Gov Sovereigns/Treasurys

Highlights Undue pessimism about global growth is giving way to unbridled optimism. Chinese growth has accelerated. However, there is a risk that the economy hits a speed bump later in 2017, as fiscal policy becomes less accommodative, monetary policy is tightened in an effort to curb capital outflows, and recent steps by the authorities to crack down on rampant speculation in the property sector begin to bite. The threat of a trade war will also loom large. U.S. fiscal policy will remain stimulative, but may fail to live up to expectations: There is little appetite among Republicans for increasing infrastructure spending; the multiplier effects from the proposed tax changes are likely to be small; and many GOP leaders are already chomping at the bit to take an ax to government spending. Fortunately, the U.S. economy has enough momentum to continue growing solidly above trend, even if fiscal policy disappoints. This will allow the Fed to raise rates three times this year, one more hike than the market is currently pricing in. Developed market equities are overbought and vulnerable to a correction, but will be higher 12 months from now. Favor Europe and Japan over the U.S. in local-currency terms. Stay underweight EM. Feature Global Growth Is Accelerating, But Headwinds Persist The global economy is on the mend. Measures of current activity are rebounding, as are a variety of leading economic indicators (Charts 1 and 2). Chart 1Global Economy ##br##Springing Back To Life Global Economy Springing Back To Life Global Economy Springing Back To Life Chart 2Global Leading Economic ##br##Indicators Are Improving Global Leading Economic Indicators Are Improving Global Leading Economic Indicators Are Improving Investors have taken notice: Market-based inflation expectations have risen, as have growth-sensitive commodity prices. Earnings growth expectations have surged, rising in the U.S. to nearly the highest level in a decade. Cyclical stocks have also bounced back, after having lagged the overall market for five years (Chart 3). We agree with the market's positive re-rating of global growth prospects, but worry that undue pessimism is starting to give way to excessive optimism. Two potential developments in particular could end up giving investors pause: A slowing of China's economy later this year. The possibility that U.S. fiscal policy will end up being less stimulative than expected. China: Living On Borrowed Time? Chinese growth has been surprising to the upside of late (Chart 4). Timely indicators such as excavator sales and railway freight traffic, which are well correlated with industrial activity, have been rising at a fast clip. Manufacturing inventory levels have come down, corporate profitability has improved, and producer price inflation has turned positive. The labor market has also picked up steam, as evidenced by the expansion in the employment subcomponents of the PMI indices. Chart 3Market's Positive Re-Rating Of Growth Prospects Market's Positive Re-Rating Of Growth Prospects Market's Positive Re-Rating Of Growth Prospects Chart 4Chinese Growth Has Been Surprising To The Upside Chinese Growth Has Been Surprising To The Upside Chinese Growth Has Been Surprising To The Upside Looking out, however, there are reasons to worry that the economy will weaken anew. Growth in government spending slowed from a high of 25% in November 2015 to nearly zero in December (Chart 5). Recent efforts by policymakers to clamp down on rampant property speculation could also cause the economy to cool. Meanwhile, capital continues to flee the country (Chart 6). This has put the government in a no-win situation: Raising domestic interest rates could entice more people to keep their money at home, but such a step could increase debt-servicing costs and undermine the country's creaky financial system. Chart 5China: Fiscal Stimulus Is Running Off China: Fiscal Stimulus Is Running Off China: Fiscal Stimulus Is Running Off Chart 6China: Ongoing Capital Outflows China: Ongoing Capital Outflows China: Ongoing Capital Outflows A Problem Of Inadequate Demand There is no shortage of commentary discussing the problems that ail China. Much of the analysis, however, has focused on the country's inefficient allocation of resources and other supply-side considerations. While these are obviously important issues, they overlook what has actually been the most significant binding constraint to growth: a persistent lack of aggregate demand. It has been this deficiency of demand - the flipside of a chronic excess of savings - that has kept the economy teetering on the edge of deflation. If a country suffers from excess savings, there are only three things that it can do. First, it can try to reduce savings by increasing consumption. The Chinese government has been striving to do that by strengthening the social safety net in the hopes that this will discourage precautionary savings. However, this is a slow process which will take many years to complete. Second, it can export those excess savings abroad by running a current account surplus. This would allow the country to save more than it invests domestically through the famous S-I=CA identity. The problem here is that no one wants to have a large current account deficit with China. Certainly not Donald Trump. Third, it can channel those excess savings into domestic investment. This is what China has done by pressing its banks to extend credit to state-owned companies and local governments. Remember that debt is the conduit through which savings is transformed into investment. From this perspective, China's high debt stock is just the mirror image of its high savings rate. The problem is that China already invests too much. Chart 7 shows that capacity utilization has been trending lower over the past six years and is back down to where it was during the Great Recession. The good news is that as long as there is plenty of savings around, Chinese banks will have enough liquid deposits on hand to extend fresh credit. The bad news is that there is no guarantee that borrowers taking on this debt will be able to repay it. This has made the Chinese economy increasingly sensitive to changes in financial conditions. And that sensitivity has, in turn, made global financial markets more fragile. Chart 8 shows that global equities have sold off whenever China stresses have flared up. The risk of another such incident remains high. Chart 7China: Capacity Utilization Back ##br##To Pre-Recession Levels China: Capacity Utilization Back To Pre-Recession Levels China: Capacity Utilization Back To Pre-Recession Levels Chart 8When China Has a Cold, ##br##Global Equities Sneeze When China Has a Cold, Global Equities Sneeze When China Has a Cold, Global Equities Sneeze China Trade War: The U.S. Holds The Trump Card Chart 9China Would Suffer More ##br##From A Trade War With The U.S. China Would Suffer More From A Trade War With The U.S. China Would Suffer More From A Trade War With The U.S. Adding to the pressure on China is the prospect of a trade war with the United States. Donald Trump has flip-flopped on almost every issue over the years, but he's been perfectly consistent on one: trade. Trump has always been a mercantilist at heart, and nothing that has happened since the election suggests otherwise. It is sometimes argued that the damage to the U.S. economy from a trade war with China would be so grave that Trump would not dare initiate one. This is wishful thinking. Chinese exports to the U.S. account for 3.5% of Chinese GDP, while U.S. exports to China account for only 0.6% of U.S. GDP (Chart 9). And much of America's exports to China are intermediate goods that are processed in China and then re-exported elsewhere. Blocking these exports would only hurt Chinese companies. Yes, China could threaten to dump its huge holdings of U.S. Treasurys. However, this is a hollow threat. The yield on Treasurys is largely determined by the expected path of short-term interest rates, which is controlled by the Federal Reserve. To be sure, the dollar would weaken if China started selling Treasurys. But why exactly is that a problem for the U.S.? Donald Trump wants a weaker dollar! In short, the U.S. would not lose much by provoking a trade war with China. Where does this leave us? The most likely outcome is that China blinks first and takes more concerted steps to open up its market to U.S. goods. This would hand Donald Trump a major political victory. However, the path from here to there is likely to be a very rocky one, which means that the reflation trade could suffer a temporary setback. A Trumptastic Fiscal Policy? Getting tough with China was one of Trump's key campaign promises; increasing infrastructure spending and cutting taxes was another. Unfortunately, investors may end up being disappointed both by how much fiscal stimulus is delivered and by the bang for the buck that it generates. For starters, much of Trump's proposed infrastructure program may never see the light of day. The $1 trillion ten-year program that he touted during the campaign was scaled back to $550 billion on his transition website. And even that may be too optimistic. Most Republicans in Congress have little interest in expanding public infrastructure spending. They opposed a big public works bill in 2009 when millions of construction workers were out of a job, and they will oppose one now. The public-private partnership structure that Trump's plan envisions will also limit the universe of projects that can be considered. Most of America's infrastructure needs consist of basic maintenance, rather than the sort of marquee projects that the private sector would be keen to invest in. Granted, the definition for what counts as public infrastructure could be expanded to include such things as hotels and casinos, to cite two completely random examples. But even if one ignores the obvious governance problems that this would raise, such a step could simply crowd out private investment that would otherwise have taken place. The reason that governments invest in infrastructure to begin with is because there are certain categories of public goods that do not lend themselves well to private ownership. To purposely exclude such goods from consideration, while devoting public funds to projects that the private sector is already perfectly capable of doing, is the height of folly. Trump And Taxes House Republicans are pursuing a sweeping tax reform agenda. There is much to like about their proposal. In particular, the shift to a cash flow destination-based tax system could encourage new investment over time, while making it more difficult for firms to carry out a variety of tax-dodging strategies. However, as with many major policy initiatives, the Republican tax proposal could generate significant near-term economic dislocations. Most notably, as we discussed in detail last week, the inclusion of a border adjustment tax could lead to a sharp appreciation in the dollar.1 This would benefit foreign holders of U.S. assets, but hurt debtors with dollar-denominated loans. Such an outcome could put stress on emerging markets, potentially undermining the global reflation trade. Trump's proposed cuts to personal income taxes may not boost spending by as much as some might hope. The Tax Policy Center estimates that the top one percent of income earners will see their after-tax incomes increase by 13.5%, while those in the middle quintile of the distribution will receive an increase of only 1.8% (Table 1). Since the very rich tend to save much of their income (Chart 10), measures which boost their disposable income may not translate into a substantial increase in spending. In fact, cutting the estate tax, as Trump has proposed, could actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Table 1Trump's Proposed Tax Cuts Would Largely Favor The Rich Two Speed Bumps For The Global Reflation Trade Two Speed Bumps For The Global Reflation Trade Chart 10Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Savings Heavily Skewed Towards Top Earners Spending Cuts On The Horizon? Then there is the question of whether Congressional Republicans will try to take an ax to government spending. The Hill reported last week that several senior members of Trump's transition team have proposed a plan to cut federal spending by $10.5 trillion over the next 10 years.2 The plan contains many of the same elements as the Republican Study Committee's Blueprint for a Balanced Budget, which called for $8.6 trillion in cuts over the next decade. Separately, Representative Sam Johnson of Texas, the chairman of the House Ways and Means subcommittee on Social Security, has introduced legislation seeking large cuts to pension benefits. Under his plan, workers in their mid-thirties earning $50,000 per year would see a one-third reduction in lifetime Social Security payments.3 Paul Ryan and other Congressional Republicans have also begun to argue that the goal of health care reform should be to guarantee "universal access" to high-quality medical care, rather than "universal coverage." This is a bit like arguing that the goal of transportation policy should be to ensure that everyone has access to a Bentley, provided that they can pony up $200,000 to buy one. It remains to be seen whether President Trump will acquiesce to these changes. He has repeatedly insisted that no one will lose medical coverage under his administration. However, one of his first actions in office was to loosen the mandate that requires healthy individuals to purchase insurance under the Affordable Care Act. Such a measure, however well intentioned, could greatly undermine the Act. If healthy people can wait until they are sick to sign up for insurance, only sick people will sign up. In order to cover their costs, insurance providers would have to raise premiums, ensuring that even fewer healthy people sign up. Such a vicious "adverse selection cycle," as economists call it, could lead to the collapse of health insurance exchanges, which currently provide coverage for 12.7 million Americans. Our guess is that Trump will ultimately put the kibosh on any plan to radically cut government spending or curtail Medicare and Social Security benefits. Say what you will of Trump, he has proven to be a skilled political operator for someone who has never been elected to public office. He knows that people were chanting "build the wall" at his rallies, not "cut my Medicare." Indeed, it is possible that Trumpcare will ultimately look a lot like Obamacare but with more generous subsidies for health care providers. Nevertheless, the path to this more benign investment outcome will be a bumpy one, suggesting that market volatility could rise in the months ahead. Investment Conclusions Chart 11DM Stocks Are Overbought DM Stocks Are Overbought DM Stocks Are Overbought Markets tend to swing from one extreme to another. This time last year, investors were fixated on secular stagnation. Now they are convinced that we are on the edge of a new global economic boom. Neither position is justified. Global growth has picked up, and this should provide a tailwind to risk assets over the next 12 months. However, as this week's discussion makes clear, there are still plenty of headwinds around. This suggests that the recovery will be a halting affair, with plenty of setbacks along the way. The surge in developed market equities since the U.S. presidential election has pushed stocks deep into overbought territory (Chart 11). A correction is likely over the next few weeks. We expect global equities to fall by 5%-to-10%, paving the way for higher returns over the remainder of the year. Once that recovery begins, European and Japanese stocks will outperform their U.S. counterparts in local-currency terms. We continue to expect EM equities to lag DM. In contrast to stocks, bond yields have already moved off their highs. As we discussed in our Strategy Outlook in early January, the transition from deflation to inflation will be a protracted one.4 Nevertheless, the path of least resistance for yields is to the upside. The Fed is likely to raise rates three times this year, one more hike than the market is currently pricing in. This should be enough to keep the dollar bull market intact. We expect the trade-weighted dollar to rise another 5% by year-end, with the risk tilted to the upside if Congress ends up approving a border adjustment tax. