Gov Sovereigns/Treasurys

Highlights Overall Strategy: The global economy is entering a reflationary sweet spot that will last for the next two years. Investors should overweight equities, maintain slightly below benchmark exposure to government bonds, and underweight cash over a 12-month horizon. Fixed Income: Global bond yields will rise only modestly over the next two years, reflecting an abundance of spare capacity in many parts of the world. A major bond bear market will begin towards the end of the decade, as stagflationary forces gather steam. Equities: Investors should underweight the U.S. for the time being, while overweighting Europe and Japan in currency-hedged terms. Emerging markets will benefit from the reflationary tailwind, but deep structural problems will drag down returns. Currencies: The broad trade-weighted dollar will appreciate another 6% from current levels. The yen still has considerable downside against the dollar. The euro will grind lower, as will the Chinese yuan. The pound is approaching a bottom. Commodities: Favor energy over metals. Gold will move higher once the dollar peaks later this year. Feature I. Key Theme: A Reflationary Window The global economy is entering a reflationary sweet spot where deflationary forces are in retreat but fears of excess inflation have yet to surface. Activity data are surprising to the upside and leading economic indicators have turned higher (Chart 1). Falling unemployment in most major economies is boosting confidence, fueling a virtuous cycle of rising spending and even further declines in joblessness. Manufacturing activity is bouncing back after a protracted inventory destocking cycle (Chart 2). In addition, the stabilization in commodity prices has given some relief to emerging markets, while fueling a modest rebound in resource sector capital spending. Meanwhile, easier fiscal policy is providing a welcome tailwind to growth. The aggregate fiscal thrust for advanced economies turned positive in 2016 - the first time this has happened in six years. We expect this trend to persist for the foreseeable future. Reflecting these developments, market-based measures of inflation expectations have risen, offsetting the increase in nominal interest rates. In fact, real rates in the euro area and Japan have actually declined across most of the yield curve since the U.S. presidential election (Chart 3). This should translate into higher household and business spending in the months ahead. Chart 1Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating Chart 2Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Inventory Destocking Was A Drag On Growth Chart 3Falling Real Rates In The Euro Area And Japan Falling Real Rates In The Euro Area And Japan Falling Real Rates In The Euro Area And Japan Supply Matters Yet, there has been a dark side to this reflationary trend, and one that could sow the seeds for stagflation as the decade wears on. Simply put, much of the reduction in spare capacity over the past eight years has occurred not because of much faster demand growth, but because of continued slow supply growth. Chart 4 shows that output gaps in the main developed economies would still be enormous today if potential GDP had grown at the rate the IMF forecasted back in 2008. Chart 4AWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Chart 4BWeak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Weak Supply Growth Has Narrowed Output Gaps Unfortunately, we do not expect this state of affairs to change much over the coming years. The decline in birth rates that began in the 1960s has caused working-age populations to grow more slowly in almost all developed and emerging economies (Chart 5). In some countries such as the U.S., the downward pressure on labor force growth has been exacerbated by a structural decline in participation rates, especially among the less educated (Chart 6). Chart 5Slowing Workforce Growth Slowing Workforce Growth Slowing Workforce Growth Chart 6U.S.: The Less Educated Are Shunning The Labor Force First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Productivity growth has also fallen (Chart 7). Part of this phenomenon is cyclical in nature, reflecting the impact of several years of weak corporate investment in new plant and equipment. However, much of it is structural. As Fed economist John Fernald has shown, the slowdown in productivity growth since 2004 has been concentrated in sectors that benefited the most from the adoption of new information technologies in the late 1990s (Chart 8).1 Recent technological innovations have focused more on consumers than on businesses. This has resulted in slower productivity growth. Chart 7Slowing Productivity Growth Around The World Slowing Productivity Growth Around The World Slowing Productivity Growth Around The World Chart 8The Productivity Slowdown Has Been ##br##Greatest In Sectors That Benefited The Most From The I.T. Revolution First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation To make matters worse, human capital accumulation has decelerated both in the U.S. and elsewhere, dragging productivity growth down with it. Globally, the fraction of adults with a secondary degree or higher is increasing at half the rate it did in the 1990s (Chart 9). Educational achievement, as measured by standardized test scores, has also peaked, and is now falling in many countries (Chart 10). Chart 9The Contribution To Growth ##br##From Rising Human Capital Is Falling First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 10Math Skills Around The World