices in the past several months has coincided with improving Chinese economic data, one would expect the mainland to be the driving force behind the rally. However, Chart I-10 demonstrates that China's imports of industrial metals actually contracted in 2016. This is puzzling, but we have to take it at face value. The top panel of Chart I-11 depicts that traders' net long positions in copper are at a six-year high. This might partially explain the rally in copper in the recent months. Chart I-10China's Import Of Base Metals##br## And Base Metals Prices China's Import Of Base Metals And Base Metals Prices China's Import Of Base Metals And Base Metals Prices Chart I-11Traders Are Long ##br##Copper And Oil Traders Are Long Copper And Oil Traders Are Long Copper And Oil Clearly, China has been depleting its stock of industrial metals, and is likely primed to increase its imports. Nevertheless, periods of metals re-stocking by the mainland have historically not entailed higher industrial metals prices (Chart I-10). On the contrary, rising Chinese imports of metals have actually coincided with falling prices. One can interpret this relationship as China buying industrial metals when prices are falling. This is consistent with China attempting to buy commodities on dips. As to metals inventories in China, the picture is as follows: Steel inventories have plummeted and are low (Chart I-12). One can safely argue that there will be an inventory re-stocking cycle in China. Nevertheless, it is highly uncertain if this will be bullish for steel prices and steel stocks. In fact, there has been a mild negative correlation between steel prices and inventories; historically, when inventories have risen, prices declined (Chart I-12, top panel). This confirms that inventory levels are a residual of demand and supply, and prices are often driven by final demand - not inventories. This is also corroborated by the bottom panel of Chart I-12, which illustrates that share prices of global steel companies are sometimes negatively correlated with China's steel inventories. Stock prices occasionally sell off when inventories rise, and rally when inventories are shrinking. In contrast to steel and steel products, iron ore inventories have risen, and it seems the re-stocking cycle is well advanced (Chart I-13). Chart I-12China: Steel Inventories And Prices China: Steel Inventories And Prices China: Steel Inventories And Prices Chart I-13China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices China: Iron Ore Inventories And Prices Yet, again there is no strong correlation between inventories and prices of iron ore (Chart I-13). In our discussions with clients, investors often attribute the rally in industrial metals in general and steel prices in particular over the past 12 months to supply cutbacks in China. While supply reductions have helped in the case of certain metals, it is also evident that the rally in industrial commodities has been driven by rising demand globally and in China. First, China's aggregate credit and fiscal impulse was positive until very recently, implying strengthening demand and thereby higher metals prices. Second, if there were only production cutbacks in steel and other commodities and not demand recovery, the mainland's manufacturing PMI would not have risen (Chart I-14). Finally, steel production has risen both in China and the rest of the world (Chart I-15). Hence, world steel supplies have expanded in the past 12 months. Given this has coincided with rising steel prices, it confirms there has been notable improvement in demand for steel. Chart I-14China: Steel Prices Are Up ##br##Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand China: Steel Prices Are Up Because Of Strong Demand Chart I-15Chinese And Global ##br##Steel Production Chinese And Global Steel Production Chinese And Global Steel Production We are not experts in the ebbs and flows of commodities supplies, but it seems the Chinese government's mandated steel capacity cutbacks have not prevented rising steel output in China. In the meantime, rising prices amid rising production and falling inventories are indicative of robust final demand for many metals. Bottom Line: Industrial metals prices have risen because demand in the real economy and among financial investors has been strong. That said, a rollover in China's fiscal and credit impulse and a strong U.S. dollar will likely create headwinds for industrial metals prices over the course of this year. A Word About Oil Inventories OECD oil product inventories have continued to rise, despite supply cuts (Chart I-16, top panel). At the same time, our proxy for change in China's oil inventories has been very elevated for a while, depicting strategic and/or commercial inventory building on the mainland (Chart I-16, bottom panel). It is true that supply curtailments have been instrumental to the rally in oil prices, but the continued inventory buildup also indicates that supply is still outpacing demand. Besides, traders' net long positions in crude have spiked close to their 2014 highs (Chart I-11, bottom panel). This corroborates that demand for crude, like for copper, has partially been financial rather than from final consumers. Finally, U.S. rig counts have recovered somewhat, which may be indicative of a continued rise in America's oil output (Chart I-17). Chart I-16Oil Inventories Keep On Rising Oil Inventories Keep On Rising Oil Inventories Keep On Rising Chart I-17U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production U.S. Rig Counts And Oil Production Bottom Line: While we do not have expertise to follow or forecast oil supply dynamics, we are biased in believing that the risk-reward for oil prices is unattractive because of a strong U.S. dollar and potentially weak EM/China asset prices, which could trigger a reduction in net long positions in crude. Investment Conclusions Complacency reigns in the global financial markets. EM equity volatility has fallen close to its cycle lows, the U.S. VIX is depressed, U.S. equity investor sentiment is very elevated and EM corporate credit spreads have plummeted to a ten-year low (Chart I-18). While the timing of a reversal is impossible, the risk-reward profile of EM financial markets is greatly unattractive. The U.S. trade-weighted dollar has consolidated recently, and might be primed for another upleg. As the U.S. dollar resumes its uptrend, EM risk assets will likely sell off. Finally, EM share prices have failed to outperform the developed bourses much, despite the rally in commodities and amelioration in Chinese growth (Chart I-19). Chart I-18Complacency Reigns Complacency Reigns Complacency Reigns Chart I-19EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed EM Equities Have Not Yet Outperformed Remarkably, analysts' net earnings revisions for EM stocks have so far failed to turn positive (Chart I-20). Either analysts' EPS expectations were originally still too high, or companies are failing to deliver profits. Whatever the reason, the implication is that the consensus is more bullish on EM than is suggested by the underlying fundamentals. Within an EM equity portfolio, our overweights remain Taiwan, Korea, India, China, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. We are neutral on other bourses. Finally, the EM equity benchmark is at a critical technical resistance level (Chart I-21) but odds do not favor a sustainable breakout. Chart I-20EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative EM EPS Net Revisions Are Still Negative Chart I-21EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt EM Stocks: A Breakout Attempt Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Special Report titled, "Revisiting China's Fiscal And Credit Impulses", dated April 13, 2016, available at ems.bcaresearch.com 2 Trilogy of Special Reports on money/loan creation, savings and investment, titled, "Misconceptions About China's Credit Excesses" dated October 26, 2016, "China's Money Creation Redux And The RMB", dated November 23, 2016 and "Do Credit Bubbles Originate From High National Savings?", dated January 18, 2017, available at ems.bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Fed & Yields: Positive U.S. growth and inflation momentum is maintaining the credibility of the Fed's 2017 rate hike plans. U.S. bond yields, in particular, and global yields, in general, will remain under upward pressure in this environment, despite the aggressive short positioning in the U.S. Treasury market. Maintain a below-benchmark portfolio duration stance. "Soft" vs. "Hard" Data: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The cyclical outlook Down Under has become murkier of late, even with the RBA starting to shift in a more hawkish direction. We are taking profits on our recommended pro-growth tilts in Australia. Feature The positive momentum on global growth continues to put upward pressure on bond yields, despite the large short positioning already in place in the government bond markets. The benchmark 10-year U.S. Treasury yield returned to 2.5% at one point last week, led by a rash of better-than-expected data on U.S. retail sales and inflation, combined with hawkish comments from numerous Fed officials (Chart of the Week). Markets started to more seriously consider a March Fed rate hike, although we still see June as the more likely date for the Fed's next tightening move. As we have discussed in several recent reports, it is a surge in global economic survey data that suggests that a broad-based upturn currently underway. While this is all good news for risk assets, there is some concern among investors that a pick-up in growth has been slow to appear clearly in the "hard" economic data related to final demand. Without a boost in actual economic activity, and not just "feel good" surveys, the pro-growth momentum currently embedded in equity and bond markets may melt away as rapidly as it was built up. Mark McClellan, the Chief Strategist at BCA's flagship publication, The Bank Credit Analyst, is releasing a report this week that digs into the differences between "soft data" (i.e. surveys) and "hard data" (i.e. employment and production).1 We present some excerpts from that report in the following section. Global Growth Pickup: Fact Or Fiction? Investors have taken some comfort from the fact that leading indicators are trending up across most of the developed and emerging economies. BCA's Global Leading Economic Indicator is moving higher and will climb further in the coming months given that its diffusion index is well above 50 (Chart 2). The Global ZEW indicator and the BCA Boom/Bust growth indicator are also constructive on the growth outlook. Chart of the WeekNo Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. No Bond-Bearish Data In The U.S. Chart 2A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth A Consistent, Positive Message On Growth Consumers and business leaders are feeling more upbeat as well, both inside and outside of the U.S. (Chart 3). Importantly, the improvement in sentiment began before the U.S. election. Surveys of business activity, such as the Purchasing Managers Indices (PMI), are painting a uniformly positive picture for near-term global output in both the manufacturing and service industries. While this is all good news for risk assets, there is concern that a growth impulse has been slow to show up clearly in the "hard" economic data related to final demand. The good news is that there is more to the cyclical upturn than hope. The improved tone in the forward-looking data is now clearly showing up in some measures of final demand. The caveat is that there is no evidence yet that the cyclical mini up-cycle in 2017 is any less vulnerable to negative shocks than was the case in previous upturns since the Great Recession. The Hard Data First, we start with some bad news. There has been a worrying loss of momentum in job creation in recent months (Chart 4). While employment gains have accelerated in Japan, Canada and Australia, the payroll slowdown is mainly evident in the U.S. and U.K. This may reflect supply constraints as both economies are near full employment, but it is difficult to determine whether it is supply or demand-related. The good news is that the employment component of the global PMI has rebounded sharply following last year's dip, suggesting that the pace of job creation will soon turn up. Chart 3Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Surging Confidence, Production Following Suit Chart 4Global Employment Growth Cooling Off Global Employment Growth Cooling Off Global Employment Growth Cooling Off Also on the positive side, households are