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 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. 2 Please see Alexander Bolton, "Trump Team Prepares Dramatic Cuts," The Hill, dated January 19, 2017. 3 Please see Stephen C. Goss memorandum to Sam Johnson, "Estimates Of The Financial Effects On Social Security Of H.R. 6489, The 'Social Security Reform Act Of 2016,' Introduced On December 8, 2016 By Representative Sam Johnson," Social Security Administration, Office Of The Chief Actuary (December 8, 2016). 4 Please see Global Investment Strategy, "Strategy Outlook First Quarter 2017: From Reflation To Stagflation," dated January 6, 2017, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights Look below the surface, and the euro area economy reveals some surprising and encouraging truths: Euro area employment is near an all-time high. Euro area inflation is little different to other major economies. The euro area excluding Germany is among the world's top-performing major economies. Stay underweight German bunds versus U.S. T-bonds. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. But underweight the Eurostoxx600 because the European equity index is a play on sectors and currencies, not on the euro area economy. Feature "There's nothing so absurd that if you repeat it often enough, people will believe it." - William James In today's post-truth world, the rigorous scrutiny and analysis of facts and data has never been so important. With that in mind, this week's report puts some of the prejudices about the euro area economy under the microscope. Look below the surface, and euro area employment, inflation and growth reveal some surprising and encouraging truths. Euro Area Employment: Near An All-Time High The percentage of the euro area population in employment is close to an all-time high (Chart of the Week). Chart of the WeekThe Percentage Of The Euro Area Population In Work Is Near An All-Time High The Percentage Of The Euro Area Population In Work Is Near An All-Time High The Percentage Of The Euro Area Population In Work Is Near An All-Time High How could this be when the unemployment rate stands at a structurally elevated 10%? The answer is that euro area labour participation is in a very strong uptrend (Chart I-2). As millions of formerly inactive citizens have entered the labour market, it has structurally swelled the numbers of both the employed and the unemployed. Remember that to count as unemployed, a person has to be in the labour market looking for work. Chart I-2Euro Area Labour Participation Is In A Strong Uptrend Euro Area Labour Participation Is In A Strong Uptrend Euro Area Labour Participation Is In A Strong Uptrend The euro area's strongly rising labour participation means that we must interpret the headline unemployment rate with care. Indeed, we would argue that the healthy percentage of the working age population in employment is the truer measure of labour utilisation. One counterargument is that euro area citizens have simply flooded into the registered labour force to claim generous and long-lasting unemployment benefits. This argument might be valid during downturns, but it cannot explain the 17-year uptrend since the turn of the century. Unpalatable as it might be to the euro doomsayers, we are left with a more positive explanation. Since the monetary union, many euro area countries have succeeded in bringing down structurally high inactivity levels in the working age population that was the accepted norm in previous decades. Admittedly, Italy and Greece are the laggards in this structural movement, and still have much work to do - but even they have made substantial progress in recent years (Chart I-3). Chart I-3Italy And Greece Are The Laggards, But Even They Are Making Progess Italy And Greece Are The Laggards, But Even They Are Making Progess Italy And Greece Are The Laggards, But Even They Are Making Progess Bottom Line: the structural state of euro area employment is much better than the headline unemployment rate might suggest. Euro Area Inflation: Little Different To Other Major Economies The euro area and U.S. inflation rates are almost identical when compared on an apples for apples basis. The key words here are "apples for apples". A fair comparison between inflation rates in the euro area and the U.S. must adjust for a crucial difference in the two price baskets. The euro area's Harmonized Index of Consumer Prices - excludes the consumption costs of owner-occupied housing; whereas the U.S. CPI includes it at a substantial 25% weighting. As Eurostat explains,1 "the comparison of inflation across different countries and regions can be undermined by the use of different approaches to owner-occupied housing." To compare apples with apples, a simple approach is to exclude housing costs from the U.S. CPI too. This shows that the ex-shelter inflation rates - both headline and core - are almost identical in the euro area and the U.S. (Chart I-4 and Chart I-5). Chart I-4Apples For Apples: Little Difference In ##br##Euro Area And U.S. Headline Inflation... Apples For Apples: Little Difference In Euro Area And U.S. Headline Inflation... Apples For Apples: Little Difference In Euro Area And U.S. Headline Inflation... Chart I-5...Or Core##br## Inflation ...Or Core Inflation ...Or Core Inflation A more correct approach would be to estimate the inclusion of housing costs in the euro area consumer basket, given that they represent a sizable proportion of euro area household expenditures. The proportion of homes that are owner-occupied in the euro area, 67%, is actually higher than that in the U.S., 65%. Our approach uses two steps. First, to realise that owner-occupied housing cost inflation just follows house price inflation. Second, to observe that house price inflation in the euro area is now identical to that in the U.S. (Chart I-6 and Chart I-7). We infer that if owner-occupied housing were included in the euro area consumer basket, there would be no major difference in the euro area and U.S. inflation numbers. But what about inflation expectations? The market-based expectations for the euro area and U.S. 5 year inflation rate 5 years ahead - the so-called 5 year 5 year inflation swap - show that the euro area is consistently below the U.S., albeit by just 0.5% (Chart I-8). But again, this difference exists largely because the market is ignoring owner-occupied housing costs, which are not in the euro area's official inflation rate. Chart I-6House Price Inflation Is Now Identical ##br##In The Euro Area And U.S. House Price Inflation Is Now Identical In The Euro Area And U.S. House Price Inflation Is Now Identical In The Euro Area And U.S. Chart I-7Owner Occupied Housing Inflation##br## Follows House Price Inflation Owner Occupied Housing Inflation Follows House Price Inflation Owner Occupied Housing Inflation Follows House Price Inflation Chart I-8Inflation Expectations Move Together ##br##In The Euro Area And U.S. Inflation Expectations Move Together In The Euro Area And U.S. Inflation Expectations Move Together In The Euro Area And U.S. Bottom Line: The euro area is not suffering a noticeably greater deflation threat than any other major economy. Euro Area Growth: One Of The Best In Class Since the end of 2013, euro area real GDP per capita has outperformed both the U.S. and Japan. Once again, we must compare apples with apples. To adjust for the different demographics in the major economies, a fair comparison of economic performance must be on a per capita basis. But isn't the euro area's outperformance due mostly to Germany? Actually, no. Over the past three years, the star performers are Spain and the Netherlands, whose per capita real GDPs have grown by 9% and 4.5% respectively. By comparison, the U.S. clocks in at 3.5% and Japan at 3%. The ECB might argue that its extraordinary policy is responsible for this outperformance. However, the evidence does not support this thesis. The revival in the euro area economy began in early 2014, long before the ECB had even mooted its asset-purchases, TLTROs or negative interest rates. Instead, the turning-point can be traced back to December 31, 2013, the mark-to-market date for the bank asset quality review (AQR). As soon as euro area banks ended the aggressive de-levering that the stress tests forced upon them, a deeply negative credit impulse also eased. Which allowed the economy to begin a sustained recovery. Bottom Line: The euro area excluding Germany is among the world's top-performing major economies (Chart I-9). Chart I-9The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Euro Area Ex Germany Is Among The World's Top-Performing Major Economies The Investment Implications The proportion of the euro area working age population in employment is close to an all-time high, underlying inflation is almost identical to that in the U.S., and the euro area ex Germany is the world's best-performing major economy over the past three years. Yet the expected difference between ECB looseness and Federal Reserve tightness stands at a multi-decade extreme (Chart I-10). Chart I-10The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme The Expected Difference Between ECB Looseness And Fed Tightness Is Too Extreme Lean against this. Either go long the Eurodollar two year out interest rate future contract and short the equivalent Euribor contract. Or go long the U.S. 5-year T-bond and short the German 5-year bund.2 A further ramification comes in the currency market. The dominant recent driver of the euro has been the so-called fixed income portfolio channel. When global bond investors fled the euro area in search of higher safe nominal yields, the euro came under pressure. These outflows are abating, and indeed reversing, as investors come to realise that the ECB's radical and experimental policy-easing has peaked. Stay long euro/pound until the trigger of Article 50. Stay long euro/yuan structurally. Finally, contrary to popular perception, the state of the euro area economy does not translate into Eurostoxx600 relative performance. Major equity market indexes are a collection of multinational dollar-earning companies which happen to be quoted in a particular city - say, Frankfurt, London, or New York - in a particular currency - say, the euro, pound, or dollar. Therefore, as demonstrated in More Investment Reductionism,3 the main driver of equity market relative performance tends to be currency movements, or the relative performance of industry sectors that dominate the particular index. Based on this currency and sector logic, stay underweight Eurostoxx600 versus FTSE100, and underweight Eurostoxx600 versus S&P500.4 Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Detailed Technical manual on Owner-Occupied Housing for Harmonised Index of Consumer Prices, Eurostat. 2 BCA strategists differ on this position. 3 Published on November 24, 2016 and available at eis.bcaresearch.com 4 BCA strategists differ on this position. Fractal Trading Model* This week's trade is to go long Norwegian krone / Russian ruble. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long NOK/RUB Long NOK/RUB * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear client, We have received several questions about a potential U.S. border tax adjustment. Peter Berezin, Senior Vice President of BCA's Global Investment Strategy service addresses this issue in the attached Special Report titled, "U.S. Border Adjustment Tax: A Potential Monster Issue For 2017". Peter analyses the economic and financial market implications of the plan and concludes it is likely to be an additional support to the dollar bull market should it be implemented in full. We trust you will find this report very interesting and relevant. As always, please do not hesitate if you have further questions. Best regards, Lenka Martinek Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Chart Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Chart 1 Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 2 Chart 3Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Chart Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason Chart 5 Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.