First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation From Deflation To Inflation To reiterate what we have discussed at length in the past, the slowdown in potential GDP growth tends to be deflationary at the outset, but becomes inflationary later on.2 Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also curtails consumption, as households react to the prospect of smaller real wage gains. Eventually, however, economies that suffer from chronically weak productivity growth tend to find themselves rubbing up against supply-side constraints. This leads to higher inflation (Chart 11). One only needs to look at the history of low-productivity economies in Africa and Latin America to see this point - or, for that matter, the U.S. in the 1970s, a period during which productivity growth slowed and inflation accelerated. Likewise, a slowdown in labor force growth tends to morph from being deflationary to inflationary over time. When labor force growth slows, two things happen. First, investment demand drops. Why build new factories, office towers, and shopping malls if the number of workers and potential consumers is set to grow more slowly? Second, savings rise, as spending on children declines and a rising share of the workforce moves into its peak saving years (ages 35-to-50). The result is a large excess of savings over investment, which generates downward pressure on inflation and interest rates. As time goes by, the deflationary impact of slower labor force growth tends to recede (Chart 12). Workers who once brought home paychecks start to retire en masse and begin drawing down their accumulated wealth. Since there are few young workers available to take their place, labor shortages emerge. At the same time, health care spending and pension expenditures rise as a larger fraction of the population enters its golden years. The result is less aggregate savings and higher interest rates. Chart 11A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 12An Aging Population Eventually Pushes Up Interest Rates First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Is Debt Deflationary Or Inflationary? The answer is both. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Moreover, once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. Acting on that incentive also becomes easier as the output gap evaporates. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to maintain interest rates at ultra-low levels, even after full employment has been reached, may hold little sway. After all, many things can happen between now and then: A change of central bank leadership, an adverse economic shock, etc. In contrast, if the output gap is already close to zero, a promise to let the economy run hot is more likely to be taken seriously. The U.S. Economy: Still In A Reflationary Sweet Spot The stagflationary demons described above will eventually come back to haunt the U.S., but for now and probably for the next two years, the economy will remain in a reflationary sweet spot. After a weak start to 2016, growth has bounced back. Real GDP grew by 3.5% in Q3. The Atlanta Fed's GDPNow model points to still-healthy growth of 2.9% in Q4. We expect growth to stay robust in 2017, as improving confidence and a stabilization in energy-sector investment lift overall business capex, homebuilding picks up after contracting in both Q2 and Q3 of 2016, and rising wages push up real incomes and personal consumption. Above-trend growth will continue to erode spare capacity. The headline unemployment rate has fallen to 4.6%, close to most estimates of NAIRU. Broader measures of unemployment, which incorporate marginally-attached and involuntary part-time workers, are also approaching pre-recession levels (Chart 13). Consistent with this observation, the job openings rate in the JOLT survey, the share of households reporting that jobs are "plentiful" versus "hard to get" in the Conference Board's Consumer Confidence survey, and the share of small businesses reporting difficulty in finding suitably qualified workers in the NFIB survey are all at or above 2007 levels (Chart 14). In contrast to most measures of labor market slack, industrial utilization still remains quite low by historic standards (Chart 15). In fact, the Congressional Budget Office's "capacity utilization-based" estimate of the output gap stands at around 3% of GDP, whereas its "unemployment-based" estimate is close to zero. Chart 13U.S. Labor Market: Not Much Slack Left First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 14Most U.S. Labor Market Measures ##br## Are Back To Pre-Recession Levels Most U.S. Labor Market Measures Are Back To Pre-Recession Levels Most U.S. Labor Market Measures Are Back To Pre-Recession Levels Chart 15U.S.: Industrial Capacity Utilization Remains Low U.S.: Industrial Capacity Utilization Remains Low U.S.: Industrial Capacity Utilization Remains Low A strong dollar, as well as the ongoing decline of the U.S. manufacturing base, partly explain the low level of industrial utilization. However, another important reason bears noting: Years of depressed real wage growth has made labor scarce compared with capital. The free market solution to this problem is higher wages for workers. Good news for Main Street; but perhaps not so good news for Wall Street. Stagflation Is Coming, Just Not Yet While inflation will creep higher in 2017, a major spike is unlikely over the next two years. There are two main reasons for this. First, if the economy does run into severe capacity constraints, the Fed will have to step up the pace of rate hikes. Higher interest rates will push up the value of the dollar, curbing growth and inflation. Second, the historic evidence suggests that it takes a while for an overheated economy to generate meaningfully higher inflation. Consider how inflation evolved during the 1960s. U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 due to rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 16). The relationship between economic slack and inflation is depicted by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 17). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Chart 16It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 17The Phillips Curve Has Flattened First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation The adoption of inflation targeting, coupled with more transparent Fed communication, has helped anchor inflation expectations. This has flattened the Phillips curve. A flatter Phillips curve implies a lower "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. Going forward, the temptation to exploit the flatness of the Phillips curve may be too great to resist. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that she is at least willing to entertain the idea. Interest rates are still fairly low and a few more hikes are unlikely to cause much distress among corporate and household borrowers. As rates continue to climb, however, this may change, making it difficult for the Fed to further tighten monetary policy. This is especially the case if potential real GDP growth remains lackluster, as this would make it harder for borrowers to generate enough income to service their debts. Trump's budget-busting fiscal deficits may also put some pressure on the Fed to eschew raising rates too much in an effort to hold down interest costs. Even if such political pressures do not materialize, the challenges posed by the zero bound constraint on nominal interest rates could still justify efforts to raise the Fed's 2% inflation target. After all, if inflation were higher, this would give the Federal Reserve the ability to push down real rates further into negative territory in the event of an economic downturn. Admittedly, such a step is unlikely to be taken anytime soon. Nevertheless, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF; San Francisco Fed President John Williams; and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. The bottom line is that inflation is likely to move up slowly over the next two years, but could begin to accelerate more sharply towards the end of the decade. Japan: The End Of Deflation? Like the U.S., Japan has also entered a reflationary window. Retail sales surprised on the upside in November, rising 1.7%, against market expectations of 0.8%. Industrial production and exports continue to rebound, a trend that should persist thanks to the yen's recent depreciation (Chart 18). Stronger economic growth is causing the labor market to heat up. The Bank of Japan estimates that the "labor input gap" is now positive, meaning that the economy has run out of surplus workers (Chart 19). Reflecting this, the ratio of job openings-to-applicants has reached a 25-year high (Chart 20). Chart 18Japan: Some Positive Economic News Japan: Some Positive Economic News Japan: Some Positive Economic News Chart 19Japan: Labor Market Slack Has Evaporated, But Industrial Capacity Utilization Has Fallen First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Chart 20Japan: Sign Of Tightening Labor Market Japan: Sign Of Tightening Labor Market Japan: Sign Of Tightening Labor Market Wage growth so far has been tepid, but that should change over the next two years. The labor force expanded by 0.9% year-over-year in November - the latest month for which data are available - largely due to the continued influx of women into the labor force. Chart 21 shows that the employment-to-population ratio for Japanese prime-age women now exceeds that of the U.S. by three percentage points. As Japanese female labor participation stabilizes, overall labor force growth will turn negative, pushing up wages in the process. Chart 21Japan: Female Labor Force ##br##Participation Now Exceeds The U.S. Japan: Female Labor Force Participation Now Exceeds The U.S. Japan: Female Labor Force Participation Now Exceeds The U.S. In contrast to the Fed, the BoJ is unlikely to tighten monetary policy in response to higher inflation. As a consequence, real yields will continue to fall as inflation expectations rise further. This will lead to higher net exports via a weaker yen, as well as increased spending on interest-rate sensitive goods such as consumer durables and business equipment. Indeed, a virtuous circle could develop where an overheated labor market pushes down real rates, causing aggregate demand and inflation to rise, leading to even lower real rates. If this occurs, growth could accelerate sharply, avoiding the need for more radical measures such as "helicopter money." In short, Japan may be on the verge of escaping its deflationary trap. This is something that could have happened shortly after Prime Minister Abe assumed office, but was short-circuited by the government's lamentable decision to tighten fiscal policy by 3% of GDP between 2013 and 2015. It won't make the same mistake again. Europe: Fine... For Now The European economy grew at an above-trend pace in 2016. Real GDP in the EU is estimated to have expanded by 1.9%, compared to 1.6% in the U.S. The euro area is estimated to have grown by 1.7% - the first time that growth in the common currency bloc exceeded the U.S. since the Great Recession. Euro area