opening their wallets a little wider according to the retail sales data (Chart 5), where growth has accelerated sharply in all the major economies except U.K. and Australia (NOTE: we discuss the Australian bond outlook later in this Global Fixed Income Strategy report). Similarly, business capital spending is finally showing some signs of life following a rocky 2015 and early 2016. An aggregate of Japanese, German and U.S. capital goods orders2 is a good leading indicator for G7 real business investment (Chart 6). The acceleration of imported capital goods for our 20-country global aggregate corroborates the stronger new orders reports (bottom panel). Chart 5On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! On Your Mark, Get Set, Shop!! Chart 6Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Global Capex Cycle Turning Positive Recent data on industrial production show that the global manufacturing sector is clearly emerging from last year's recession. Short-term momentum in production growth has accelerated over the past 3-4 months across all of the major advanced economies (Chart 7). Production growth has been particularly robust in the Eurozone, U.K. and Japan. Industrial output related to both household and capital goods is showing increasing signs of vigor in recent months (Chart 8). Chart 7A Global Manufacturing Upturn A Global Manufacturing Upturn A Global Manufacturing Upturn Chart 8A Broad-Based Acceleration A Broad-Based Acceleration A Broad-Based Acceleration At the moment, the upturn in manufacturing production is being driven by a broader pickup in business spending. The acceleration in production and orders related to consumer goods in the major countries suggests that household final demand is also showing increased vitality, consistent with the retail sales data. The Soft Data Chart 9Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Global GDP Growth Is Accelerating Notwithstanding the nascent upturn in the hard data, some believe that the soft data are sending an overly constructive signal in terms of near-term growth. The soft data generally comprise measures of confidence and surveys of business activity. One could discount the pop in U.S. sentiment as simply reflecting hope that President Trump's election promises to cut taxes, remove red tape and boost infrastructure spending will come to fruition. Nonetheless, improved sentiment readings are widespread across the major countries, which means that it is probably not just a "Trump" effect. Moreover, there is no reason to doubt the surveys of actual business activity. Surveys such as the PMIs, the U.K. CBI Business Survey, the German IFO current conditions index and the Japanese Tankan survey are all measures of activity occurring today or in the immediate future (i.e. 3 months). There is no reason to believe that these surveys have been contaminated by "hope" and are sending a false signal on actual spending. To test the reliability of the growth message from the "soft data", we employed these indicators in regression models for real GDP in the four major advanced economies and for the G7 as a group (Chart 9). The models predict that G7 real GDP growth will accelerate to 2½% on a year-over-year basis in the first quarter of 2017. We expect growth of close to 3% in the U.S. and a little over 2½% in the Eurozone, although the model for the latter has been over-predicting somewhat over the past year. Japanese growth should accelerate to about 2% in the first quarter based on these indicators. The implication is that the survey data are not sending a distorted message; underlying growth is accelerating even though it is only now showing up in the hard economic data. Turning for a moment to the emerging world, output is picking up on the back of an upturn in exports. However, we do not see much evidence of a domestic demand dynamic that will help to drive global growth this year. The main exception is China, where private sector capital spending growth has clearly bottomed. Stronger Chinese capital spending in 2017 will boost imports and thereby support activity in China's trading partners, particularly in Asia. Conclusions We have little doubt that a meaningful global growth acceleration is underway. Our sense is that 'animal spirits' are finally beginning to stir, following many years of caution and retrenchment. American CEOs appear to have more swagger these days. Since the start of the year there have been a slew of high-profile announcements of fresh capital spending and hiring plans from companies such as Amazon, Toyota, Walmart, GM, Lockheed Martin and Kroger. A return of animal spirits could prolong a period of stronger growth, even if President Trump's growth-boosting policies are delayed or largely offset by spending cuts or trade wars. This economic backdrop is positive for risk assets and bearish for government bonds. Bottom Line: After a deep dive into the economic data for the major countries, both "hard" demand indicators and "soft" survey measures, we have little doubt that a tangible global growth acceleration is underway. This positive economic backdrop will continue to put upward pressure on government bond yields while boosting the relative return performance for corporate credit. Australia: The Equation Gets More Complicated Two weeks ago, the Reserve Bank of Australia (RBA) unsurprisingly left its cash rate unchanged at 1.5%. The post-meeting statement by RBA Governor Philip Lowe was considered hawkish by economic analysts. Nonetheless, the market reaction has been relatively muted, with the Australian government bond yield curve steepening by only 5 bps, and the Aussie dollar remaining stable, since the meeting. Pricing in the OIS curve suggests that the RBA will probably remain on hold throughout 2017, but the implied odds of a rate hike are rising, standing now at 20%. The RBA's assessment of the current global economic backdrop was relatively constructive, pointing to above-trend growth expectations in a number of advanced economies. Domestically, the RBA foresees a boost to Australian export growth from the resource sector, an end to the decline in mining investment and a pick-up in non-mining capital spending.3 With such a tone, the central bank might have set up the market for some disappointments. The new forecast of economic growth around 3% for the next couple of years seems overly optimistic. This is higher than the median expectation of economists surveyed by Bloomberg, who foresee 2.5% and 2.8% growth for 2017 and 2018, respectively. The IMF does not expect growth to reach 3% until 2019. Granted, several parts of the economy have shown very robust performances of late. The service sector PMI has surged to pre-crisis levels. The NAB survey of business conditions also shot higher last week. Goods exports have exploded at a 40% annual growth rate, causing the December trade balance to jump to $3.5bn, nearly double the consensus $2.0bn estimate (Chart 10). Those jumps in activity are hard to ignore. From a big picture perspective, however, Australian economic data has not been surprising to the upside, unlike the trend in in the rest of the world over the past few months (Chart 11). This is intriguing, since an easy monetary policy, loose bank credit conditions, improving profit expectations and a reflationary impulse coming from China were all tailwinds that should have supported Australian growth; this was our view last year.4 Now, those favorable factors have started to reverse, raising the chances of a cyclical economic downturn. Chart 10Surging Numbers Surging Numbers Surging Numbers Chart 11Surprisingly Unsurprising Surprisingly Unsurprising Surprisingly Unsurprising Foremost, overall labor market conditions are uninspiring (Chart 12): Although the monthly employment change for January did positively surprise, at 13.3k versus an expected 10k, the pace of job creation remains under 1% year-over-year, which is low by historical standards. The diverging trend between plunging full-time and steady part-time job growth indicates a sub-optimal labor market. The labor force participation rate declined from 65.2 to 64.6 in 2016, suggesting an increasing amount of discouraged workers. Underemployment has not budged in the last two years and is stuck at historically high levels. As result, a rise in labor market slack poses a risk for the Australian consumer; wage growth has already been in a downtrend since 2011 (Chart 12, bottom panel). The construction sector further confirms our apprehensions on the true strength of the economy. Households believe that it is not a good time to buy a home, while building approvals for new dwelling units fell from bubbly levels at the end of last year. At the same time, speculative money, which was supposed to have been curbed by macroprudential policy measures, has returned to the housing market (Chart 13). Lower supply and increased speculation could push residential prices even higher, inflating debt burdens, and leaving households with fewer dollars to consume. Chart 12Consumption: Set To Deteriorate Consumption: Set To Deteriorate Consumption: Set To Deteriorate Chart 13The Foundations Are Shaking The Foundations Are Shaking The Foundations Are Shaking Externally, the Chinese reflationary mini-boom - which boosted the prices of iron ore and other commodities exported by Australia last year - will probably retreat to some extent in 2017. Although China's overall cyclical momentum remains solid, according to our GFIS China Checklist,5 government spending growth has severely relapsed, potentially signaling an end to last year's largesse (Chart 14). With that in mind, it has become difficult to envision a continuation of the positive effects from the terms of trade shock experienced by Australia in 2016. In a similar vein, but domestically-driven, Australia's credit growth has become a headwind. Between 2013 and 2015, business credit growth was expanding, creating a positive impulse for the economy. Unfortunately, this trend changed tack in 2016, with slowing credit growth now representing a negative economic force (Chart 15). With Australian banks having suffered declining profits and rising bad debt charges in the last few quarters, credit conditions could tighten going forward. This is especially worrisome since personal credit was already contracting in 2016. Chart 14China Mini-Boom Could Be Over China Mini-Boom Could Be Over China Mini-Boom Could Be Over Chart 15Negative Credit Impulse Negative Credit Impulse Negative Credit Impulse top of all this, the IMF is projecting that Australia's fiscal thrust - the change in the primary government budget balance - will be negative in each of the next five years (Chart 16). As such, this economy could run out of supporting impulses in the short to medium term. Summing it all up, we agree with the current market pricing of interest rates, given the economic uncertainties. The RBA will most likely remain on hold for the foreseeable future. The story remains the same; the central bank wants to depreciate the overvalued Aussie dollar, but excesses in the housing market prevent them from weakening the currency through interest rate cuts (Chart 17). Now, the declining cyclical outlook will only complicate the equation. Chart 16Negative Fiscal Impulse Negative Fiscal Impulse Negative Fiscal Impulse Chart 17The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver The RBA Has Little Room To Maneuver Investment Implications Our updated and more balanced economic view of Australia leads us to neutralize our recommended pro-growth Australia bond tilts: Asset allocation. As discussed above, the previously favorable factors supporting the Australian economy are progressively reversing. This is not the case in most of the other bond markets where additional cyclical upward pressure on global yields is anticipated. To reflect this view, today we are upgrading our recommended Australian bond exposure to neutral, from below-benchmark, within global hedged bond portfolios. This underweight position produced +188bps of excess return versus the global benchmark since inception in June 2016. Duration. The 10-year Australian government bond yield, 1-year forward, is 3.04%, 25bps above the current yield of 2.79%. There is a good chance that yields will rise at a faster pace than implied by the forwards at times over the course of the year, given the improving global growth and inflation backdrop. However, these instances will be opportunities to extend duration within dedicated Australian fixed income portfolios. Current Australian government bond valuation has become very cheap and is now at a level that has been associated with the beginning