Highlights House Republicans are pushing for a radical overhaul of the existing tax code, including adding a "border adjustment" mechanism that would effectively subsidize exports and tax imports. Despite President Trump's apparent mixed feelings about border taxation, we see a 50% chance that some version of the proposal will be implemented. This is a higher probability than the market currently is discounting. The trade-weighted dollar will rally by another 5% even in the absence of any tax changes, but could rise by 15% if the border adjustment tax is introduced. If the latter were to happen, it would take some time for the dollar to rise to its new equilibrium level. This, in conjunction with sticky import and export prices, would likely lead to a temporary narrowing of the U.S. trade deficit. Such an outcome could prompt the Fed to raise rates more aggressively than it otherwise would. Investors should underweight U.S. bonds on a currency-hedged basis. A stronger dollar will push down commodity prices and hurt external borrowers with dollar-denominated loans. A protectionist backlash against the U.S. might ensue. We are closing our long Chinese banks trade for a gain of 32%, and our long RUB/USD trade for a gain of 20%. Feature Making The Tax Code Great Again? Republicans in Congress are proposing an ambitious revamp of the tax code. A central element of their plan is the replacement of the existing corporate income tax with a so-called "destination-based cash flow tax." Key features of this plan include: Cutting the current federal corporate tax from a top rate of 35% to 20%. Allowing businesses to depreciate capital expenditures immediately, rather than writing them off over many years. Disallowing businesses from deducting interest expenses when calculating their tax bills. Moving to a system of territorial taxation, meaning that taxes would only be assessed on the value added of goods consumed in the United States. Since not all goods that are produced in the U.S. are consumed in the U.S., and not all goods that are consumed in the U.S. are produced in the U.S., a destination-based system requires what is known as a "border adjustment." Such an adjustment would tax the value added of imports and rebate the value added of exports at an equivalent rate. While border adjustments are routinely used in other settings - most notably by countries that have VATs - their application to corporate income taxes is a novel idea. As such, it is not surprising that the proposal has generated significant confusion among investors. With that in mind, we offer our thoughts on the matter using a Q&A format. Q: How exactly would a border adjustment on corporate income taxes work? A: Under current U.S. law, corporate income taxes are assessed on worldwide profits, which are the difference between worldwide revenues and worldwide costs. The introduction of a border tax adjustment would change the tax system to one where taxes are assessed only on the difference between domestic revenues and domestic costs (i.e., revenues derived in the U.S. minus costs incurred in the U.S.). Table 1 offers a simplified example to illustrate this point. Consider three types of companies: 1) A purely domestic producer whose revenues and costs are realized at home; 2) An exporter whose revenues are entirely derived from abroad but whose costs are all incurred in the U.S.; 3) An importer whose revenues are completely generated in the U.S. but whose costs are all incurred abroad. Suppose that all three companies have revenues of $100 and costs of $60 - implying $40 in pre-tax profits - and face a corporate tax rate of 20%. Before the border adjustment, each company would pay a tax of $8 ($40 times 0.2). The border adjustment is zero for the domestic producer. However, it would impose an additional tax of $12 on the importer ($60 times 0.2), while giving the exporter a rebate of $20 ($100 times 0.2). In the end, the importer and exporter face final tax bills of $20 and -$12, respectively, while the domestic producer continues to pay $8. Note that this conforms with the tax paid on domestic revenues minus domestic costs (for the domestic producer, domestic revenue minus domestic cost is equal to $40; for the exporter it is equal to -$60; and for the importer, it is equal to $100). Q: A tax on imports and a subsidy on exports? Sounds like massive protectionism! A: That depends on the extent to which the dollar appreciates. As Table 1 shows, if the dollar appreciates by 1/(1-tax rate) = 1/(1-0.2) = 25%, there would be no impact on the trade balance or on the distribution of after-tax corporate profits in the economy. This is because the stronger dollar would nullify the subsidy on exports, while reducing import costs by precisely the amount necessary to restore importers' after-tax profits to their original level. Chart Q: This seems like splitting hairs. If a country imposes a 20% tax on imports, most people would still regard this as a protectionist act, even if a currency appreciation offsets the impact. A: That's why a corresponding export subsidy is necessary. That may sound strange since export subsidies are also seen as protectionist measures, but consider the following: Imagine that the government only taxes imports. A tax on imports would curb import demand, implying less demand for foreign currency. This would push up the value of the dollar, leading to lower import prices. How high would the dollar go? Suppose it rose so much that the decline in import prices exactly offset the tariff, thereby restoring import volumes (and importer profits) back to their original level. Is that a stable equilibrium? The answer is no because a stronger dollar would also reduce the demand for U.S. exports, causing the trade deficit to swell. Thus, for the trade balance to remain unchanged, the dollar would have to rise only part of the way, leaving importers worse off than before the tariff was introduced. Such a policy would be protectionist because it would favor U.S.-based companies that produce for the domestic market over foreign exporters. Only in the case where importers are subject to a tax and exporters receive a subsidy will the dollar strengthen to the point that neither exports nor imports change. Intuitively, this is because an export subsidy indirectly benefits importers by pushing up the value of the dollar, while directly benefiting exporters by offsetting the effect of a stronger dollar on profits. Q: If there is no change in the trade balance, what is the advantage of border-adjusting the corporate income tax? A: Contrary to Donald Trump's assertion that border adjustments are "too complicated," their chief advantage is their simplicity. Accurately assessing taxes on worldwide income is hard. Companies routinely engage in practices that purposely lower taxable profits. In particular, importers may overstate the value of their imports and exporters may understate the value of their exports. In a world where many companies have overseas subsidiaries, such "transfer pricing" machinations are easy to pull off. Border adjustments eliminate such incentives in one fell swoop. Recall that with a border adjustment, taxes are assessed on the difference between domestic revenues and domestic costs - both of which the IRS has the means to monitor. Yes, a U.S. company that overstates imports will be able to report a lower gross profit to the IRS, but now it will be on the hook for a higher import tax. What it puts in one pocket it takes from the other. Likewise, an exporter that understates its overseas sales will end up with a lower gross profit, but will now receive a smaller subsidy. Q: And I suppose that because the U.S. imports more than it exports, the border adjustment will end up raising additional revenues? A: That is correct. The annual U.S. trade deficit currently stands at $500 billion. A border adjustment tax rate of 20% would thus raise $100 billion in additional revenue. Given that the corporate income tax brings in about $350 billion, this would allow corporate taxes to be substantially cut without any loss in overall revenue. And this calculation excludes any indirect revenue that would accrue to the Treasury from reducing the incentive for U.S. companies to engage in profit-shifting behavior. Keep in mind, however, that the revenue boost from the border adjustment will decline if the U.S. trade deficit narrows over time. To the extent that the U.S. must finance its trade deficit through the sale of assets such as stocks, bonds, and property, it is possible that foreigners will one day decide to swap all these assets in exchange for U.S. goods. This would lead to an improvement in the U.S. trade balance. Indeed, to the extent that the U.S. is a net debtor to the rest of the world, it is possible that the average future U.S. trade balance will be positive. If that were to happen, the government would lose revenue from the border adjustment over the long haul. Meanwhile, a 25% appreciation in the greenback would reduce the dollar value of the assets that Americans hold abroad, without much of a corresponding decline in U.S. external liabilities. A reasonable estimate is that this would impose a paper loss on the U.S. of about 13% of GDP.1 Q: Ouch! But this assumes that a 20% border adjustment tax will lead to a 25% appreciation in the dollar. That is a mighty big can opener your fellow economists are assuming! What's to say this actually happens? A: Good point. Less than 10% of the turnover in the global foreign exchange market is directly related to the cross-border trade in goods and services. The rest represents financial market transactions. There are many things that can influence the value of the dollar beside trade flows. For example, suppose the government introduces a border adjustment tax, but the Federal Reserve fails to raise rates sufficiently fast in response to rising inflation stemming from a narrowing trade deficit. In that case, U.S. real rates could actually decline, leading to a weaker dollar. Our sense is that this won't happen, but the point is that there is no automatic link between a border tax and the dollar. Much depends on how the Fed responds and the underlying economic conditions. And even if the Fed does hike rates to keep the economy from overheating, two important forces will limit the extent of any dollar appreciation: First, questions about the timing and magnitude of the border adjustment tax - including the possibility that such a measure could be reversed by a future Congress - are likely to lead to only a partial appreciation in the dollar. Second, other central banks - particularly in emerging markets - are liable to take steps to limit the dollar's ascent so as not to place too great a burden on borrowers with dollar-denominated debt. Q: So what happens to countries with hard currency pegs to the dollar? Borrowers with dollar-denominated loans will be spared, but won't these countries end up suffering due to a sharp loss of competitiveness against other economies that have more flexible currencies? A: Correct. It is damned if you do, damned if you don't. Assuming that countries with exchange rate pegs to the dollar are strong enough to fend off a speculative attack, they will still need to engineer an equivalent real depreciation of their currencies via a decline in their nominal wages relative to U.S. wages - what economists call an "internal devaluation." That could impose a deflationary impulse on those economies. Q: You're losing me. A: Think about an extreme case - one where all countries have currency pegs to the dollar. How would the economic adjustment to a U.S. border tax work then? The answer is that initially, a tax on U.S. imports, combined with a subsidy on U.S. exports, would lead to a smaller trade deficit. This would cause the U.S. economy to overheat, putting upward pressure on prices and wages. By definition, an improving trade balance in the U.S. implies a worsening trade balance in the rest of the world. This would sap demand in other countries, putting downward pressure on prices and wages abroad. The adjustment will be complete only after relative wages have shifted enough to restore the U.S. trade balance to its original level. The important point is that in a world where some countries have flexible exchange rates while others have fixed exchange rates or dirty floats, the economic adjustment to a U.S. border tax will come through some combination of a stronger nominal dollar, higher U.S. inflation, and lower inflation abroad. Q: Bullish for the dollar, but bearish for U.S. bonds, correct? A: Precisely. The degree to which bond yields adjust around the world depends on the extent to which nominal exchange rates and domestic prices are sticky. If exchange rates are slow to change, more of the adjustment has to occur through higher inflation in the U.S. and lower inflation everywhere else. But even if nominal exchange rates adjust quickly, sticky goods prices would still push up U.S. bond yields. To see this point, consider what would happen if the dollar appreciated by 25% in response to the introduction of a border adjustment tax, but neither import prices nor export prices (expressed in U.S. dollars) changed. If that were to happen, the profit margins of U.S. importers would tumble because they would now have to pay an import tax but would not benefit from lower import prices. Meanwhile, the margins of U.S. exporters would soar as export prices stayed firm and they received a subsidy from the government. The result would be less imports and more exports, and hence, an improved trade balance. This would raise U.S. aggregate demand and put upward pressure on inflation and Treasury yields. Considering that 97% of U.S. exports and 93% of U.S. imports are denominated in dollars, such an outcome is hardly far-fetched. The bottom line is that in the "real world," the introduction of a border adjustment tax would cause Treasurys to sell off and the dollar to rally. Q: What sort of numbers are we talking about? A: Assuming a 20% border tax is introduced, a reasonable guess is that the trade-weighted dollar would rise by 10% over a 12-month period above and beyond our current forecast of a 5% gain. This would imply 15% upside from current levels. The 10-year Treasury yield would probably rise to about 3%. Q: It still puzzles me how you can claim that bond yields will rise if the dollar strengthens. Wouldn't a stronger dollar normally lead to lower bond yields? A: Your premise is wrong. It is not the stronger dollar that leads to higher bond yields. It is a third factor - namely the improvement in the trade balance arising from the decision to tax imports and subsidize exports - that causes both the dollar and bond yields to rise. This is similar to what happens when the government loosens fiscal policy. Mind you, at some point the positive correlation between the dollar and bond yields could break down. If the dollar rises too much, emerging markets will crumble under the stress. This will trigger safe-haven flows into the Treasury market, leading to a stronger dollar and lower yields. Such an outcome is not our base case, but it cannot be dismissed. Q: Got it. Presuming that the global economy holds up, it sounds like a border tax would be great news for Boeing, but bad news for Walmart? Chart 1 A: Yes, but there are two important qualifications to consider. First, it is possible that the dollar overshoots its new long-term equilibrium level, so that the pain to Boeing from the appreciation of the greenback ends up outweighing the benefits from the export subsidy it receives. Second, given the potential economic and financial dislocations from the shift to a destination-based tax system, there is likely to be some delay between when the tax bill is signed into law and when it is implemented. And even once implementation begins, the adjustment in tax rates may be phased in only gradually. Since the dollar will rise in anticipation of all this, it is possible that exporters will actually suffer initially, while importers receive a temporary boost to profits. Nevertheless, we think that investors will see through the near-term hit to exporter margins and focus on the medium-term gains. As such, equity investors should maintain a preference for exporting companies over those that heavily rely on imports (Chart 1). Q: This assumes that the market has not fully priced in this outcome already. What are the chances that this border adjustment tax proposal actually sees the light of day? A: The border tax idea originated in the House of Representatives and has its strongest support there. There might be more opposition in the Senate, but this could be overcome if enough Democrats with protectionist leanings can be found. President Trump panned the idea in an interview with the Wall Street Journal earlier this week.2 He noted that "Anytime I hear about border adjustment, I don't love it... because usually it means we're going to get adjusted into a bad deal. That's what happens." Trump's comments suggest he may not fully understand how border adjustments work. This implies that he might be persuaded to go along with the idea if Republican legislators are able to reach a "great deal" on adjustments in his eyes, whatever that means. Subjectively, we would assign 50% probability to a border tax being introduced in some form or another, although our sense is that it will be somewhat watered down so as not to generate major dislocations for the economy. This might entail excluding certain types of imports from a border tax if they are consumed disproportionately by the poor or represent an important input for U.S. manufacturing firms. Apparel and energy products would probably be on that list. It might also entail reducing the border adjustment tax to a lower level, say 10%, as Tom Barrack, head of Donald Trump's inaugural committee, has suggested. It is hard to know how much of this is already reflected in asset prices. The dollar fell after the WSJ article was published, but that may have had less to do with border adjustments and more to do with Trump's comment that he prefers a weaker dollar - an unprecedented statement for a U.S. president. Goldman Sachs' securities group has constructed two baskets using firm-level data, one comprised of "destination tax winners" and the other of "destination tax losers."3 The loser basket actually outperformed in the immediate aftermath of the election. While the relative performance of the winner basket has recovered more recently, it still remains below where it was last April (Chart 2). The limited reaction to the prospect of a border adjustment tax has been echoed in the fact that market expectations of the future volatility of the dollar has not changed much since the election, despite the possibility that the coming legislative debate could lead to wild swings in the greenback (Chart 3). Chart 2 Chart 3Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated Dollar Volatility Has Not Escalated On balance, we conclude that investors are understating the likelihood of even a watered down border adjustment tax being introduced as part of a comprehensive tax reform program. This is broadly consistent with our client discussions, which have revealed that most investors - with a few notable exceptions - are only vaguely aware of the issue. Q: Won't the WTO rule against a border adjustment tax? That could explain why investors are discounting it. A: Yes, it probably will. The WTO permits border adjustments in the case of "indirect" taxes such VATs, but not in the case of direct taxes such as income or corporate profit taxes. Granted, the U.S. has brushed off WTO decisions in the past, such as when it ignored the trade body's ruling that U.S. laws restricting internet gambling contravened the General Agreement on Trade in Services. Considering that Donald Trump threatened to pull the U.S. out of the WTO during the election campaign, such an outcome cannot be easily dismissed. Nevertheless, given the magnitude of the border tax issue, even the Trump administration is likely to think twice about running afoul of WTO rules. Nevertheless, it might be possible to modify the border adjustment proposal to make it WTO-compliant. The distinction between direct and indirect taxes is one of those things self-styled experts like to pretend is important, but is not. It does not really matter whether a tax is levied on the sale of a good or service, or whether it is levied on income. In the end, someone has to pay the tax - be it a worker or a shareholder. The adoption by the U.S. of a border-adjusted destination tax would move the global economy in the direction of greater harmonization, not away from it. As noted at the outset, most other countries border adjust their value-added taxes. They do this so that their VATs mirror a consumption tax, as Table 2 illustrates with a simple example. Conceptually, a corporate cash flow tax coupled with a payroll tax functions in much the same way as a VAT (bottom part of Table 2). The U.S. already has both a corporate income and a payroll tax, so it is not that far away from having a VAT. All that is missing is a few tweaks to depreciation rules and the addition of the border adjustment. Chart Yes, the dollar would strengthen if that were to happen, but this would put the greenback on par with other currencies. Chart 4 shows that the U.S. has run a trade deficit with the rest of the G7 since 1990, despite the fact that the dollar has traded on average 9% below its Purchasing Power Parity (PPP) over this period. One of the reasons this has occurred is that other G7 economies have a VAT, whereas the U.S. does not (Chart 5). This has kept the dollar weaker than it otherwise would have been. Chart 4The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason The Dollar Was Cheap For A Reason Chart 5 Q: Okay, let's wrap this up. What are the main investment implications I should take away from this? A: Our main takeaway is that investors are underestimating the likelihood that the U.S. adopts a destination-based tax system. This suggests that the risks to the dollar are to the upside, as are the risks to U.S. Treasury yields. Global investors should underweight U.S. bonds on a currency-hedged basis. The implications for global equities are more nuanced. It may take some time for the dollar to adjust to the border tax. This, combined with the fact that import and export prices tend to be sticky in the short run, implies that the U.S. trade deficit will decline, boosting U.S. aggregate demand in the process. While that is potentially good news for U.S. corporate profits, the benefits will be curtailed by the fact that the U.S. economy is approaching full employment. This means that any further stimulus could simply result in higher real wages for workers without any offsetting increase in unit sales for U.S. companies. A shrinking U.S. trade deficit will diminish America's role as "the global consumer of last resort." This is problematic for export-dependent emerging markets. While a border adjustment may be justifiable on economic grounds, politically, it could be seen as the first volley in a global trade war. This could sour sentiment towards EM stocks. To make matters worse, a stronger dollar would harm emerging markets with high levels of dollar-denominated debt such as Turkey, Malaysia, and Chile, while also weighing on commodity prices. We recommend that investors underweight EM stocks relative to their DM counterparts. With these considerations in mind, we are closing our long Chinese banks trade for a gain of 32% and our long RUB/USD trade for a gain of 20%. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 U.S. external assets amount to 133% of GDP, while foreign liabilities stand at 175% of GDP. About 68% of U.S. external assets are denominated in foreign currency, compared with only 16% of external liabilities. Thus, the paper loss to the U.S. from a 25% appreciation in the dollar would be (175*0.16-133*0.68)*(1-1/1.25) = 12.5% of GDP. 2 Please see "Donald Trump Warns On House Republican Tax Plan," The Wall Street Journal, dated January 16, 2017, available at www.wsj.com. 3 The Bloomberg tickers for these baskets are GSCBDTW1 and GSCBDTL1. For more information, please see "US Daily: What Policy Changes Is The Equity Market Expecting?" Goldman Sachs Economic Research, dated January 11, 2017.

Highlights Duration: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. Fed Balance Sheet: The Fed could start to reduce the size of its balance sheet as early as the end of this year, but more likely in 2018. In any case, allowing securities to run off its portfolio will not have much of an impact on long-dated Treasury yields. MBS: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Feature As we pointed out in our December 6 report, the bond selloff had proceeded too far, too fast, and was due for a pause. The 10-year Treasury yield then peaked at 2.6% on December 16 and has now fallen back to 2.4% as we go to press. It is of note that all of the reversal has come from the real component of yields while the compensation for expected inflation has remained firm (Chart 1). Chart 1Bear Market On Pause Bear Market On Pause Bear Market On Pause In our end-of-year "Themes For 2017" Special Report 1 we explained why we believe Treasury yields will level-off in the near term before heading higher throughout most of 2017. Now that we have entered this first "consolidation phase" it is time to consider what factors would cause us to reinstate a below-benchmark duration stance. But first, let us quickly recap our bearish 6-12 month outlook for Treasuries. The Cyclical Outlook For Treasury Yields Many of the headwinds that held back economic growth last year - including fiscal policy, inventory drawdowns and the impact of a distressed energy sector on capital spending - are poised to abate in 2017. With stronger growth and an already tight labor market, core inflation will continue to gradually rise toward the Fed's target. We expect trailing 12-month core PCE inflation will reach the Fed's 2% target near the end of 2017. Consequently, the cost of inflation protection embedded in bond yields will also converge with levels that are consistent with the Fed's target (Chart 2). We judge this level to be in the range of 2.4% to 2.5% for long-dated TIPS breakevens. With the 5-year/5-year forward TIPS breakeven rate at 2.13% and the 10-year TIPS breakeven rate at 2%, long-dated Treasury yields have approximately 30-50 bps of upside from the inflation component alone. Chart 2Breakevens Still Too Low Breakevens Still Too Low Breakevens Still Too Low Chart 3Real Yields Also Biased Higher Real Yields Also Biased Higher Real Yields Also Biased Higher We are less certain about how much higher real yields might move during the next 12 months. However, the downside in real yields is surely limited. Chart 3 shows that changes in the 10-year real yield and changes in our 12-month Fed Funds Discounter2 are almost always positively correlated. At present, the reading from our discounter is 46 bps, meaning the market is priced for about 2 more rate hikes during the next 12 months. Given our positive economic outlook, 2 or 3 rate hikes in 2017 sounds reasonable. Is Now The Time To Trim Duration? Barring any major economic setbacks we will consider three factors when making this decision: (i) valuation, (ii) economic policy uncertainty and (iii) sentiment & positioning. Factor 1: Valuation When we last shifted from a below-benchmark to a benchmark duration stance on December 6 the 10-year Treasury yield traded 14 bps above the fair value reading from our 2-factor Global PMI Model. At present, the 10-year yield is only 9 bps cheap on this model (Chart 4). In other words, valuation is essentially neutral. But since global PMI is likely to trend higher over the course of the year, we would be comfortable cutting duration at current valuation levels should the other two factors on our checklist fall into place. Factor 2: Uncertainty We've been talking a lot about uncertainty recently, mostly in reference to the Global Economic Policy Uncertainty Index created by Baker, Bloom and Davis.3 This index exhibits a strong inverse correlation with Treasury yields over time and has shot higher during the past couple of months without a corresponding decrease in yields. When we consider the uncertainty index alongside Global PMI and bullish sentiment toward the U.S. dollar in our 3-factor model of Treasury yields, we find that the 10-year Treasury yield now appears 38 bps cheap (Chart 5). Chart 4Close To Fair Value... Close To Fair Value ... Close To Fair Value ... Chart 5...But Uncertainty Remains Elevated ... But Uncertainty Remains Elevated ... But Uncertainty Remains Elevated What is particularly odd is that the uncertainty index has diverged so sharply from measures of both consumer and small business confidence (Chart 6). This epic split can mean only one of two things: Chart 6Excessive Optimism Or A False Reading From The Uncertainty Index? Excessive Optimism Or A False Reading From The Uncertainty Index? Excessive Optimism Or A False Reading From The Uncertainty Index? Businesses and consumers are excessively optimistic in the face of an increasingly uncertain back-drop, or The uncertainty index is unable to distinguish between policy shocks with positive and negative economic implications We turn to history in an attempt to determine whether the warning from the uncertainty index should be heeded. Specifically, we searched for other one-month periods when there was a one standard deviation increase in the uncertainty index alongside increases in both consumer and small business