of positive absolute performance in the past. Moreover, the 10-year inflation breakeven is already pricing in a fair amount of inflation increases; those expectations will be hard to surpass, especially considering the low starting point (Chart 18). Curve. In May 2016, we initiated an Australian butterfly curve trade, going long the 2-year/6-year barbell versus the 4-year bullet. At the time, the 2/4/6 part of the government bond yield curve was kinked, with the 4-year sector trading very expensive versus the 2-year and 6-year maturities, reflecting the perception of a dovish stance by the RBA. then, the market has priced out these rate cut expectations, as we expected, and this part of the curve has bear steepened (Chart 19). Today, we close this trade at a +36bps profit. The RBA's future potential actions - or, more likely, inaction - are now properly discounted in the curve and reflect our neutral stance on the RBA. Chart 18Time To Buy Australian Bonds Time To Buy Australian Bonds Time To Buy Australian Bonds Chart 19Taking Profits On Our 2/4/6 Butterfly Trade It's Real Growth, Not Fake News It's Real Growth, Not Fake News Credit trades. Developing economic uncertainties warrant more cautiousness towards Australian credit. In March 2016, we recommended going long Australian semi government debt versus federal government bonds as an initial way to play what was, at the time, a relatively constructive view on the Australian economy.6 Now, given the increased economic risks, we are closing this relative value trade with a +133bps profit. Mark McClellan, Senior Vice President markm@bcaresearch.com Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com Robert Robis, Senior Vice President rrobis@bcaresearch.com 1 Please see The Bank Credit Analyst, Section II, "Global Growth Pickup: Fact Or Fiction?," dated March 2017, available at bca.bcaresearch.com 2 Machinery orders used for Japan 3 http://www.rba.gov.au/media-releases/2017/mr-17-02.html 4 For details, please see BCA Global Fixed Income Strategy Weekly Report, "Last Minute Recommendations Before The Brexit Vote," dated June 21, 2016, available at gfis.bcaresearch.com 5 For details concerning this indicator, please see BCA Global Fixed Income Strategy Weekly Report, "How To Assess The "China Factor" For Global Bonds," dated November 11, 2016, available at gfis.bcaresearch.com 6 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters," dated March 29, 2016, available at gfis.bcaresearch.com The GFIS Recommended Portfolio Vs. The Custom Benchmark Index It's Real Growth, Not Fake News It's Real Growth, Not Fake News Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Feature Valuations, whether for currencies, equities, or bonds, are always at the top of the list of the determinants of any asset's long-term performance. In this optic, we regularly update the set of long-term valuation models for currencies we introduced in a February 16 Special Report titled "Assessing Fair Value In FX Markets." Included in these models are variables such as productivity differentials, terms-of-trade shocks, net international investment positions, real rate differentials, and proxies for global risk aversion.1 These models cover 23 currencies, incorporating both G10 and EM FX markets. Twice a year, we provide clients with a comprehensive update of all these long-term models in one stop. This time around, a few fair value estimates have changed. This reflects the revisions to the productivity estimates we source from the Conference Board. These models are not designed to generate short- or intermediate-term forecasts. Instead, they reflect the economic drivers of a currency's equilibrium. Their purpose is therefore threefold. First, they provide guideposts to judge whether we are at the end, beginning, or middle of a long-term currency cycle. Second, by providing strong directional signals, these models help us judge whether any given move is more likely be a countertrend development or not, offering insight on its potential longevity. Third, they help us and our clients to cut through the fog, and understand the key drivers of cyclical variations in a currency's value. The U.S. Dollar Chart 1Upward Revisions To Productivity Have Lifted The USD's Fair Value Upward Revisions To Productivity Have Lifted The USD's Fair Value Upward Revisions To Productivity Have Lifted The USD's Fair Value Based on its key long-term drivers - real yield differentials and the relative productivity trend between the U.S. and its trading partners - the U.S. dollar is trading around 5% above its upward-pointing fair value. Moreover, the equilibrium exchange rate for the USD has risen from previous estimations as the U.S. productivity series computed by the Conference Board have been revised upward. This comforts us in our bullish stance on the U.S. dollar. For one, the valuation premium has fallen relative to its previous estimate. Second, the dollar remains substantially below previous overvaluation peaks, where it traded at a more than 20% premium to fair value (Chart 1). Additionally, with the U.S. slack being much smaller than in most other major economies, the Fed is in a much firmer position to increase rates than most of its counterparts. This suggests that U.S. rates will continue to boost the dollar higher, justifying a growing premium to its long-term equilibrium. Finally, the dollar's recent valuation picture on a broad basis reflects the fact that many EM currencies and commodity producers are still pricey. As such, this also comforts us in our stance to underweight commodity currencies versus European ones and the yen. The Euro Chart 2The Euro Can Cheapen Further The Euro Can Cheapen Further The Euro Can Cheapen Further On a multi-year time horizon, the euro is driven by the relative productivity trend of the euro area with its trading partners, its net international investment position, terms-of-trade shocks, and rates differentials. The euro continues to trade at a 6% discount to its fair value (Chart 2). However, the euro was in fact 15% below equilibrium in both 1984 and 2002, respectively, suggesting that the valuation advantage of the euro is not yet large enough to justify aggressively bidding up the common currency. Additionally, monetary divergences with the U.S. will continue to weigh on the EUR. On a structural basis the euro area continues to exhibit signs of slack. The employment-to-population ratio for prime age workers is at 2008 levels and domestic inflationary pressures remain muted, especially when one considers how cheap the euro is. The ECB policy is therefore likely to remain very easy for the foreseeable future. Additionally, the ECB might leave policy even easier than the broad euro area economic averages would suggest as it focuses its efforts on the weakest members of the union. While in the early 2000s it was Germany, today it is the European periphery that is in need of easy money to create fiscal room and ease latent deleveraging pressures. The Yen Chart 3The Yen Will Stay Cheap The Yen Will Stay Cheap The Yen Will Stay Cheap The yen's long-term equilibrium is a function of Japan's net international investment position, global risk aversion, and commodity prices. The large Japanese current account surplus continues to lift the yen's fair value, albeit at a slower pace than last year. While the yen may have strengthened substantially in recent months against the dollar, on a broader basis the yen is still very cheap (albeit not as cheap as a year ago) (Chart 3). This simply reflects the fact that many Asian currencies and the euro - key competitors of Japan - and the CNY - the currency of the most crucial export market for the Japanese - have also fallen substantially versus the dollar. The current outsized efforts by the Bank of Japan to lift domestic inflation expectations at any costs suggest that Japanese policy will maintain a dovish bias for an extended period of time, even if realized inflation perks up. As such, like the euro, the yen is likely to remain a prey to global monetary policy divergences, especially against the USD. Nonetheless, the yen's attractive valuation - comparable to that which prevailed around the time of the Plaza Accord - implies that USD/JPY could stay as the preferred cross by which to play any dollar correction that should emerge along the upward trajectory of the greenback. The British Pound Chart 4GBP: The Economy Matters More Than Valuations GBP: The Economy Matters More Than Valuations GBP: The Economy Matters More Than Valuations The fair value of the pound has fallen over the past year and is projected to continue doing so in 2017. This development is explained by the U.K.'s poor trend productivity growth, falling real yields, and slowing house price appreciation. Despite this change in the fair value, following the drubbing received by the pound in the Brexit vote aftermath, GBP is cheap on a long-term basis (Chart 4). However, the decline in investment that may materialize following the fall in British FDI inflows mean that the U.K.'s productivity may deteriorate even faster than is currently projected. This would further depress the pound's fair value, implying that the GBP may not be as cheap as the model currently highlights. Even if this prospect were to materialize, the pound could still be an attractive play on a cyclical horizon. For one, British real rates are likely to pick up as the economy continues to surprise to the upside, mitigating some of the negative implications of falling productivity on the GBP's fair value. Additionally, the last legal hurdles to the invocation of the Article 50 of the Lisbon Treaty are being cleared, suggesting that the Brexit negotiations will begin in earnest in March. While this could create some episodes of currency volatility as the British and EU negotiators establish their stances, the end of the anticipation of this fearful moment may let investors focus on the U.K.'s economic robustness. The Canadian Dollar Chart 5CAD At Fair Value: The Future Depends On Oil CAD At Fair Value: The Future Depends On Oil CAD At Fair Value: The Future Depends On Oil The Loonie's fair value is driven by commodity prices, relative productivity trends, and the Canadian net international position. While the Canadian current account deficit and the nation's poor productivity growth would argue for a lower fair-value, these have been compensated by a rebound in commodity prices, creating stability for the CAD's equilibrium exchange rate. The sharp rebound in the Canadian dollar over the past 12 months means that the exceptional undervaluation in February last year has been fully eradicated (Chart 5). However, the CAD is not experiencing the same level of overvaluation as many of the other commodity currencies, like the AUD, the NZD, the BRL, or the RUB. This could reflect the NAFTA discount now created by Trump's demanding a renegotiation of the trade deal, which puts Canadian exports at marginal risk. Ultimately, with the CAD troughs and peak very much a direct negative function of the USD, our bullish stance on the greenback suggests that the CAD could once again experience a discount in the coming 12 to 18 months, especially as the U.S. dollar carries such a heavy weight in the trade-weighted CAD. In fact, we expect the Canadian economy to underperform that of the U.S. as the Canadian consumer remains hampered by higher debt loads and as Canadian capex remains hurt by excess capacity. This will only accentuate the monetary divergence between the CAD and the USD. The Australian Dollar Chart 6The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The AUD Has Overshot Fundamentals: Use Further Rallies To Sell The fair value of the Aussie, driven by Australia's net international position and commodity prices, has stabilized. However, it may begin to deteriorate anew if commodity prices lose some of their luster, a growing probability event in the face of a strong USD. Moreover, the AUD's rally has only caused this currency to become ever more expensive and it now offers one of the poorest risk-reward profiles in the G10. Historically, current levels of overvaluation have proved a reliable sell-signal for the Aussie and warrant shorting this currency right now (Chart 6). Our portfolio has a negative AUD bias. The AUD's poor valuations suggest that it is discounting an extremely positive growth outcome in the Chinese economy. We think China is likely to surprise to the downside, especially against such lofty expectations. Raising the AUD's risk profile even further, China has not only exhausted its latest fiscal stimulus and clamped down on the real estate market, but also cracked down on excess