confidence. Since 1991, ten months meet these criteria (Table 1). Table 1Periods Displaying One Standard Deviation Increase In Global Economic Policy##br## Uncertainty Index* And Increase In Both Consumer Sentiment Index** ##br##And Small Business Confidence Index*** (1991 To Present) Is It Time To Cut Duration? Is It Time To Cut Duration? First we note that Treasury yields declined in 7 out of the 10 flagged periods, but in many of those episodes the scale of the positive confidence shocks was not very large. The two months that appear most similar to the present situation are September 2008 and December 2013. Chart 7Investors Still Bearish Investors Still Bearish Investors Still Bearish The Fed announced the tapering of its asset purchases in December 2013 amidst signs of an improving economy. The hawkish Fed announcement and improving economic outlook sent yields higher on the month, while the uncertainty index spiked as a large number of Fed-related news stories hit the papers.4 One thing that makes December 2013 an imperfect comparable to the present day is that the uncertainty shock was relatively small compared to the confidence shocks. In September 2008 the confidence shocks were not as large as the uncertainty shock, much like today, and the 10-year Treasury yield managed a 2 bps increase. However, it is definitely unfair to draw a conclusion based on the extremely volatile price movements that were witnessed at the height of the financial crisis in September 2008. Based on the example of December 2013, we cannot decisively rule out the possibility that the uncertainty index is simply giving a false signal. However, if that is the case we would expect the uncertainty index to mean revert in relatively short order. Given the strong historical relationship between the uncertainty index and Treasury yields, we will wait for some mean reversion in the uncertainty index before shifting back to a below-benchmark duration stance. Factor 3: Sentiment & Positioning When we shifted from a below-benchmark to a benchmark duration stance measures of investor sentiment and positioning were at bearish extremes, sending a decisive signal that the bond market was oversold. As of today, some of these indicators have started to reverse course while others have not (Chart 7). Our BCA Bond Sentiment Indicator, a composite of a survey of bullish sentiment toward bonds and the 13-week rate of change in bond yields is no longer at an oversold extreme. However, net speculative positions in the 10-year Treasury futures contract have moved even further into "net short" territory. The J.P. Morgan client survey shows that investors remain below benchmark duration in aggregate, although active traders are no longer net short. Although some capitulation of shorts has already taken place, we will await some further normalization of positioning - particularly in net speculative futures - before reinitiating a below-benchmark duration stance. Bottom Line: In the absence of a major economic shock we will reinitiate a below-benchmark duration recommendation once the Global Economic Policy Uncertainty Index displays some mean reversion and positioning indicators are at less bearish extremes. The Fed's Balance Sheet & The Shortage Of Bills The minutes from December's FOMC meeting revealed that: Several participants noted circumstances that might warrant changes to the path for the federal funds rate could also have implications for the reinvestment of proceeds from maturing Treasury securities and principal payments from agency debt and mortgage-backed securities Since then, three different FOMC members have also spoken about the size of the Fed's balance sheet. Philadelphia Fed President Patrick Harker said that the Fed should consider shrinking its balance sheet once the fed funds rate reaches 1%.5 Boston Fed President Eric Rosengren made the case for more immediate action6 and St. Louis Fed President James Bullard said the Fed should consider shrinking its balance sheet in 2017.7 Clearly, talk of unwinding the Fed's balance sheet is heating up. The Fed's only official stated position on this topic is that it will keep its balance sheet level until normalization of the fed funds rate is "well under way", a statement we have long interpreted to mean "until the fed funds rate is 1%, or perhaps even higher". As such, we would not expect any action on winding down the Fed's balance sheet until late this year at the earliest, and more likely in 2018. The Impact On Treasury Yields In any case, as we detailed in a report published in August 2015,8 we do not think that the Fed allowing its balance sheet to shrink will itself have much of an impact on Treasury yields. The reason relates to the way in which maturing Treasury securities are currently rolled over at auction and the persistent shortage of T-bills in the market. Chart 8Fed Runoff Will Increase##br## Issuance To Public ... Fed Runoff Will Increase Issuance To Public ... Fed Runoff Will Increase Issuance To Public ... At the moment, balances of matured Treasury securities are added to upcoming note/bond auctions as non-competitive bids. In other words, as Treasury securities mature the Fed buys an equal amount at upcoming Treasury auctions. If the Fed were to cease this reinvestment, that amount would need to be added to the competitive portion of the auctions and would greatly increase the gross issuance of Treasury debt to the public. For a sense of scale, we calculate that Treasury issuance to the public would need to increase by $426 bn in 2018 and $378 bn in 2019 if the Fed were to cease the reinvestment of its portfolio at the end of this year (Chart 8). We contend, however, that a significant portion of this extra financing requirement will be met through increased T-bill issuance and will therefore not impact long-dated Treasury yields. The Treasury department has had a stated goal of increasing T-bill issuance since May 2015 and bill supply as a percentage of total Treasury debt remains near a multi-decade low (Chart 9). Further, T-bills are still in high demand as evidenced by the fact that they are trading at a substantial premium to other money market instruments (Chart 10). This premium exists despite the fact that the Fed has been soaking up a lot of T-bill demand through its Overnight Reverse Repo facility (Chart 10, bottom panel). If the Fed were to phase this program out alongside a reduction in the size of its balance sheet - which is its current stated exit strategy - the shortage of T-bills would be exacerbated. Chart 9... But Mostly Through T-Bills ... But Mostly Through T-Bills ... But Mostly Through T-Bills Chart 10T-Bills In High Demand T-Bills In High Demand T-Bills In High Demand Of course there is a new regime about to enter the White House and the Treasury department, and also a lot of uncertainty about how large the deficit will be going forward. If the deficit is increased substantially then it would likely be necessary for the Treasury department to increase the size of both bill and coupon issuance in the years ahead. Bottom Line: It is necessary to consider both fiscal policy and the Fed's balance sheet together when forecasting Treasury issuance. Further, whatever the government's financing requirement, a considerable portion of it will be addressed through increased T-bill issuance in the years ahead. This will limit the impact on long-dated Treasury yields. A Quick Note On MBS Chart 11MBS Spreads Are Too Low MBS Spreads Are Too Low MBS Spreads Are Too Low Any unwind of the Fed's balance sheet will have a much greater impact on MBS spreads than on Treasury yields since it will add directly to the supply of MBS available to the public, which tends to correlate with MBS option-adjusted spreads (Chart 11). Of course, other factors such as the rate of prepayments will determine how quickly the Fed's MBS holdings run off and the state of the housing market will determine how much new mortgage origination takes place. We hope to explore these issues in more depth in the coming weeks. Of more immediate concern for MBS spreads though is the recent divergence between nominal spreads, rate volatility and the slope of the yield curve (Chart 11, bottom two panels). MBS spreads have not widened in recent weeks despite curve steepening and rising rate vol. MBS spreads are already low compared to investment alternatives and have upside in the near term, especially if the yield curve continues to steepen, as we expect it will. Looking further out, the eventual wind down of the Fed's balance sheet is another risk the MBS market will have to face. Bottom Line: Remain underweight MBS. Spreads are already low and have near-term upside based on the slope of the yield curve and the uptrend in interest rate volatility. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 207", dated December 20, 2016, available at usbs.bcaresearch.com 2 Our 12-month discounter measures the expected change in the fed funds rate during the next 12 months as discounted in the overnight index swap curve. 3 www.policyuncertainty.com 4 The uncertainty index is in part based on an algorithm that scans newspapers for coverage of policy-related economic uncertainty. 5 http://www.reuters.com/article/us-usa-fed-harker-idUSKBN14W1W4 6 http://www.cnbc.com/2017/01/09/reuters-america-interview-rosengren-urges-more-rate-hikes-slimmer-balance-sheet.html 7 http://www.businessinsider.com/lets-shrink-the-balance-sheet-bullard-says-2016-12 8 Please see U.S. Bond Strategy Weekly Report, "Currencies: The Tail Wagging The Dog", dated August 18, 2015, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Argentina's structural reform story keeps getting better and the bull market in the nation's assets has further to go. Further interest rate cuts means a cyclical economic recovery is in the making. The South American nation will continue to attract, and retain, global capital. Stay with the long ARS / short BRL trade. Dedicated EM and FM investors should remain overweight Argentine equities, and stay with the long Argentina / short Brazil relative equity trade. Sovereign credit traders should stay overweight Argentine credit within EM credit portfolios. In addition, go overweight Argentine local currency government bonds versus the EM benchmark. A new trade: go long 7-year Argentine local currency government bonds, currency unhedged. Feature After taking a pause over the past few months, Argentine share prices have once again begun to climb (Chart 1), and rightfully so. Yet another round of reforms and needed policy adjustments by the all-star cabinet of President Mauricio Macri have been rolled out. In fact, the sheer volume and frequency of orthodox policy measures deployed so far has been so extensive that not a week has gone by when seemingly yet another price control has been lifted or incentive-distorting subsidy scrapped. This is also a sign of how many distortions were in place to begin with, but clearly the government's reform momentum remains in high gear. Chart 1The Bull Market In Argentine Equities Has More To Go The Bull Market In Argentine Equities Has More To Go The Bull Market In Argentine Equities Has More To Go With positive long-term reform, however, comes short-term pain, as we highlighted back in September.1 Unsurprisingly, Argentina's recession has been deep and prolonged. This is about to change. A strong disinflationary momentum is starting emerge, and will re-animate growth in the months to come as interest rates drop significantly. Ultimately, what matters for investors is the outlook for the economy's return on capital, and signs point towards a potentially multi-year and sustainable economic expansion in the making. The re-rating process has further to go. Stay long/overweight Argentine assets, including equities, sovereign and local credit, and the Argentine peso versus the Brazilian real. Full-Out Structural Transformation Continues 2017 has been kicked off with a full reform swing in Argentina, as the Macri administration has implemented another round of orthodox measures. Among them: Capital Markets Liberalization. Capital controls have been eliminated. The 120-day holding period for repatriating capital has been abolished. In addition, the central bank has done away the maximum monthly amount of foreign exchange purchases. Energy Reform. A major agreement with oil companies and oil unions has been announced regarding the nation's massive Vaca Muerta shale oil and gas basin. Competitiveness will be boosted via lower labor costs as unions have agreed to more flexible contracts and to limit benefits. In addition, firms have pledged to invest US$5 billion in 2017. Also, export taxes on crude oil and derivatives have been removed, and oil price subsidies will continue to be reduced. Telecom Reform. For the first time since 2001, the government is no longer intervening to block price increases, even for regulated services where tariffs had not increased since 2001. In addition, regulations in the telecommunications sector will be loosened in a bid to increase competition, boost investment and modernize the nation's internet service. On top of these recent reforms, the government is already beginning to implement an ambitious infrastructure plan while currently drafting a long-term strategy - its so-called 2020 Production Plan. The plan boasts eight main pillars, among them: developing and deepening local capital markets to attract more foreign investment; lowering the cost of capital for firms; working towards much needed tax reforms to lower the incredibly high tax burden on corporations; improving labor legislation; fostering innovation; increasing competition; reducing red tape; and boosting infrastructure. This continued supply-side reform push, coupled with a big pullback in the role of the state in the economy to crowd in investment, is exactly what this capital-starved economy needs (Chart 2). Startlingly, even among low savings/investment South American economies, at 14% of GDP, Argentina's capex-to-GDP is the lowest in the region, with Brazil now in a close second-to-last place (Chart 3). As a capex-boom materializes in Argentina, the potential upside for return-on-capital of such a mismanaged and underinvested economy is enormous. Chart 2Argentina: More Investment, Less Government? Argentina: More Investment, Less Government? Argentina: More Investment, Less Government? Chart 3Structural Reforms Will Improve Argentina's Abysmal Investment Rate Structural Reforms Will Improve Argentina's Abysmal Investment Rate Structural Reforms Will Improve Argentina's Abysmal Investment Rate A clear advantage is that the nation boasts an overall well-educated population, at least by South American standards. The country's tertiary educational enrollment rate, a quantity measure, currently stands at 80% - a high level both in absolute terms and relative to South American peers (Chart 4). And when looking at standardized test scores, a quality measure, Argentina stands close to the middle of the pack relative to other emerging market (EM) and frontier market (FM) economies, but near the top versus its Latin American peers (Chart 5). Overall, a supply-side reform bonanza, agile and orthodox policymaking and a relatively educated population means Argentina's overall return on capital and languishing labor productivity growth could experience a similar surge to the one seen during the 1990s (Chart 6). Chart 4Argentina Versus South America: ##br##Educational Attainment Argentina Versus South America: Educational Attainment Argentina Versus South America: Educational Attainment Image Chart 6Labor Productivity Is Set To Improve,##br##Significantly Labor Productivity Is Set To Improve, Significantly Labor Productivity Is Set To Improve, Significantly Bottom Line: Argentina's structural outlook is extremely positive. A Dollar Deluge... In Argentina? Argentina has been known much more for repelling capital (i.e. capital flight) than attracting it. However, its ongoing structural transformation means that foreign capital will continue to make its way back in. Attracting sufficient foreign capital is key to finance the Macri administration's ambitious capex-led growth plan. Yet at 15% of GDP, Argentina's domestic savings rate is low, also reflected by its current account deficit (Chart 7). Will the nation be able to attract sufficient capital to finance its current account deficit of 2.8% of GDP, or US$16 billion dollars? We believe so. If an economy offers a high return on capital, as is likely in Argentina at present for the reasons mentioned above, it will attract more than enough capital to finance its current account deficit - possibly even more than it requires. So far, this appears to be the case in Argentina. For instance: Portfolio inflows have gone vertical over the past year, reaching an astounding annualized level of US$29.1 billion dollars, a 20-year high (Chart 8, top panel). Chart 7Argentina's Domestic Savings Rate Is Low Argentina's Domestic Savings Rate Is Low Argentina's Domestic Savings Rate Is Low Chart 8Capital Will Likely Continue ##br##To Flood Into Argentina Capital Will Likely Continue To Flood Into Argentina Capital Will Likely Continue To Flood Into Argentina Moreover, cross-border M&A deals, a robust leading indicator for net FDI capital inflows, have surged (Chart 8, bottom panel). Chart 9Argentine Banks Are Flush With Dollars Argentine Banks Are Flush With Dollars Argentine Banks Are Flush With Dollars The first phase of a tax amnesty scheme that ran from May to last December has been a massive success. Roughly US$100 billion dollars' worth of assets were repatriated and/or declared, which generated ARS 108 billion, or 1.3% of GDP worth of tax revenues. The second round ends this March, and there may be much more to come. The Federal Reserve has suggested that due to decades of crises, Argentineans along with former Soviet countries have hoarded an enormous amount of (most likely undeclared) U.S. dollars.2 The result of repatriated or undeclared dollar financial assets as well as a boom in agricultural exports receipts, which followed from a more competitive currency and the elimination of almost all export taxes a year ago, has caused foreign currency deposits at commercial banks to soar to US$24 billion, or 20% of total deposits (Chart 9). Chart 10Argentina: Falling Foreign Lending Rates, ##br##Despite Rising U.S. LIBOR Argentina: Falling Foreign Lending Rates, Despite Rising U.S. LIBOR Argentina: Falling Foreign Lending Rates, Despite Rising U.S. LIBOR As foreign currency loans can only be made to exporters with revenue streams in U.S. dollars, the government has recently loosened regulations so that banks can use the equivalent of half the amount they lend out to exporters, currently US$9 billion in total, to underwrite dollar-denominated Treasury bonds. This means that at least US$4.5 billion worth of U.S. dollar sovereign debt will be able to be bought by local banks, something not possible since 2001. This will provide an additional source of demand for Argentine dollar-denominated debt in the event of any major global financial stress. Lastly, such an ample supply of foreign currency is being reflected in local dollar interest rates, which have been plummeting at a time when U.S. LIBOR rates have been rising fast (Chart 10). This will provide a cushion of cheaper U.S. financing for Argentine exporters as U.S. interest rates continue to rise.3 Importantly, the reason the Argentine peso has been relatively weak in the face of large capital inflows is largely due to the sizable pent-up demand for foreign capital (hard currency assets), following the removal of capital controls in place for so many years. Thus, it was natural there would be some sort of capital flight by households and firms. In addition, corporates that had been previously unable to repatriate profits abroad did so. However, we believe these were one-off's. Going forward the currency should stabilize and/or likely strengthen as the nation's robust macro policy framework boosts the country's return-on-capital, attracting further global capital. Bottom Line: Only a year ago Argentina was locked out of international debt markets and starved for foreign currency. Now, in the face of rising global interest rates, it is flush with foreign currency, with more on the way. A Disinflationary Boom Is On Its Way While the recession in Argentina will likely last a bit longer, there are already signs of an economic recovery in the making. Mainly: Not only has inflation begun to drop in earnest, but importantly inflation expectations are plunging (Chart 11). This is an incredibly significant development as inflation expectations tend to be "adaptive", meaning that they are set based on past experience rather than through some rational, forward-looking thought process. Therefore, such a dramatic fall in inflation expectations appears to be marking the end of Argentina's most recent battle with hyperinflation. Hoping to avoid a major policy mistake on its way toward implementing an inflation-targeting framework, the central bank has been relatively cautious. However, further rate cuts are on their way, which should re-ignite the credit cycle and boost economic activity (Chart 12 and 13). Chart 11Has Hyperinflation Finally Come To An End? Has Hyperinflation Finally Come To An End? Has Hyperinflation Finally Come To An End? Chart 12Much Lower Interest Rates Should Help Support Growth Much Lower Interest Rates Should Help Support Growth Much Lower Interest Rates Should Help Support Growth Chart 13Argentina's Credit Cycle Is About To Turn Up Argentina's Credit Cycle Is About To Turn Up Argentina's Credit Cycle Is About To Turn Up For their part, wages in real (inflation-adjusted) terms will be slow to recover (Chart 14), as dislocations to the labor market caused by the Macri government's shock therapy will take time to work themselves out. This is bullish for corporate profit margins and return on capital. In turn, high potential profitability will incentivize local and international companies to ramp up their capital spending in Argentina. Notably, capital goods imports are already rising, a sign that investment is recovering (Chart 15, top panel). As Argentine firms faced foreign currency restrictions for years, an increase in imported capital is bound to go a long way toward boosting productivity. Chart 14Incomes Will Take Time To Recover From Shock Therapy Incomes Will Take Time To Recover From Shock Therapy Incomes Will Take Time To Recover From Shock Therapy Chart 15Early Signs Of A Recovery In Investment? Early Signs Of A Recovery In Investment? Early Signs Of A Recovery In Investment? In addition, rising apparent consumption of cement suggests that the collapse in construction activity is in late stages (Chart 15, bottom panel). Lastly, as to external accounts, chances are the pros and cons will mostly balance out (Chart 16). Chart 16External Accounts Will Not Be A Drag ##br##On Growth External Accounts Will Not Be A Drag On Growth External Accounts Will Not Be A Drag On Growth Argentina's agribusiness exports will be aided by a competitive currency, and the current investment boom taking place in the sector. However, the country's single largest trading partner, Brazil, which consumes 15% of all its exports and most of its manufactured exports, has so far failed to even recover. Thus, gains from commodities exports will be offset by weak exports to Brazil, which at least will help keep the trade and current account balances in check as import demand recovers. Bottom Line: Aided by structural tailwinds, a cyclical economic recovery is in the making. Politics And Fiscal Policy Exactly one year ago the key risks we highlighted to our bullish Argentine view centered around the ability of the Macri administration to navigate the turbulent waters of shock therapy successfully.4 Specifically, history has shown the failure of Argentine center-right leaders to effectively balance meaningful economic reform with labor relations. In addition, the Macri administration and its alliance – made up mainly of Macri’s Republican Proposal (PRO), the Civic Coalition ARI (CC), the Radical Civic Union (UCR) parties – did not have a majority in either house of Congress, making restoring fiscal discipline challenging, given the deep hole dug by the previous government. While closing the fiscal deficit of 5% of GDP has indeed proved quite difficult in the midst of a recession and full-out structural transformation of the economy, as we expected, Macri's team has brilliantly managed all other risks. Now, as growth is set to recover, the deficit will be lifted by higher tax revenues in real (inflation-adjusted) terms. Chart 17Can Macri Walk On Water? Can Macri Walk On Water? Can Macri Walk On Water? Importantly, with US$19 billion, or 3.1% of GDP, in external debt service due this year (principal and interest), fixed-income markets have been jittery over the 2017 debt financing plan. However, the latest news is once again incredibly bullish for Argentine assets. Just last week the administration unveiled its 2017 debt plan and it has already secured an 18-month repo line with international banks worth US$6 billion. The country also plans on borrowing another US$4 billion from multilateral agencies, and will tap global capital markets with US$10 billion worth of sovereign paper. The government is front-loading the debt issues and tapping global capital before U.S. President-elect Donald Trump takes office on January 20 to hedge against possible market turbulence. External debt service requirements will also drop off considerably after this year - making tapping debt markets now an equally prudent move. To be sure, this year's legislative elections, to be held in October, will be important to monitor, as the balance of power in Congress may speed up or slow down the government's ambitious reform agenda. At present, we do not expect any major change. As a result, Macri's reform efforts will likely continue, particularly if the economy continues to recover. Besides, Macri's team has already proved not only incredibly capable of negotiating with labor unions, but also with politicians of diverse stripes, as was the case during last December's tax reform. To conclude, we warned investors last January that Macri would not "walk on water" when it came to suddenly reining in the fiscal accounts and engineering economic shock therapy. To his and his administration's credit, however, a year on and it appears they have managed to tip-toe on razor-thin ice rather successfully and even maintain a high approval rating to boot (Chart 17). Bottom Line: Argentina's fiscal situation seems poised to improve considerably, which is very bullish for Argentine fixed-income assets. Investment Recommendations Chart 18Stay Overweight Argentine Sovereign ##br##Debt Versus The EM Credit Benchmark Stay Overweight Argentine Sovereign Debt Versus The EM Credit Benchmark Stay Overweight Argentine Sovereign Debt Versus The EM Credit Benchmark Stay long ARS / short BRL. The Argentine peso is not expensive and structural reforms and orthodox macroeconomic policies will likely attract more than enough FDI to fund the nation's balance of payments. And while FDI inflows have also been strong in Brazil, we believe these FDI inflows are set to decelerate,5 in contrast to accelerating inflows in Argentina. Sovereign credit traders should stay overweight Argentine credit within EM credit portfolios (Chart 18), as the growth recovery will greatly improve the nation's fiscal metrics. Fiscal revenues in real (inflation-adjusted) will grow helping contain the fiscal deficit, and the recovery in economic activity will bring down the public debt-to-GDP ratio which currently stands at 57% of GDP. In addition, now that capital controls have been completely lifted, local fixed-income instruments yielding a 1400-basis-point spread above duration-matched U.S. Treasurys are incredibly attractive. Overweight local currency government bonds as well. A new trade: go long 7-year Argentine local currency government bonds, currency unhedged, yielding 15%. Dedicated EM and FM investors should remain overweight Argentine equities via the local market or the more liquid ADR market versus their respective benchmarks, and stay with the long Argentina/short Brazil equity trade. The Argentine FM benchmark and local Merval index are energy heavy, with 20% and 33% of their total market cap, respectively, comprising of energy companies. As we believe energy plays will outperform other commodities plays, particularly industrial metals, Argentine equities will benefit.6 Meanwhile, bank stocks, which account for 38% and 15% of the FM and Merval markets, respectively, are poised to perform well. As there was no credit buildup, unlike in many EMs, the looming rise in non-performing loans (NPL) will not hit earnings much. Moreover, private commercial banks have shifted massively into government bonds since 2014. Public debt holdings have risen 4-fold since 2014, and banks will reap capital gains on these investments as local rates drop. As government bond holdings now stand at nearly 20% of commercial banks total assets, these earnings streams will compensate from a compression in net interest margins (NIM) as interest rates continue falling. As to valuations, although price-to-book values seem elevated, we believe that these valuations have been distorted by hyperinflation. The value of shareholder equity did not rise as much as stock prices and earnings rose with hyperinflation. Thus, we believe Argentine equities will continue to benefit from a genuine re-rating story, and valuations are much cheaper than may appear using conventional metrics. Santiago E. Gómez, Associate Vice President Santiagog@bcaresearch.com 1 Please refer to the Emerging Markets Strategy and Frontier Markets Strategy Special Report titled, "Argentina: Short-Term Pain, Long-Term Gain," dated September 7, 2016, available at fms.bcaresearch.com 2 Please see Judsun, Ruth (2012), "Crisis and Calm: Demand for U.S. Currency at Home and Abroad From the Fall of the Berlin Wall to 2011," International Finance Discussion Papers, no. 1058. Board of Governors of the Federal Reserve System November 2012. 3 Please refer to the Emerging Markets Strategy Weekly Report, titled "The U.S. Dollar's Uptrend And China's Options," dated January 11, 2017, available on at ems.bcaresarch.com 4 Please refer to the Emerging Markets Strategy Weekly Report, titled "Assessing Political And Financial Landscapes In Argentina, Venezuela And Brazil," dated January 6, 2016, available on at ems.bcaresarch.com 5 Please refer to the Emerging Markets Strategy Special Report, titled "Brazil: The Honeymoon Is Over," dated August 3, 2016, available at ems.bcaresarch.com 6 Please refer to the Emerging Markets Strategy Weekly Report, titled "EM Got "Trumped," dated November 16, 2016, available at ems.bcaresarch.com