steel production. This means that the demand for iron ore and coking coal - of which China has accumulated large inventory piles - could weaken even more than a Chinese economic deceleration would imply. Australian terms-of-trades could suffer a nasty shock. The New Zealand Dollar Chart 7NZD Is Expensive, But Not As Much As The AUD NZD Is Expensive, But Not As Much As The AUD NZD Is Expensive, But Not As Much As The AUD Natural resources prices, real rate differentials, and the VIX are the key determinants of the Kiwi's fair value, highlighting the NZD's nature as both a commodity currency and a carry currency. Both the fall in the VIX and the rebound in commodities are currently causing the gradual appreciation in the New Zealand's dollar equilibrium exchange rate. Thus, this trend could easily reverse if the global reflation trade begins to wane. Currently, the NZD is expensive (Chart 7), albeit not as exceptionally so as the AUD, the BRL, or the RUB. This partly explains why we like the Kiwi more than these currencies. In fact, while we worry about the outlook for the NZD versus the USD, the attractive domestic situation in New Zealand, where growth is the highest in the G10 and employment is growing at an eye-popping 6% annual rate, suggests that the RBNZ could abandon its new-found neutral bias in favor of a hawkish one later this year. Hence, we like the Kiwi against the AUD, the BRL, or the RUB. The Swiss Franc Chart 8The Swiss Net International Investment Position Makes The SNB's Life Difficult The Swiss Net International Investment Position Makes The SNB's Life Difficult The Swiss Net International Investment Position Makes The SNB's Life Difficult Switzerland's enormous and growing net international investment position continues to be the most important factor lifting the fair value of the Swiss franc. Yet, in the short-term, this is irrelevant. The SNB has demonstrated its capacity and credibility when it comes to keeping a floor under EUR/CHF. Thus, the Swiss franc will continue to trade in line with the euro, even if the current French political risks would have normally caused an appreciation in the Swiss Franc versus the euro. This means that the real trade-weighted CHF should not deviate much from its long-term fair value estimate (Chart 8). Nonetheless, this peg contains the seeds of its own demise. The cheaper the CHF gets, the larger the economic distortions in the Swiss economy become. Already, Switzerland sports the most negative interest rates in the world. This directly reflects the large injections of liquidity required from the SNB to stem any CHF appreciation. A consequence of these low real rates has been the appreciation in the already-expensive Swiss real estate. Ultimately, we expect the SNB to be forced to capitulate to all the inflows and abandon its floor. While this will not happen tomorrow, it will likely result in a comparable move to the one that followed the tentative unpegging of January 2015. Back then, the CHF was not particularly cheap. While it is too early to make this bet, we suspect that a pick-up in actual inflation will constitute the key signal for investors to begin betting against the SNB's current policy. The Swedish Krona Chart 9The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Riksbank Has Achieved One Of Its Goal: SEK Is Cheap The Swedish krona continues to trade cheaply, even if its long-term fair value remains on a secular downward trajectory (Chart 9). Yet, the undemanding valuations of the SEK hides a complex picture. It is approximately fairly valued against the GBP and expensive against the NOK, two of its largest trading partners. However, the SEK is cheap against the USD and the euro. Amongst the latter two, we prefer buying the Swedish krona against the EUR rather than against the USD. The SEK has historically been very sensitive to the USD; therefore, USD/SEK is very exposed to the dollar's cyclical bull market. However, the current widening of European government spreads echoes the 2010-2012 period, when EUR/SEK softened considerably as the survival of the euro was up in the air in investors' minds. Dutch, French, and potential Italian elections this year could prove similarly unnerving for investors, creating a source of downside risk in EUR/SEK. Moreover, Swedish domestic fundamentals remain much stronger than those of the euro area, further strengthening the case of for shorting EUR/SEK. The Norwegian Krone Chart 10NOK, Still Undervalued Despite The Rally NOK, Still Undervalued Despite The Rally NOK, Still Undervalued Despite The Rally A year ago, when global markets were in full panic mode, the Norwegian krona became the most attractive currency in the world on a valuation basis. After a blistering rally, this is not the case anymore (Chart 10). Nonetheless, it continues to trade on the cheap side, and remains the cheapest commodity currency in the world along with the Colombian peso. We therefore maintain a positive bias toward the NOK against the rest of the commodity complex, especially the very expensive and equally oil-exposed RUB. While USD/NOK, like USD/SEK, is very exposed to general dollar strength, we remain short EUR/NOK on a 12-month basis. The NOK's main long-term favorable factor still is its enormous net international investment position of 194% of GDP, which creates a structural upward bias on the country's current account surplus. Today, while the euro area runs a record high current account surplus of 3% of GDP, its net international investment position remains negative at 8% of GDP. Additionally, in an almost perfect mirror image to the euro area, Norway shows little signs of having entered a liquidity trap post-2008. The money multiplier remains high, loan growth has stayed strong, and inflation has remained perky. This means that the Norges Bank is in a better position to cyclically increase rates than the ECB. Chinese Yuan Chart 11Can The Yuan Weaken More? Can The Yuan Weaken More? Can The Yuan Weaken More? As commodity prices strengthened and Chinese productivity growth slowed, the strong upward bias to the yuan's long-term fair value paused in 2016 and may even fall a bit in 2017. Nonetheless, the CNY continuous fall has cheapened this currency considerably since 2015 (Chart 11). Does this mean that the CNY is a buy at this juncture? No. First, on a trade-weighted basis, the experience of the past 20 years has been that it bottoms at greater discounts to fair value. Moreover, while testing the current model, we also tried various productivity series for China. Depending on the one used, the yuan's discount to fair value would considerably shrink, implying a high degree of uncertainty around the actual cheapness of the RMB. Second, China continues to suffer from capital outflows, suggesting that domestic expected returns have yet to be equilibrated with those available in the rest of the world. A lower RMB would help generate this adjustment. Third, China is still an economy with too much capacity and too much debt that also intends to liberalize its internal markets and external accounts, even if slowly. Historically, this set of circumstances has most often come along with a weak currency, a key tool to alleviate the deflationary tendencies created by these forces. Fourth, and more specific to the dollar, the PBoC now targets a basket of currencies which means that when the DXY strengthens, USD/CNY also rallies. The dollar bull market will therefore continue to hurt the RMB versus the USD. Finally, Trump's protectionist rhetoric represents a big risk for China as exports to the U.S. represent 4% of China's GDP. A simple way to regain some of the competitiveness that would be lost to tariffs would be for the PBoC to let the CNY drift lower against the USD, though this would also aggravate the trade tensions. The Brazilian Real Chart 12Trouble In Rio Trouble In Rio Trouble In Rio Hampered by poor productivity trends, which weigh on the Brazilian current account balance, the fair value of the real remains quite depressed, even as commodity prices have sharply rebounded over the course of the past 12 months. In fact, the violent rally in the BRL over the same timeframe has made it one of the most expensive currencies tracked by our models (Chart 12). At current levels of overvaluation, the next 6 months return on the BRL has always been negative. The potential downside for BRL over the next 12-18 months is large. The rally reflected a general easing in EM financial conditions, fiscal stimulus in China, and the ejection of Dilma Rousseff, replaced by Michel Temer. While the change of government has depressed the geopolitical risk premium, any real improvement rests on the Temer administration's stated goal of slashing the size of the public sector. In the Mundell-Fleming model, the resulting destruction in domestic demand cuts local real rates, and therefore, the BRL's appeal to international investors. This a severe headwind to overcome, especially when coupled with as clear of a message as the one currently sent by valuations. Finally, the recent strength in the dollar along with the rise in DM global rates is creating a tightening of global and EM liquidity conditions, exactly as the Chinese fiscal stimulus wanes. This is a very poor risk profile for the BRL. The Mexican Peso Chart 13MXN Is Not Cheap Enough Yet MXN Is Not Cheap Enough Yet MXN Is Not Cheap Enough Yet Interestingly, despite the surge in USD/MXN in the wake of Trump's electoral victory, the MXN is not very cheap on a real trade-weighted basis (Chart 13). The peso's equilibrium rate has been pulled lower by the nation's persistent current account deficit which has continuously hurt its net international investment position. Conceptually, this is akin to a relative oversupply of Mexican assets to the rest of the world, depressing the peso's fair-value. The large stock of Mexican USD-denominated debt is a testament to this phenomenon. At this juncture, while PPP valuations suggest that the peso is attractive relative to the USD, Mexico's negative net international investment position and its large stock of U.S.-dollar debt warrant cautiousness. The Mexican economy is very exposed to a tightening in global liquidity conditions and the borrowing-costs squeeze represented by a higher dollar and higher U.S. rates. Hence, USD/MXN could have more upside from here on a 12-to-18 month basis. Compared to other EM currencies like the BRL, the RUB, or the CLP, however, the Mexican peso seems very attractively priced as all these currencies currently trade at large premia to their fair value. Additionally, a "Trump-protectionism" risk premium is already embedded in the Mexican peso, but the above currencies do not seem to suffer from the same handicap. While not as directly exposed to this risk as Mexico, these countries would nonetheless be affected by a trade war between the U.S. and Asia, and particularly between the U.S. and China. The Chilean Peso Chart 14The CLP Has Overshot The CLP Has Overshot The CLP Has Overshot The Chilean peso real effective exchange rate is driven by the country's productivity trend relative to its trading partners and the real price of copper - which proxies the Chilean terms-of-trade. As a result of the rally since the winter of 2015, the real CLP is at a 4-year high and is now in expensive territory (Chart 14). Global risks point to downside for the CLP, as copper is likely to underperform against other commodities. EM liquidity conditions should dry up due to the rising dollar, compounding potential problems created by China's efforts to crack down on real estate activity, the biggest source of copper consumption by a wide margin. The recent meteoric surge in copper prices will leave the red metal vulnerable to such dynamics. Domestic factors also don't bode well for the peso. The Chilean housing market is currently going through its biggest downturn since 2008 while economic activity remains anemic. Furthermore, the worker's strike in "La Escondida", the world's biggest copper mine, should cause strains on Chilean exports. All of these factors will be too great for the CLP to overcome. Thus, we remain short the peso. The Colombian Peso Chart 15COP Is A Cheap Oil Play COP Is A Cheap Oil Play COP Is A Cheap Oil Play The real COP is driven by Colombia's relative productivity trends and the price of oil, the country's main export. With oil prices having rebounded, the fair value has returned to 2014 levels. Nevertheless, the COP still undershoots its fundamentals (Chart 15). This reflects the premium demanded by investors to compensate for Colombia's large current account deficit equal to 6.3% of GDP. The outlook for the COP has