Highlights The global 6-month credit impulse is now in its longest upcycle in a decade. Given also that bond yields have had their sharpest spike in a decade, we would not bet on the upcycle lasting much longer. Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500. Underweight the IBEX versus the Eurostoxx600. Feature A few days into the New Year, two over-arching economic questions are exercising our minds. Is the relationship between sharply higher bond yields and weaker bank credit creation still valid? And is the relationship between weaker bank credit creation and decelerating economic growth still valid? Chart of the WeekCredit Impulses Heading In Different Directions Credit Impulses Heading In Different Directions Credit Impulses Heading In Different Directions We suspect the answers are yes and yes. European Investors Must Think Globally, Not Locally Europe is not an investment island. Major European stock market indexes comprise large multinational companies whose sales and profits come from across the world. The upshot is that European stock markets almost always move up and down in tandem with other major world stock markets, such as the S&P500 and Nikkei225 (Chart I-2). Mainstream bond markets might seem to be more parochial, given that they are supposedly under the influence of the local central bank. But investors buy and sell high quality bonds as a global asset class. The upshot is that European bond markets also almost always move up and down in tandem with other major developed bond markets (Chart I-3). Chart I-2Major Equity Markets Move Together Major Equity Markets Move Together Major Equity Markets Move Together Chart I-3Major Bond Markets Move Together Major Bond Markets Move Together Major Bond Markets Move Together Hence, European investors must look first and foremost at global drivers. For us, the most important such driver is the global 6-month credit impulse - which sums the 6-month (dollar) credit impulses in the euro area, the United States and China. Does the global 6-month credit impulse have any predictive power? Yes. Chart I-4 shows that it has consistently led the 6-month cycle in the global government bond yield, which is a good proxy for the global growth cycle. Admittedly, this powerful predictive relationship weakened somewhat through 2013-14 during the most aggressive and distortive phase of worldwide QE. However, in the past couple of years, as QE has waned, the global 6-month credit impulse's predictive power has strongly re-asserted itself (Chart I-5). Chart I-4The Credit Impulse Leads ##br##The Global Growth 'Mini-Cycle' The Credit Impulse Leads The Global Growth 'Mini-Cycle' The Credit Impulse Leads The Global Growth 'Mini-Cycle' Chart I-5The Credit Impulse's Predictive ##br##Power Has Re-Asserted Itself The Credit Impulse's Predictive Power Has Re-asserted Itself The Credit Impulse's Predictive Power Has Re-asserted Itself In effect, the charts illustrate that whatever the structural economic backdrop, the global economy experiences a perpetual 'mini-cycle' lasting about 15-24 months. Higher bond yields (or credit restrictions) weaken the credit impulse; the weaker impulse then depresses growth; the depressed growth lowers bond yields; lower bond yields (or credit easing) strengthen the credit impulse; the stronger impulse then boosts growth; the boosted growth lifts bond yields; and back to the beginning... Remember, the credit impulse measures the growth in the credit flow. The important point to grasp is that the impulse can weaken even if the credit flow numbers themselves seem strong. For example, if the credit flow increased from $100bn to $150bn to $190bn it might appear to be growing very healthily. But actually, the impulse would have weakened from $50bn to $40bn, creating a headwind. Where are we in the perpetual mini-cycle? Today, the euro area credit impulse is losing momentum, while the U.S. impulse is waning. Which leaves China's rising credit impulse as the only component supporting the global credit impulse (Chart of the Week). But for how much longer? To repeat, it would just take the global credit flow to decelerate for the impulse to roll over. Now consider that high-quality bond yields have had their sharpest 6-month spike in a decade. And that the current 10 month upcycle in the global credit impulse already makes it the longest in a decade. Hence, we would not bet on this mini-upcycle lasting much longer. A Few Words On Our Credit Cycle Framework Our credit cycle framework has several features which uniquely define it. First, the framework focusses on bank credit. This is because the magic of fractional reserve banking allows a bank to create money and new spending power out of thin air. When somebody borrows from a bank, his bank account and spending power goes up, but nobody's spending power has to go down. In contrast, when somebody borrows by issuing a bond, it merely reallocates spending power from one person to another person. The borrower sees his bank account and spending power go up, but the lender sees his bank account and spending power go symmetrically down. Spending will rise to the extent that the borrower has a higher propensity to spend than the lender, but this may or may not be the case. Second, as already discussed, the framework focusses on the bank credit impulse - which measures the growth in the bank credit flow. This is just to compare apples with apples. Remember that GDP is itself a flow statistic. So the growth in GDP receives a contribution from the growth in the credit flow1 (and not from the flow itself). Third, the framework focusses on the 6-month bank credit impulse. We choose this periodicity because 6 months is about the time that it takes to for credit to be fully spent, thereby yielding the greatest predictive power from the credit impulse to economic activity. Fourth, the framework calculates the credit cycle using bank credit to the non-financial sector2 rather than the more commonly-quoted money supply statistics such as euro area M3. The simple reason is that not all loans generate economic activity. Bank to bank lending may stay trapped in the financial system. The money supply - which is on the liabilities side of the banks' balance sheet - would not pick up this distinction. As M3 captures all bank deposits, it would still be expanding rapidly, giving the false signal that demand should be growing. Hence, it is better to focus on bank lending - which is on the assets side of the banks' balance sheet - and only count lending that is likely to generate economic activity (Chart I-6). This reasoning only works if the official data on bank loans is accurate and complete. In China, this is unlikely to be the case, given its large shadow banking system. But unofficial shadow lending must eventually show up in the money supply. Therefore, exceptionally for the China sub-component, our credit cycle framework does prefer to use the money supply (Chart I-7). Chart I-6Our Euro Area Credit Impulse##br## Uses Bank Lending... Our Euro Area Credit Impulse Uses Bank Lending... Our Euro Area Credit Impulse Uses Bank Lending... Chart I-7...But Our China Credit Impulse ##br##Uses Money Supply ...But Our China Credit Impulse Uses Money Supply ...But Our China Credit Impulse Uses Money Supply A Few Words On Our Reductionist Framework We are also strong believers in Investment Reductionism. This philosophy stems from two guiding principles: Occam's Razor - which says that when there are competing explanations for the same effect, the simplest explanation is usually the best; and the Pareto Principle - which says that 80% of effects come from just 20% of causes.3 The important point is that most of the moves in most financial markets result from a very small number of over-arching macro drivers. To reiterate, Europe is not an investment island. Investment Reductionism means that much of asset allocation, sector selection, and regional and country allocation distills down to getting the global growth cycle right. The remaining charts should leave readers in no doubt. Chart I-8 shows that the global 6-month credit impulse leads the cyclical direction of the global bond yield, and thereby determines asset class selection. Chart I-9 then shows that the direction of bond yields determines sector selection: for example Banks versus Technology. Chart I-8Investment Reductionism Step 1: The Global##br## Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Investment Reductionism Step 1: The Global Credit Impulse Leads The Bond Yield Cycle Chart I-9Step 2: The Bond Yield ##br##Drives Sector Selection Step 2: The Bond Yield Drives Sector Selection Step 2: The Bond Yield Drives Sector Selection Chart I-10 and Chart I-11 then show that the sector selection of Banks versus Technology determines both the regional allocation of Eurostoxx600 versus S&P500, and the country allocation of IBEX versus Eurostoxx600. Chart I-10Step 3: Sector Selection Drives##br## Regional Allocation Step 3: Sector Selection Drives Regional Allocation Step 3: Sector Selection Drives Regional Allocation Chart I-11Step 4: Sector Selection Drives ##br##Country Allocation Step 4: Sector Selection Drives Country Allocation Step 4: Sector Selection Drives Country Allocation To sum up, the global 6-month credit impulse is now in its longest up-cycle in a decade, and bond yields have had their sharpest spike in a decade. Hence, we would not chase cyclicality at this juncture. Which means that on a 6-month horizon: Lean against the rise in bond yields and bank equities. Underweight the Eurostoxx600 versus the S&P500.4 Underweight the IBEX versus the Eurostoxx600. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Equivalently, the credit impulse is the growth in the growth (second derivative) of the credit stock. 2 The non-financial sector includes households, (non-financial) firms and government. 3 Often known as the 80-20 rule. 4 BCA Strategists differ on this position. Fractal Trading Model* This week's trade is to express a tactical short in equities via Italy's MIB. An alternative market-neutral trade is to go short Italy's MIB and symmetrically long Hong Kong's Hang Seng. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Short Italy's MIB Short Italy's MIB Chart I-13 Short Italy's MIB / Long Hong Kong's Hang Seng Short Italy's MIB / Long Hong Kong's Hang Seng Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II_2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch ##br##- Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

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

Highlights Chart 1Upside Risks & Uncertainty Upside Risks & Uncertainty Upside Risks & Uncertainty The evidence of economic acceleration continues to pile up and we maintain our view that bond yields will be higher than current forwards by the end of 2017. In the near-term, however, the bond market has been too quick to discount a more positive growth outlook, especially considering still-elevated levels of economic policy uncertainty. Our cautious optimism is echoed by the readings from our global PMI models and also by the Fed. The minutes from December's FOMC meeting revealed that more participants saw upside risks to growth and inflation than saw downside risks, but also that this improved economic forecast was judged to be more uncertain than any Fed forecast since 2013 (Chart 1). We remain bond bears on a 12-month horizon, but advocate a benchmark duration stance in the near term. A period of flat bond yields is the most likely outcome until elevated uncertainty levels revert to a more normal range (see the global economic policy uncertainty index). Feature Investment Grade: Neutral Chart 2Investment Grade Market Overview Investment Grade Market Overview Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 82 basis points in December and by 478 basis points in 2016. The index option-adjusted spread tightened 6 bps on the month and 42 bps on the year. At 122 bps, the spread is currently well below its historical average (134 bps). Corporate spreads have tightened substantially since last February despite elevated gross leverage (Chart 2).1 As we pointed out in our end-of-year Special Report titled "Seven Fixed Income Themes For 2017",2 it is very rare for spreads to tighten when leverage is in an uptrend. While a rebound in profit growth will likely cause the uptrend in leverage to abate this year, spreads have already moved to discount a significant reversal. Although valuations are by no means attractive, accelerating economic growth and still-accommodative Fed policy will keep spreads at tight levels during the first half of this year. This sweet spot will persist at least until TIPS breakeven inflation rates return to pre-crisis levels, which would likely presage a hawkish shift in Fed policy. Energy sector debt returned 12.5% in excess of duration-equivalent Treasuries in 2016, compared to excess returns of under 5% for the overall corporate index. Despite this large outperformance, energy credits still appear attractive according to our model (Table 3), and should continue to outperform into the New Year. Table 3ACorporate Sector Relative Valuation##br## And Recommended Allocation* Cautious Optimism Cautious Optimism Table 3BCorporate Sector##br## Risk Vs. Reward* Cautious Optimism Cautious Optimism High-Yield: Underweight Chart 3High-Yield Market Overview High-Yield Market Overview High-Yield Market Overview High-yield outperformed the duration-equivalent Treasury index by 188 basis points in December and by 1539 basis points in 2016. The index option-adjusted spread narrowed 46 bps on the month and 251 bps on the