brightened, especially against other commodity currencies. The OPEC deal to cut oil production seems to be on track so far, with 90% compliance amongst OPEC members. Furthermore, the potential for a strong economic performance in DM economies suggests that oil demand should remain firm. This should help the COP outperform currencies that have a higher sensitivity to metals like the BRL and the ZAR. Domestic factors also paint a positive picture for the peso. The Colombian economic situation is more robust than in other EM economies. During the commodity boom years, Colombian banks were much more orthodox in their lending than their EM counterparts. Thus, this Andean country does not suffer from unsustainable debt dynamics, and therefore, if EM suffers a liquidity-induced slowdown, Colombia should withstand this shock better. The South African Rand Chart 16ZAR Has Outshined Gold, Higher Rates Will Be A Problem ZAR Has Outshined Gold, Higher Rates Will Be A Problem ZAR Has Outshined Gold, Higher Rates Will Be A Problem South Africa's dismal productivity trends continue to force a downtrend upon the rand's long-term fair value. The rally in commodity prices has nonetheless lifted the current fair value of the ZAR for early 2017 compared to estimates run last year. Despite this improvement, the rand's 6% rally in real terms has still overshot any justifiable fundamentals, leaving this currency overvalued (Chart 16). Furthermore, if commodity prices were to correct, not only would the fair value of the rand fall, but the current overshoot would also correct. This implies substantial downside risk to the ZAR. The ZAR may remain stable in the short term as the dollar's correction continues and gold prices enjoy a healthy bounce. However, the rand's copious handicaps will come back to haunt investors once the previous dollar strength is fully digested and the USD resumes its cyclical bull market. Moreover, such a move is likely to come hand-in-hand with rising U.S. rates, embracing both gold and the rand in an inescapable kiss of death. The Russian Ruble Chart 17RUB Has Fully Priced Any Russia-American Rapprochement RUB Has Fully Priced Any Russia-American Rapprochement RUB Has Fully Priced Any Russia-American Rapprochement Buoyed by both the perceived benefits to the Russian economy of OPEC oil production cuts and the fall in the geopolitical risk premium coming from the expected Trump/Putin rapprochement, the Ruble is now very expensive (Chart 17). While RUB was more expensive in the years prior to the 1998 Russian default, it still manages currently to trade at its highest premium in more than 18 years. Trump and Putin really need to get along famously well - and it is not clear that they will at the moment. As the RUB is massively expensive, we would not chase it higher from here. Not only is the upside to oil prices limited, since at current oil prices, shape of the oil curve, and financing costs, shale producers are once again investing in their oil fields, pointing to higher U.S. production in the coming quarters. Also, the civility between Trump and Putin is likely to prove ephemeral: Russia's commercial links are with Europe and China, not the U.S. If anything, the U.S.'s growing exports of energy products mean that both nations will soon compete in that market. We know how much Trump loves foreign competition. Thus, we prefer other petro currencies to the RUB. At the current juncture, buying CAD/RUB and NOK/RUB makes sense. Especially as the valuation disadvantage is clear enough to point to a large ruble-bearish move in both crosses. The Korean Won Chart 18No Big Discount In The KRW No Big Discount In The KRW No Big Discount In The KRW The fair value of the won is positively correlated with the nation's net international investment position, but shows a strong negative relationship with oil prices. This reflects the status of the nation as an oil importer, and thus lower oil prices constitute a positive terms-of-trade shock for Korea. Also, the real trade-weighted won is inversely correlated with EM spreads. This makes sense as the won is a very pro-cyclical currency reflecting the tech and manufacturing bias of the Korean economy. At the current juncture, the won is moderately cheap (Chart 18). The Korean won may be trading on the cheap side, but we worry that this good value may prove somewhat illusory. A strong U.S. dollar and rising DM real rates are likely to result in stresses for many EM borrowers, whether they borrow in USD, produce commodities, or even worse, do both. Such an event would put pressure on EM spreads and push down the fair value of the KRW. An additional problem for the won is Donald Trump. Korea has been one of the greatest beneficiaries of the expansion of globalization from 1980 to 2008, as its export growth was some of the strongest in the world. Today, if Trump's protectionist tendencies gather momentum, Korea is likely to end up on his line of sight. The passage of import-punishing tax reform, cancellation of the KORUS free trade agreement, or imposition of tariffs on that country would have two potential effects on the won. They could cause the country's current account to deteriorate, hurting the prospective path of Korea's net international position and dragging the KRW fair value lower. This would be a slower drag on the won. Or, the other path, which we judge more likely, market participants (probably helped by Korean monetary authorities) could embed a discount into the KRW's fair value equivalent to the expected impact of the tariffs. This discount would alleviate the pain of the tariff, and would materialize in swift fashion. The Indian Rupee Chart 19SGD Has Downside INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook The fair value of the real trade-weighted INR is driven by India's productivity performance relative to its trading partners - the key factor behind the gentle upward slope in the equilibrium value for the rupee, its net international investment position, and Indian real interest rate differentials. However, the elevated level of inflation by global standards in India means that despite its long-term nominal downtrend, the INR is not cheap (Chart 19). Yet, while it will be difficult for this currency to rally against the USD if the dollar is in a broad-based uptrend, things are looking up for the INR relative to other EM currencies. The swift implementation of the currency reform last year was a bit of a debacle, but results are beginning to show through: deposit growth is improving. Thus, the constant shortage of loanable savings that has structurally hurt Indian capex and fomented elevated inflation in that country might begin to decrease. This means that over the long term, India's relative productivity performance might improve further and the country's stubborn inflation might decrease. This would lift the INR's fair value over time. The key to this positive outlook will be the RBI. With the personnel and political-administrative changes at its helm, it is hard to judge whether the Indian central bank will lift rates enough as capex perks up. That would limit future inflation and protect the value of the fiat currency and hence the long-term attractiveness of keeping money in Indian banks. We are optimistic, but await clearer proofs. The Philippine Peso Chart 20The Duterte Discount The Duterte Discount The Duterte Discount President Rodrigo Duterte's politics have been a source of fear for investors. As a result, PHP has depreciated against the USD and is now trading at a 10% discount (Chart 20). The fair value of the peso, driven by the cumulative current account and commodity prices, is on an uptrend. This will likely continue as a strong USD should depress commodity prices, improving the Philippines' trade balance and terms of trade. Additionally, improving DM economies will likely generate higher remittances to the Philippines, boosting the current account balance, domestic consumption, and the PHP's long-term value. These dynamics underpin our bullish long-term view on the PHP. However, potential political risks still loom large for the economy. So far Duterte has allowed technocrats to run economic policy, but if he takes a greater personal interest in this area it is likely to be unfriendly to foreign investors, potentially endangering broader FDI inflows. This could erode the PHP long-term equilibrium value over time. Relations with the Trump administration do not have any clarity yet but potentially offer substantial downside risks. Tempering our fear for now, Duterte is taking a reasonable approach to economic management and opening the way for new investment from China, suggesting political risks to foreign investment remain contained. The Singapore Dollar Chart 21INR Real Equilibrium Keeps Rising, But Inflation Still Clouds The Outlook SGD Has Downside SGD Has Downside Our model points to a relatively stable long-term valuation of the Singaporean Dollar. The currency displays little statistical significance with economic factors, with its relationship with commodities being one of indirect statistical coincidence. This is because the Monetary Authority of Singapore (MAS) utilizes the currency as its main monetary policy tool, underpinning the SGD's cyclical nature. As inflation has only just stepped back into positive territory in December 2016, and retail prices remain weak, MAS is unlikely to deviate from its current policy stance and will remain accommodative. Therefore, SGD is likely to depreciate from its current 3.6% overvaluation (Chart 21). This strong mean-reverting characteristic warrants a short position on the SGD. Last September, we suggested selling SGD against USD over JPY, a recommendation we stick to, since a dollar bull market will add additional pressure onto the SGD. The Hong Kong Dollar Chart 22HKD Is Expensive But The Peg Will Survive HKD Is Expensive But The Peg Will Survive HKD Is Expensive But The Peg Will Survive While USD/HKD is pegged, the real trade-weighted Hong-Kong dollar can still experience wild swings. Since 2011, its real appreciation has been driven by a wave of EM currency weakness and higher inflation in HK than the U.S. Also, the strength in USD/CNY since January 2014 has added to the HKD's surge. Thanks to this combination, the Hong Kong dollar remains more expensive than it was in 1997, on the eve of the Asian Crisis (Chart 22). This does not mean that HKD is about to depreciate. In fact, we expect the Hong Kong Monetary Authority to keep the peg alive as it has been a pillar of stability since its introduction in 1983. With reserves of 114% of GDP, not only does the HKMA have the financial fire-power to support the HKD, but also Hong Kong continues to sport a current account surplus of 4%. While it is possible that USD/HKD will appreciate toward 7.85, the upper range of the target zone, any depreciation in the real HKD will be a consequence of deepening deflation. This suggests that HK real estate prices will suffer more, especially as they remain significantly overvalued. The Saudi Riyal Chart 23Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come Saudi Needs Higher Oil Prices Or An Internal Devaluation Will Rage For Years To Come The Saudi Riyal shares two attributes with the HKD: It is a pegged currency and a prohibitively expensive one (Chart 23). Moreover, the very poor productivity performance of the Saudi economy necessitates a perpetually falling real effective exchange rate. Like the HKMA, SAMA will continue to defend its exchange rate for now, as it holds reserves of US$538 billion to protect its currency. Also, Saudi budget deficits can be curtailed further and the Saudi government can continue to borrow in the debt market. Finally, the production-cut agreements between OPEC and Russia have put a floor under oil prices for the time being, exactly as the market was already moving into deficit. They give SAMA even more time. However, one cannot forget that following the 1986 oil collapse, USD/SAR rose by 11%. Therefore, if oil prices relapse as U.S. shale production picks up anew or as the broad USD rallies further, the probability of a SAR surprise devaluation grows. Moreover, selling SAR could also act as insurance against further trouble in the Middle East, especially if Trump follows through on his demand that America's allies pay more for their own defense. At the current juncture, a small long USD/SAR position within a portfolio is equivalent to owning an instrument with a deep out-of-the-money option-like payoff: It costs little, has a small probability of being exercised, but if it does, it will pay great rewards. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Haaris Aziz, Research Assistant haarisa@bcaresearch.com Juan Manuel Correa, Research Assistant juanc@bcaresearch.com 1 For a more detailed discussion of the various variables incorporated in the models, please see Foreign Exchange Strategy Special Report, "Assessing Fair Value In FX Markets," dated February 26, 2016, available at fes.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights We expect the high level of compliance with the OPEC - non-OPEC production agreement engineered by the Kingdom of Saudi Arabia (KSA) and Russia will endure, leading to significant reductions in global oil inventories this year and next. All else equal, this should backwardate WTI and Brent forward curves later this year. However, recent developments in the North American pipeline market - i.e., U.S. President Donald Trump's orders to revive development of the Keystone XL (KXL) and completion of the Dakota Access (DAPL) pipelines - could send as much as 1mm barrels/day (bbl/d) of crude south from Canada and the Bakken, which would boost inventories at Cushing and other Midwest storage facilities later in this decade. Depending on when these pipelines are completed - likely by 2020 in the case of KXL - the WTI forward curve could return to a sustained contango.1 The expanded flows of heavy crude via KXL, and light-tight oil south via the DAPL could undo a subtle benefit arising from the backwardation induced by the KSA - Russia production pact, which we uncovered in our modeling. Energy: Overweight. At Tuesday's close, our short Dec/19 WTI vs. long Dec/19 Brent spread elected last week at $.07/bbl (WTI over) was up 700%. Our long Dec/17 WTI vs. short Dec/18 WTI front-to-back spread, entered into at -$0.11/bbl on Feb 9/17, was up 263%. Base Metals: Neutral. BHP declared force majeure at its Escondida mine, which accounts for ~ 5% of global supply, after workers voted to strike. Union leaders agreed to another round of government-mediated talks with BHP management. Precious Metals: Neutral. Fed Chair Yellen's Senate Banking Committee testimony was more hawkish than expected, which rallied the USD and muted gold's overnight strength. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. The USDA revised grain and soybean supply/demand estimates last week, showing markets tightening slightly, with ending stocks for the 2016/17 crop year expected to be a touch lower. We remain bearish. Feature Chart of the WeekStorage Drawdowns Should Accelerate ##br##As U.S. Oil Imports Slow Storage Drawdowns Should Accelerate As U.S. Oil Imports Slow Storage Drawdowns Should Accelerate As U.S. Oil Imports Slow Regular readers of BCA's Commodity & Energy Strategy service will not be surprised by the very high compliance levels seen in the wake of the OPEC - non-OPEC production Agreement engineered by KSA and Russia late last year.2 Because the stakes are so high for KSA and Russia - and their respective oil-producing allies - we expect compliance to remain high into June, resulting in a drawdown of global oil storage, the stated goal of the deal. We believe the pact will result in both WTI and Brent forward curves returning to backwardation, as global storage levels fall some 300mm bbl (Chart of the Week). We are positioned for this outcome by being long Dec/17 WTI vs. short Dec/18 WTI. We are expecting to see the last of the Persian Gulf export surge to the U.S. this month, as the 45- to 50-day sailing time from the Gulf to the U.S. implies the last of these vessels will be arriving this week or next. This backwardation will, in all likelihood, restrain the rate at which U.S. shale-oil producers return rigs to the market next year. Chart 2Curve Shape Can Affect Rig Counts Curve Shape Can Affect Rig Counts Curve Shape Can Affect Rig Counts WTI Term Structure And Rig Counts: It's Complicated Recent modeling we've completed suggests curve shape can affect rig counts in the U.S. light-tight oil fields. When we regress U.S. rig count on the WTI forward curve, we find rig counts can be expected to increase when the forwards are in contango, and to decline when the market is backwardated. A flat forward curve can be expected to keep rig counts fairly constant (Chart 2).3 Obviously, the starting point for these outcomes is critical. We simulated rig counts by assuming Monday's closing prices for March through June WTI futures, then assumed different levels for July WTI futures as a starting point for estimating rig counts to end-2018. We used $50, $55 and $60/bbl in July as our starting point. All else equal, with the July/17 WTI at ~ $55/bbl and the forward curve backwardated by 10% 18 months out, we would expect to see average rig counts fall by 4.38 rigs/month in 2018, given the three-to-four month lag between rigs actually being deployed and the price signal being sent by the futures market. A contango term structure produces the opposite result. With the July/17 WTI at ~ $55/bbl and the forward curve in a contango of 10% 18 months out, we would expect to see rig counts increase by 4.57 rigs/month in 2018. There obviously is a price threshold from which the forward curve originates in this analysis, which we believe to be between $50 and $55/bbl. Below this level, we would expect shale producers to retreat back to their core production areas, and await a price signal to increase their rig counts. Above $60/bbl, backwardation and contango matters for rig counts over the next 2 to 2.5 years. A backwardated forward curve will, all else equal, incentivize a slightly lower level of rigs being deployed than a contango. For example, a 10% contango with a $60/bbl starting point results in 5.24 rigs/month being deployed, while 10% backwardation would lead us to expect 5.02 rigs/month being deployed. Sustaining Backwardation Will Be Difficult A sustained backwardation will be threatened later in this decade by the expansion of the North American pipeline grid, following U.S. President Trump's orders to revive the Keystone XL (KXL) pipeline's development and the completion the Dakota Access Pipeline (DAPL). The KXL and DAPL buildouts, if approved, will expand U.S. midcontinent crude deliveries by 1mm bbl/d, according to Genscape's tally.4 The KXL volumes would add close to 600k bbl/d to Canadian exports, and would flow directly into Cushing, OK. Another 400k bbl/d of light-tight oil from the Bakken LTO fields will flow to the midcontinent refining market via the DAPL. "Increased flows into Cushing due to the addition of Keystone XL could lead to a bottleneck of inventories at the hub, which would put downward pressure on crude prices," Genscape notes. Work on the KXL could start this year, and be completed before 2020. The DAPL is ~ 95% complete, and should be done in 6 months or less. Genscape believes the DAPL could be built and line fill could be in place in less than three months. Indeed, "drilling under Lake Oahe in southern North Dakota for Energy Transfer Partner's Bakken-to-Patoka, IL, Dakota Access (DAPL) crude pipeline began immediately upon receiving an easement from the U.S. Army Corps of Engineers on February 8, according to a company spokesman. It is expected to take 83 days for construction and linefill... ." We will monitor these pipeline buildouts closely, given the profound implications they have for U.S. midcontinent and Gulf Coast refiners, who could once again find themselves benefiting from a widening of the Brent vs. WTI differential, and Canadian E&Ps, who can be expected to increase production into this KXL buildout. The key market to watch as these pipelines are under construction will be the WCS vs. WTI spreads (Chart 3). As pipeline capacity opens up, exports of heavy crude from Canada will increase and the WCS - WTI differential will narrow, which will benefit Canadian E&Ps (Chart 4). A return of contango following the opening of these pipelines would benefit U.S. refiners, who can be expected to increase exports. Chart 3Expanding the N. American Pipeline Network##br## Will Widen WTI Differentials Expanding the N. American Pipeline Network Will Widen WTI Differentials Expanding the N. American Pipeline Network Will Widen WTI Differentials Chart 4Crude Differentials Will##br## Adjust To Pipeline Buildouts Crude Differentials Will Adjust To Pipeline Buildouts Crude Differentials Will Adjust To Pipeline Buildouts Bottom Line: The backwardation of the WTI and Brent forwards should accelerate as the last of the surge in exports from the Persian Gulf arrives in the U.S. President Trump's decision to expedite KXL and the completion of the DAPL in 6 months or less will have a profound impact on crude movements and storage levels in the U.S. later in the decade. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 President Trump's decision to revive KXL was endorsed by House and Senate leaders in the U.S. last month, which greatly raises the odds it will go ahead. In addition, the DAPL received an easement from the U.S. Army Corps of Engineers to complete construction. 2 Please see issue of BCA Research's Commodity & Energy Strategy Weekly Report "Raising The Odds Of A KSA-Russia Oil-Production Cut," dated November 3, 2016, available at ces.bcaresearch.com. 3 Our previous modeling indicates Granger causality goes from WTI prices to rig counts - i.e., E&P companies drilling decisions are driven by price levels and curve shape. We believe this relationship arises from the hedging behavior of shale-oil producers, many of whom hedge their forward revenues in the futures markets over a two-year interval. 4 Please see "Keystone XL, Dakota Access Could Cause Bottlenecks at U.S. Mid-Continent Storage Hubs, Shift Crude Prices," published on Genscape's blog February 14, 2017. Genscape is a near-real-time pipeline, storage and shipping monitoring service. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in

Highlights Fears that the Trump Administration will brow-beat America's trading partners into strengthening their currencies have pushed down the dollar in recent weeks. The likelihood of another Plaza-type accord remains extremely low, however. History suggests that such agreements only work when currency interventions are aligned with the underlying macroeconomic fundamentals. With the Fed eager to hike rates, that is not the case today. The only situation where a multilateral agreement to weaken the dollar could be reached is one where the dollar ascends so high that major financial stresses begin to form, particularly in emerging markets. We are not there yet. The real trade-weighted dollar is likely to rise 5%-to-10% by the end of the year. A stronger greenback will hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. Feature Dollar Under Pressure Chart 1The Recent Dollar Dip Is Not ##br##Reflected In Interest Rate Spreads The Recent Dollar Dip Is Not Reflected In Interest Rate Spreads The Recent Dollar Dip Is Not Reflected In Interest Rate Spreads After rallying sharply following the U.S. presidential election, the greenback has given up some of its gains. Since peaking in late December, the trade-weighted dollar has fallen by around 2.5%. Notably, the dollar's swoon has not been accompanied by a narrowing of 2-year real interest rate differentials between the U.S. and its trading partners (Chart 1). This suggests that shifts in relative growth expectations have played a relatively minor role during this latest dollar selloff. In our view, the more important factor has been the "weak dollar" rhetoric coming out of the Trump administration. Historically, U.S. officials have at least given lip service to America's "strong dollar policy." As with many other political customs, Trump has thrown this one out the window. Peter Navarro, head of Trump's National Trade Council, made headlines last week by calling Germany a "currency manipulator" - even though, strictly speaking, Germany does not have a currency to manipulate. This came on the heels of Trump's comments to The Wall Street Journal earlier in January where he lamented that "our currency is too strong... it's killing us." The President reiterated that sentiment last week, telling a group of pharmaceutical company executives: "You look at what China's doing, you look at what Japan has done over the years ... they play the devaluation market and we sit there like a bunch of dummies." A Deal That Worked The Trump administration's efforts to talk down the dollar have raised the question of whether another Plaza Accord is on the horizon. The original agreement was concluded at The Plaza Hotel in 1985. As fate would have it, Trump ended up buying the landmark property three years later. It would go on to be the setting for such historically momentous events as Trump's wedding to Marla Maples and his Oscar-worthy cameo in Home Alone 2: Lost In New York. The Plaza Accord prescribed that G5 nations - the U.S., Japan, Germany, the U.K., and France - intervene in currency markets with the aim of driving down the value of the dollar. At least in this respect, the Accord was a smashing success. Between early 1985 - when rumors of a deal began to swirl - and January 1987, the dollar fell by 54% against both the yen and the mark, 49% against the franc, and 44% against the pound. In fact, so effective was the Plaza Accord that it necessitated the Louvre Accord two years later, an agreement that was drawn up in order to halt the dollar's slide. Chart 2A Widening Current Account ##br##Deficit Sowed The Seeds For The Plaza Accord A Widening Current Account Deficit Sowed The Seeds For The Plaza Accord A Widening Current Account Deficit Sowed The Seeds For The Plaza Accord Then And Now: Some Similarities... There are some clear similarities between 1985 and the present. Just like today, the greenback strengthened significantly in the years leading up to the Accord. At first, the Reagan administration was content to let the dollar appreciate, seeing this as validation of its pro-growth policies. The Fed was also happy to go along with a stronger dollar since lower import prices helped to dampen inflation. As time wore on, however, the damage from an overvalued dollar became increasingly apparent: The current account balance swung from a modest surplus at the start of the 1980s to a deficit of 2.7% of GDP by the end of 1985 (Chart 2). The Big Three automakers, along with companies such as Caterpillar, IBM, and Motorola, began to lobby the U.S. government for trade sanctions against foreign competitors. With Reagan's appointment of James Baker to the post of Treasury Secretary in February 1985, U.S. trade policy moved away from being governed by a doctrinaire free market philosophy and took on a more pragmatic tone. Fearing further protectionist measures, the Japanese and Europeans agreed to take action to strengthen their currencies. ...But Some Notable Differences Despite the clear parallels between 1985 and the present, there are also a number of critical differences. First, there is the issue of magnitude. By early 1985, the greenback was entering the seventh year of a massive bull market - one that had lifted the real broad trade-weighted dollar up 53% from its lows in October 1978 (Chart 3). In contrast, the current dollar bull market is a mere 2.5 years old and has seen the dollar strengthen by "only" 20% since July 2014. Moreover, the current bull market began from a point where the dollar was highly undervalued. As a consequence, as of today, the real trade-weighted dollar remains 21% below its 1985 peak and 11% below its 2002 peak. Second, one of the reasons the Plaza Accord worked so well was because policymakers ensured that their currency interventions were consistent with the macroeconomic fundamentals. The combination of tight monetary policy and loose fiscal policy created a fertile backdrop for the dollar's ascent in the early 1980s. By 1984, however, those bullish dollar fundamentals started to break down. Chart 4 shows that the dollar continued to appreciate into 1985, even though U.S. interest rates were declining relative to other G5 economies. The dollar, in other words, had entered a full-fledged bubble - one that was ripe for a pricking. Chart 3The Dollar Is ##br##Below Past Peaks The Dollar Is Below Past Peaks The Dollar Is Below Past Peaks Chart 4A Full-Fledged Dollar ##br##Bubble Preceded The Plaza Accord A Full-Fledged Dollar Bubble Preceded The Plaza Accord A Full-Fledged Dollar Bubble Preceded The Plaza Accord Once the dollar bubble burst, monetary policy amplified the downward pressure on the greenback. Most notably, the Federal Reserve continued cutting interest rates, ultimately taking the effective Fed funds rate down from 11.8% in July 1984 to 5.8% in October 1986. As a result, the 2-year nominal interest rate differential shrank by 454 basis points against Japan over this period. For the U.K., the interest rate differential fell by 630 basis points, while for Germany it declined by 407 basis points. In contrast to the mid-1980s, the Fed is unlikely to lean into dollar weakness this time around. The output gap in the U.S. has been nearly eliminated and the economy continues to grow at an above-trend pace. This suggests that the Federal Reserve will keep raising rates. We expect the Fed to hike rates three times this year, one more than the market is pricing in. Most other central banks are nowhere near the point where they can start tightening monetary policy. As such, the interest rate differential between the U.S. and its trading partners is likely to widen further. In a world where foreign exchange trading now exceeds $5 trillion per day, any currency intervention - unless it is backed by an underlying shift in the economic fundamentals - is bound to backfire. A Political Reality Check Chart 5China's Weight Matters Plaza Accord 2.0: Unnecessary, Unfeasible, And Unlikely Plaza Accord 2.0: Unnecessary, Unfeasible, And Unlikely Political considerations also render another Plaza Accord highly improbable. In the 1980s, West Germany and Japan were politically subservient to the U.S. That is less the case today. China's role in the global economy has also expanded. The RMB now accounts for 22% of the Fed's broad trade-weighted dollar basket, the largest weight of any country (Chart 5). China's government will fiercely resist negotiating any agreement that is not in the country's best interests. The economic circumstances facing most of America's trading partners could also scuttle any hopes for a deal to weaken the dollar. Inflation expectations in Japan have risen over the past six months, but still remain well below the BoJ's 2% target. A stronger yen would undermine efforts to reflate the economy. The German economy is certainly benefiting from an undervalued exchange rate. However, a continued weak currency is necessary for Southern Europe, where unemployment is still very high. Moreover, it is not clear that Germany could stomach a much stronger euro. The German unemployment rate is at a 25-year low, but that is because the country is running a massive 9% of GDP current account surplus. Take away Germany's ability to export its excess savings abroad, and the German economy would look a lot like Japan's. The only scenario in which a new multilateral accord would be seriously entertained is if a rising dollar began to wreak havoc on the global economy. A modestly stronger dollar would boost global growth to the extent that it redistributed demand from the U.S. to economies such as Europe and Japan with greater levels of economic slack. However, if the greenback were to ascend into bubble territory, this could instigate a vicious circle where an appreciating dollar increases the local-currency value of EM dollar-denominated debt, leading to a wave of bankruptcies and defaults, and, in the process, generating even further selling pressure on EM currencies. That said, the dollar would probably need to appreciate by another 15% or so before a crisis occurred. And even if a meltdown seemed imminent, the bar for currency intervention would remain quite high. No emerging market wants to go cap-in-hand to the IMF or the U.S. Treasury. This is particularly true for China, which would likely shun any offers of assistance, even if capital were flooding out of the country. In any case, if a deal were reached, it would likely seek to prevent the dollar from rising further, rather than falling in value. That is a critical distinction. Trump, Trade, And The Fed The discussion above suggests that a new Plaza-style accord is not in the cards, at least not unless the dollar strengthens substantially from current levels. Where does that leave Trump's pledge to bring manufacturing jobs back to the U.S.? We see two possible ways that Trump could try to square this circle. First, Trump could lean on the Fed to maintain a highly accommodative monetary stance. Since inflation expectations are likely to rise further as the economy begins to overheat, it is possible that real rates would actually decline unless the Fed raised rates fast enough, pushing down the dollar in the process. The problem with this theory is that Trump's public pronouncements on monetary policy have generally been on the hawkish side. He criticized Janet Yellen on the campaign trail, accusing her of trying to goose the economy in order to help the Democrats at the polls. Granted, Trump's views on the hard money/easy money debate may have changed now that he is President and poised to benefit politically from a more stimulative monetary policy. Nevertheless, it will be difficult for him to make a complete U-turn on the subject, especially since Congressional Republicans are likely to resist efforts to pack the FOMC with doves. As long as the economy is doing well, our guess is that Trump will accede to Republican demands that he nominate members to the FOMC with a somewhat hawkish disposition. This should keep the dollar uptrend intact. If a policy U-turn does occur, it will happen towards the end of the decade, by which time the economy will be due for another recession. With another presidential election looming at that point, Trump might end up taking a page out of the old Nixon playbook and browbeat the Fed chair into pursuing a massively expansionary monetary policy.1 This could set the stage for a stagflationary episode, a prediction we discussed at length in our latest Strategy Outlook.2 In the meantime, Trump will try to mitigate the effects of a stronger dollar on U.S. manufacturing by pursuing a more protectionist trade agenda. This is likely to entail expanding the use of countervailing duties which target foreign industries that are alleged to be engaging in unfair trade practices - similar to what Obama did when he slapped an extra 35% duty onto Chinese tires in 2009. Trump is also likely to continue "twitter shaming" companies that have moved, or are contemplating moving, production abroad. On the whole, however, a radical departure from existing trade policy is unlikely as long as the economy continues to expand. Nevertheless, as with his approach to Fed policy, Trump could break with all established traditions if unemployment starts rising and his poll numbers begin tumbling. In other words, a major trade war is coming, just not yet. Investment Conclusions Chart 6The Dollar Can Climb Amid ##br##Bullish Sentiment The Dollar Can Climb Amid Bullish Sentiment The Dollar Can Climb Amid Bullish Sentiment In politics, as in life, preferences are not the only things that matter. Constraints are as important, if not more so. Just as in the early 1980s, the U.S. is pursing a policy of fiscal easing and monetary tightening. As was the case back then, this has led to a stronger dollar. It would be easy to say that Trump could badger other countries into tightening monetary policy in order to keep the dollar from appreciating. Even if we ignore the political implausibility of such a strategy, it still would not work. If a country needs a low interest rate to keep growth from stalling, then raising rates is unlikely to boost that country's currency. The market will realize in short order that the central bank will eventually have to reverse course and cut rates to keep deflationary forces from setting in. The point is that trying to influence exchange rates without changing the economic fundamentals is destined to fail. We expect the real trade-weighted dollar to rise 5%-to-10% by the end of the year. Granted, bullish dollar sentiment is widespread these days (Chart 6). However, dollar bulls were around in even greater numbers in the second half of the 1990s, and this did not prevent the greenback from scaling to new highs. If the dollar resumes its ascent, as we expect, this could hurt U.S. corporate profit margins, allowing European and Japanese stocks to outperform in local-currency terms. A stronger greenback would also weigh on commodity prices, with metals being the most vulnerable. The risks to our dollar view are fairly symmetric. On the downside, the failure of the Trump administration to loosen fiscal policy could prevent the Fed from hiking rates as much as planned. The risk here is not so much that the tax cuts will be scuttled, but rather that Congressional Republicans succeed in pushing through big spending cuts as part of any budget deal. On the upside, the passage of a Border Adjustment Tax - something to which we assign 50% odds - would lift the dollar.3 Rising stress in emerging markets could also push money into safe haven markets such as U.S. Treasurys, similar to what happened during the late 1990s. This could cause the dollar to appreciate more than our baseline forecast implies. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Burton A. Abrams, "How Richard Nixon Pressured Arthur Burns: Evidence From The Nixon Tapes," The Journal of Economic Perspectives, Vol. 20, no. 4 (2006), pp.177-188. 2 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Special Report, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017," dated January 20, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Weekly swings in U.S. inventories notwithstanding, we believe global storage is on track to draw ~ 10% by early- to mid-3Q17, which will have achieved the goal of the OPEC - Russia production Agreement negotiated late last year. This will not require an extension of the pact beyond June, based on our modeling. Unexpectedly high compliance by OPEC producers to agreed cuts is being offset somewhat by increased production in those states exempted from the deal. Strong oil consumption on the back of a synchronized global uptick in GDP growth, which started to emerge late last year, provides the impetus for sustained storage draws. Markets are overestimating offshore production's resilience, particularly in the U.S. Gulf, where we see material declines beginning to set in next year. Backwardation likely persists in 2018, absent a U.S. policy-induced USD rally that crimps EM demand and spurs production ex U.S. Energy: Overweight. The return of contango in the WTI forward curve gives us the opportunity to reset our strategic front-to-back position (long Dec/17 vs. short Dec/18) at tonight's close. Our balances assessment supports our view backwardation will return in the deferred part of the curve. Our Dec/19 short WTI vs. long Brent spread buy stop was elected at $0.07/bbl. Base Metals: Neutral. We remain neutral base metals, but are keeping a close watch on copper. Unions working at BHP's Escondida mine, the world's largest, are set to strike today. Negotiations resumed this week, following BHP's request for government mediation. Precious Metals: Neutral. We continue to look to get long gold at $1,180/oz. Ags/Softs: Underweight. Grain fundamentals remain unsupportive for a rally. We remain underweight. Feature Chart of the WeekGlobal Oil Storage On Track For 10% Drop Global Oil Storage On Track For 10% Drop Global Oil Storage On Track For 10% Drop Global oil storage levels remain on track to hit the ~ 10% draw targeted in last year's OPEC - Russia production Agreement by early- to mid-3Q17, weekly gyrations in U.S. inventories notwithstanding. This means an extension of the agreement beyond its June expiry will not be required. Early reports suggest compliance with the deal is unexpectedly high by OPEC states that agreed to cut production by up to 1.2mm b/d - exceeding 80% by various accounts. However, OPEC states not required to cut - Libya, Nigeria, and Iran - have increased production and partially offset those declines, which took total reductions in OPEC output to ~ 840k b/d, based on a Bloomberg tally last week.1 This brought total Cartel compliance to ~ 60% of the agreed cuts, which, as we noted in our 2017 Commodity Outlook in December, would be sufficient to achieve the Agreement's goal of pulling inventories in the OECD down by ~ 10% by 3Q17.2 Non-OPEC producers also appear to be complying with the Agreement. Notable among them is Russia, which is ahead of its commitment with cuts of close to 120k b/d in January, due partly to extreme cold in Siberian fields. We expect cuts in Russia to average 200k b/d in 1Q17, going to 300k b/d in 2Q17. These cuts will allow demand to outstrip supply in 1H17 and into year-end. By early- to mid-3Q17, draws to OECD storage of 300mm bbl can be expected, without extending the OPEC - Russia production agreement (Chart of the Week). We expect to see these cuts show up in OECD inventory data this month and next and continue into the end of 2017. For non-OECD states, the draws will show up in JODI data beginning in March.3 The physical deficits - i.e., supply less than demand - will force storage to draw, backwardating the WTI forward curve later this year (Chart 2).4 If markets are not surprised by a policy-induced rally in the USD on the back of a U.S. border-adjustment tax (BAT), or a too-aggressive tightening by the Fed as it seeks to normalize monetary policy, we expect the drawdown in inventories to continue keeping markets backwardated. Even with production returning to pre-Agreement levels in 2H17 in states with the capacity to expand and reliably sustain production - Gulf Arab producers, Russia and U.S. shales - we expect storage to continue to draw through the year and into 2018 (Chart 3). Chart 2We Continue To Expect Backwardation We Continue To Expect Backwardation We Continue To Expect Backwardation Chart 3Storage Drawdown On Track Storage Drawdown On Track Storage Drawdown On Track In 4Q16 the impact of the higher Kuwaiti and UAE output is apparent, along with higher Russian production. This put more crude on the market, which found its way into storage late in 4Q16 and early 1Q17, reversing the trend in draws seen earlier in 2H16. This put the market back in a temporary surplus condition, with the result being more storage will have to be worked off in 1H17 than our earlier estimates indicated. But these draws will occur, following the implementation of the production accord. Extending The KSA - Russia Deal Beyond June Is Unnecessary In our estimates, OPEC crude production increases by ~ 850k b/d in 2H17 versus 1H17 levels. Despite this recovery, the storage drawdown continues. Our modeling assumes Gulf OPEC will account for slightly more than +1mm b/d growth, and non-Gulf OPEC will see production continue to fall by 170k b/d. Russia's total liquids production goes from 10.95mm b/d in 1H17 to 11.34mm b/d in 2H17. We estimate U.S. shale production grows at an average rate of ~ 300k b/d in 2H17, while total U.S. liquids production increases 720k b/d over the same interval. Setting aside the possibility of a policy-induced rally in the USD on the back of too-aggressive Fed tightening or a border-adjusted tax becoming the law of the land, both of which would depress demand and raise production ex U.S., we expect the crude-oil market to remain backwardated next year. The globally synchronized upturn in GDP will keep demand robust, with growth coming in close to even with this year's rate of ~ 1.50mm b/d. We have global liquids production and OPEC crude output growing less than 1.0% next year. We believe the market is overestimating the resilience of offshore production next year, particularly in the U.S. Gulf, based on the stout performance put in last year and expected for this year. Our colleague Matt Conlan notes in BCA's Energy Sector Strategy, U.S. production growth since October has almost exclusively been from the Gulf of Mexico's new projects. Output in the Gulf continues to increase due to the lagged effect of final investment decisions made during 2012 - 2014, when WTI prices were consistently trading above $100/bbl. GOM production will peak in 2017 then decline in 2018 due to lack of new investments made since 2014. Indeed, as "increasing decline rates overwhelm a shrinking inventory of new projects, GOM production should peak sometime in 2017 and then start decreasing. The EIA's estimate for another 200,000 b/d increase in GOM production in 2017 seems overly-optimistic."5 Once this becomes apparent to the market, we believe backwardation will reassert itself and persist into 2018. The backwardation of the forward curve structure will affect U.S. shale production economics in 2018. However, our base case is for U.S. shale-oil production in the "Big Four" basins - Permian, Eagle Ford, Bakken and Niobrara - to grow 700k b/d next year, given the current structure of the WTI forwards, which were taken higher along with the WTI price rally at the front of the curve. This triggered the revival of rig counts; however, we want to point out that different curve shapes at different price levels produce different expected rig-count responses.6 Chart 4Barring a Policy Shock Demand Will Remain Robust bca.ces_wr_2017_02_09_c4 bca.ces_wr_2017_02_09_c4 Global Demand Firing On All Cylinders Robust demand growth - ~ +1.50mm b/d in 2017 and 2018 in our modeling - provides the impetus for the continued draws in storage this year and next (Chart 4). We revised our demand estimates for 2015 - 16 in line with the IEA's just-revised assessment of global consumption published in its January 2017 Oil Market Report.7 The IEA brought 2016 oil demand growth up to 1.50mm b/d, in line with our earlier estimates, but significantly revised 2015 demand growth upward to 2.0mm b/d. The Agency expects higher prices to crimp demand this year, taking it to 1.30mm b/d; our estimate, however, is higher, largely on the back of the first global synchronized growth we've seen since the Global Financial Crisis, which will be supported by accommodative monetary conditions worldwide, all else equal.8 Investment Implications Our analysis suggests there will be no need to extend the OPEC - Russia production accord into 2H17. In addition, it reinforces our view markets will backwardate later this year and stay backwardated in 2018, provided we do not see a BAT-induced rally in the USD, or an overly aggressive Fed normalization trajectory. As we noted in previous research, a BAT would lift the value of the USD, which would lower demand ex U.S. and raise supply at the margin.9 We make the odds of a BAT becoming the law of the land in the U.S. this year 50:50, so this is a non-trivial risk. This would be unambiguously bearish for oil prices. While we do not expect oil to be included among the imported commodities subject to a BAT, we do, nonetheless, expect the imposition of a BAT to lift the USD by 10%. This, coupled with the 5% increase in the greenback we'd already penciled in due to the Fed's monetary-policy normalization, will lift the USD 15% if it goes through. Should this occur, we would be preparing for prices to again fall below $50/bbl and push back to the $40/bbl area, which would cause supply and capex to once again contract significantly. That said, we are reinstating our long front-to-back WTI recommendation (long Dec/17 WTI vs. short Dec/18 WTI), given our updated balances assessment. Our expectation for inventories to continue to draw after the OPEC - Russia production-cutting agreement expires in June supports this recommendation. In addition, if we do see a BAT in the U.S., we believe markets will take the deferred WTI curve significantly lower in expectation of reduced demand and higher marginal supplies that almost surely will ensue in 2018. While the Dec/17 contract also will trade lower, more damage to prices will occur in 2018 contracts. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "OPEC Cuts Oil Output, But More Work Needed to Fulfill Deal," published by Bloomberg February 2, 2017. Iraq stands out among OPEC producers agreeing to cut, but apparently not following through as diligently as the rest of the Gulf Arab states; we are assuming production of 4.5mm b/d for 1H17, going to 4.6mm b/d in 2H17 for Iraq. 2 Please see BCA Research's Commodity & Energy Strategy "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 3 JODI refers to the Joint Organisations Data Initiative, a supranational producer-consumer oil-market data provider headquartered in Riyadh, Saudi Arabia. 4 "Backwardation" describes a forward price curve in which the price for a commodity for prompt delivery (e.g., tomorrow) exceeds the price of a commodity delivered in the future (e.g., next year). It is the opposite of a contango curve structure. 5 Please see issue of BCA Research's Energy Sector Strategy "Gulf Of Mexico Oil Production Likely To Peak In 2017," dated January 11, 2017, available nrg.bcaresearch.com. 6 In next week's report, we will present scenario analysis of shale-oil production as a function of WTI forward curve shape - i.e., the implications of backwardation for shale rig counts. This will update our assessments of price sensitivities to interest rates and USD movements. 7 Please see the IEA's Oil Market Report of 19 January 2017. 8 We discuss this in last week's Commodity & Energy Strategy feature article entitled "Gold Will Perform...," dated February 2, 2017, available at ces.bcaresearch.com. 9 Please see BCA Research's Commodity & Energy Strategy "Taking A BAT To Commodities," dated January 26, 2017, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed In 2017 Summary of Trades Closed in 2016