year. At 383 bps, it is currently 137 bps below its historical average. As we highlighted in our year-end Special Report,3 the uptrend in defaults is likely to reverse this year, mostly due to recovery in the energy sector. However, still-poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Given the improving default backdrop, we are actively looking to upgrade our allocation to high-yield debt. However, valuations do not present a sufficiently compelling opportunity at the moment. Our estimate of the default-adjusted high-yield spread - the average spread of the junk index less our forecast of 12-month default losses - is below 150 bps (Chart 3). This is close to one standard deviation below the long-run average. Historically, we have found that a default-adjusted spread between 100 bps and 200 bps is consistent with positive 12-month excess returns 65% of the time, but with an average 12-month excess return of close to zero. With the spread in this range, a 90% confidence interval would place 12-month excess returns between -3% and +4%. MBS: Underweight Chart 4MBS Market Overview MBS Market Overview MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 6 basis points in December, but underperformed by 11 bps in 2016. The conventional 30-year MBS yield rose 5 bps in December, completely driven by a 5 bps increase in the rate component. The compensation for prepayment risk (option cost) and option-adjusted spread were both flat on the month. In 2016, the conventional 30-year MBS yield rose 6 bps. This was driven by a 12 bps increase in the rate component that was partially offset by a 9 bps decline in the option-adjusted spread. The option cost increased 3 bps on the year. Our underweight in MBS is predicated upon very low option-adjusted spreads, relative both to history and other comparable spread product (Chart 4). Historically, the option-adjusted spread is correlated with net MBS issuance and eventually we expect rising net issuance to lead the option-adjusted spread wider. Importantly, purchase applications have remained firm in the face of higher mortgage rates even though refinancings have collapsed (bottom panel). Another tail risk for the MBS market is the possibility that the Fed ceases the reinvestment of its mortgage portfolio. While we do not expect this to occur in 2017, with two rate hikes now in the bank the fed funds rate is approaching levels where the Fed might begin to consider it. A new Fed Chair in early 2018 might also be more inclined to wind down the balance sheet. Government Related: Overweight Chart 5Government Related Market Overview Government Related Market Overview Government Related Market Overview The government-related index outperformed the duration-equivalent Treasury index by 27 basis points in December. Foreign Agency and Sovereign bonds outperformed by 84 bps and 83 bps respectively, while Local Authorities outperformed by 22 bps. Domestic Agency bonds and Supranationals were a drag on performance during the month, underperforming the Treasury benchmark by 10 bps and 7 bps respectively. The government-related index outperformed the duration-equivalent Treasury benchmark by 150 bps in 2016. The best performing sub-sectors for the year were Sovereigns (outperformed by 322 bps), Local Authorities (outperformed by 286 bps) and Foreign Agencies (outperformed by 258 bps). Domestic Agency bonds outperformed Treasuries by 38 bps, while Supranationals underperformed by 11 bps. Foreign Agency bonds and Local Authority bonds continue to appear attractive relative to U.S. corporate credit, after adjusting for credit rating and duration. We recommend focusing our government related allocation in these two sectors. In contrast, Sovereigns and Supranationals both appear expensive relative to U.S. corporate credit, and we recommend avoiding these sectors. Spreads on Domestic Agency debt have room to tighten in the near-term (Chart 5). Spreads widened to the top of their recent range last month on rumors that the new government could seek to speed up the process of GSE reform. We view these concerns as premature. This week we also remove our recommendation to favor callable agencies over bullets. Bullets have tended to outperform when the 2/5 Treasury slope steepens (bottom panel). We expect the 2/5 curve to be biased steeper in the first half of this year. Municipal Bonds: Underweight Chart 6Municipal Market Overview Municipal Market Overview Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 134 basis points in December, but underperformed the index by 103 basis points in 2016 (before adjusting for the tax advantage). The average Municipal / Treasury (M/T) yield ratio fell 8% in December, but increased 13% during 2016. At present the average M/T ratio is 98%, only slightly below its post-crisis average (Chart 6). Although M/T ratios moved higher last year, trends in issuance and fund flows suggest they are still too low. As we noted in our year-end Special Report,4 our tactical model of the M/T yield ratio - based on issuance, fund flows, ratings changes and economic policy uncertainty - pegs current fair value for the average M/T yield ratio at 112%. Further, as was also highlighted in our year-end report, the municipal credit cycle is likely to take a turn for the worse in late 2017, with muni downgrades starting to outpace upgrades. This analysis is based on indicators of state & local government budget health that tend to follow our indicators of corporate sector health with a two year lag. Just last month Moody's downgraded $1.6 billion worth of the City of Dallas' general obligation debt from Aa3 to A1. The downgrade was justified based on the city's poorly funded public safety pension plan. Attention will increasingly turn to underfunded public pensions when state & local government budget health starts to deteriorate later this year. Treasury Curve: Favor 5-Year Bullet Over 2/10 Barbell Chart 7Treasury Yield Curve Overview Treasury Yield Curve Overview Treasury Yield Curve Overview The Treasury curve shifted higher and flattened in December. The 2/10 slope flattened by 1 basis point on the month and the 5/30 slope flattened 6 bps. For 2016 as a whole, the Treasury curve bear-steepened out to the 10-year maturity. The 2/10 slope steepened 4 bps and the 5/30 slope flattened 12 bps. In our year-end Special Report,5 we detailed how the combination of accelerating economic growth and still-accommodative Fed policy will cause the Treasury curve to bear-steepen in the first half of 2017. This steepening will be driven by continued, but gradual, recovery in long-dated TIPS breakeven inflation back to pre-crisis levels (2.4% to 2.5%). Once inflation expectations return to pre-crisis levels, it is possible that the Fed will shift to a monetary policy that is focused more on tamping out inflation than supporting growth. At that point the curve will shift from a bear-steepening to a bear-flattening regime. A steepening curve environment will cause bullet trades to outperform barbells. On top of that, the 5-year bullet is currently extremely cheap on the curve (Chart 7). For these reasons we recommended entering a long 5-year bullet, short 2/10 barbell trade on December 20. This trade has already returned 8 bps since initiation, even though the 2/10 slope has flattened 10 bps during this period. A resumption of curve steepening will cause our long 5-year bullet, short 2/10 barbell trade to perform even better in the months ahead. TIPS: Overweight Chart 8TIPS Market Overview TIPS Market Overview TIPS Market Overview TIPS outperformed the duration-equivalent nominal Treasury index by 6 basis points in December, and by 331 bps in 2016. The 10-year TIPS breakeven rate increased by 1 bp in December and by 41 bps in 2016. At present it sits at 1.96%, still well below the 2.4% to 2.5% range that is consistent with the Fed's 2% inflation target. As we explained in our year-end Special Report,6 the Fed will be keen to allow TIPS breakevens to rise toward levels more consistent with its inflation target, and will quickly back away from a hawkish policy stance should breakevens fall. But while breakevens will continue to trend higher, the rate of increase should moderate to be more in line with the shallow uptrend in realized inflation. It is difficult for the Fed to drive long-dated inflation expectations higher while it is in the midst of a tightening cycle. For this reason, trends in actual inflation will be a more important determinant of TIPS breakevens than in the past. And while there are indications that the uptrend in realized inflation will persist, notably recent accelerations in wage growth and survey measures of prices paid (Chart 8). There is currently no indication that core and trimmed mean inflation are breaking out to the upside (bottom panel). We remain overweight TIPS relative to nominal Treasuries on the expectation that long-dated breakevens reach the 2.4% to 2.5% range in the second half of 2017, and that core PCE inflation reaches the Fed's 2% target by the end of the year. ABS: Maximum Overweight Chart 9ABS Market Overview ABS Market Overview ABS Market Overview Asset-Backed Securities underperformed the duration-equivalent Treasury index by 17 basis points in December but outperformed the Treasury benchmark by 94 bps in 2016. Aaa-rated ABS underperformed Treasuries by 21 bps in December but outperformed by 75 bps in 2016, while non-Aaa ABS outperformed the benchmark by 13 bps in December and by 257 bps in 2016. The index option-adjusted spread for Aaa-rated ABS widened by 11 bps in December, but tightened by 10 bps in 2016. Further, the spread differential between Aaa-rated auto ABS and Aaa-rated credit card ABS narrowed substantially in 2016. The option-adjusted spread for Aaa-rated auto loan ABS has tightened by 20 bps since the end of 2015, while the option-adjusted spread for Aaa-rated credit card ABS has tightened by 10 bps. We have previously noted that, after adjusting for spread volatility, Aaa-rated auto loan ABS no longer offer an attractive opportunity relative to Aaa-rated credit cards (Chart 9). We continue to favor Aaa-rated credit cards over Aaa-rated auto loans, given the low spread differential and divergences in collateral credit quality (bottom panel). As was noted in the Appendix to our year-end Special Report,7 consumer ABS provided better volatility-adjusted excess returns than all fixed income sectors except for Baa-rated corporates and Caa-rated high-yield in 2016. With spreads still elevated relative to other similarly risky fixed income sectors, we expect this risk-adjusted performance to continue. Non-Agency CMBS: Underweight Agency CMBS: Overweight Chart 10CMBS Market Overview CMBS Market Overview CMBS Market Overview Agency CMBS underperformed the duration-equivalent Treasury index by 40 basis points in December, but outperformed by 117 bps in 2016. The index option-adjusted spread for Agency CMBS widened 10 bps in December but tightened 6 bps in 2016. Agency CMBS still offer 50 bps of option-adjusted spread. This is similar to what is offered by Aaa-rated consumer ABS (51 bps) and greater than what is offered by conventional 30-year MBS (26 bps) for a similar amount of spread volatility. We continue to recommend an overweight position in Agency CMBS. Non-agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 19 basis points in December, but outperformed by 313 bps in 2016. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 7 bps in December but tightened 48 bps in 2016. It has recently moved well below its average pre-crisis level (Chart 10). Rising CMBS delinquency rates and tightening commercial real estate lending standards make us cautious on non-agency CMBS. This caution has only intensified now that spreads are at their tightest levels since prior to the financial crisis. Treasury Valuation Chart 11Global PMI Model Global PMI Model Global PMI Model The current reading from our 2-factor Global PMI model (which includes the global PMI and dollar sentiment) places fair value for the 10-year Treasury yield at 2.31% (Chart 11). Our 3-factor version of the model, which also incorporates the global economic policy uncertainty index, places fair value at 2.02%. The lower fair value is the result of a large spike in the global economic policy uncertainty index in November that barely reversed in December (bottom panel). Large spikes in uncertainty that do not coincide with deterioration in other economic indicators tend to mean revert fairly quickly. So we would be inclined to view the fair value reading from our 2-factor model as more indicative of true fair value at the moment. However, unusually high uncertainty is one reason we are reluctant to adopt a below benchmark duration stance for the time being even though we expect yields to be higher in 12 months. At the time of publication the 10-year Treasury yield was 2.37% For further details on our Global PMI models please refer to the U.S. Bond Strategy Weekly Report, "The Message From Our Treasury Model", dated October 11, 2016, available at usbs.bcaresearch.com. Monetary Conditions And Rate Expectations The BCA Monetary Conditions Index (MCI) combines changes in the fed funds rate with changes in the trade-weighted dollar using a 10:1 ratio. Historically, economic downturns have been preceded by a break in this index above its equilibrium level - calculated using the Congressional Budget Office's estimate of potential GDP growth (Chart 12). With the MCI having just reached this estimate of equilibrium, the shaded region in Chart 13 shows the expected path of the federal funds rate assuming that the MCI remains at its equilibrium level. The upper-end of the shaded region corresponds to a scenario where the trade-weighted dollar depreciates by 2% per year and the lower-end of the shaded region corresponds to a scenario where the dollar appreciates by 2% per year. The thick line through the middle of the region corresponds to a flat dollar. Chart 12Monetary Conditions Vs. Equilibrium Monetary Conditions Vs. Equilibrium Monetary Conditions Vs. Equilibrium Chart 13Fed Funds Rate Scenarios Fed Funds Rate Scenarios Fed Funds Rate Scenarios As can be seen in Chart 13, both the market and Fed are discounting a move in the MCI above its equilibrium level. This would be consistent with behavior witnessed in past cycles when the MCI broke above its equilibrium level several years before the next recession. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com Alex Wang, Research Analyst alexw@bcaresearch.com 1 Defined as total debt divided by EBITD. 2 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com 7 Please see U.S. Bond Strategy Special Report, "Seven Fixed Income Themes For 2017", dated December 20, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation Total Return Comparison: 7-Year Bullet Versus 2-20 Barbell (6-Month Investment Horizon)