growth should remain reasonably strong in 2017, as telegraphed by a number of leading economic indicators (Chart 22). Fiscal austerity has been shelved in favor of modest stimulus. The European Commission is now even advising member countries to loosen fiscal policy more than they themselves are targeting (Chart 23). Chart 22Euro Area Growth Will Remain On Solid Footing In 2017 Euro Area Growth Will Remain On Solid Footing In 2017 Euro Area Growth Will Remain On Solid Footing In 2017 Chart 23The European Commission Recommends Greater Fiscal Expansion First Quarter 2017: From Reflation To Stagflation First Quarter 2017: From Reflation To Stagflation Ongoing efforts to strengthen the euro area's banking system will also help. As we noted in the "Italian Bank Job," the costs of cleaning up the Italian banking system are modest compared with the size of the Italian economy.3 The failure to have done it earlier represents a massive "own goal" by the Italian and EU authorities. As banking stresses recede, the gap in economic performance between northern and southern Europe should narrow. The overall stance of monetary policy will facilitate this trend. If the ECB keeps interest rates near zero for the foreseeable future, as it almost certainly will, Germany's economy will overheat. Chart 24 shows that the German unemployment rate has fallen to a 25-year low, while wage growth is now running at twice the rate as elsewhere in the euro area. Chart 24German Labor Market Going Strong German Labor Market Going Strong German Labor Market Going Strong An overheated German economy will help the periphery in two important ways: First, higher wage inflation in Germany will give a competitive advantage to Club Med producers seeking to sell their goods in the euro area's biggest economy. Second, faster wage growth and stronger domestic demand in Germany will erode the country's gargantuan current account surplus of nearly 9% of GDP. This will put downward pressure on the euro, giving the periphery a further competitive boost. Of course, all this rests on the assumption that Germany accepts an overheated economy. One could objectively argue that it is in Germany's political best interest to do so, as this may be the only means by which to hold the euro area together. One could also argue that rebalancing German growth towards domestic demand, and away from its historic reliance on exports, would be in the country's long-term best interest. One might also contend that German banks would accept a few more years of low rates if this helped lower nonperforming loans across the euro area, while also paving the way for the eventual abandonment of ZIRP and NIRP. Chart 25Italy Lags Peers On Euro Support Italy Lags Peers On Euro Support Italy Lags Peers On Euro Support Whatever the merits of these arguments, they clash with Germany's historical antipathy towards inflation. This means that political risk could escalate over the coming years. Against the backdrop of growing anti-establishment sentiment - fueled in no small measure by the EU's deer-in-the-headlights response to the migration crisis - Europe's populist parties will continue to make gains at the polls. Timing is important, however. With unemployment trending lower, our hunch is that any truly disruptive populist shock may have to wait until the next recession, which is likely still a few years away. BCA's Geopolitical Strategy team holds a strong conviction view that Marine Le Pen, the leader of the eurosceptic National Front, will be defeated in the second round of the presidential election in May. They also think that Angela Merkel will cling to power, partly because Germany still lacks an effective anti-establishment opposition party. Italy is more of a concern, given that support for the common currency among Italians has been falling and is now lower than virtually anywhere else in the euro area (Chart 25). Nevertheless, our geopolitical strategists assign very low odds to Italy following Britain's example and voting to leave the EU. Indeed, it is still not even clear that the U.K. will actually follow through and exit the EU. Brussels is likely to play hardball with the U.K. during the negotiations slated to begin in March. EU officials are keen to send a clear warning to other EU members who may be tempted to leave the club. It is still quite possible that another referendum will be held in one or two years concerning the terms of the negotiated agreement that would govern Britain's future relationship with the EU. Given how close the first referendum was, there is a reasonable chance that U.K. voters will choose EU membership over a bad deal. In that case, Brussels will back off from its threat that triggering Article 50 would irrevocably lead to the U.K.'s expulsion from the EU. China: Still In Need Of A Spender-Of-Last Resort Investor angst about China rose to a fever pitch early last year, but has since faded into the background. The main reason for this is that the deflationary forces which once threatened to precipitate a hard landing for the economy have abated. Growth has picked up and producer price inflation has risen from -5.3% in early 2016 to 3.3% in November (Chart 26). As our China strategists have argued, the end of PPI deflation is a major positive development for the Chinese corporate sector, as it improves its pricing power while reducing its real cost of funding (Chart 27). Real bank lending rates deflated by the PPI rose to near-record highs early last year, but have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This has bestowed dramatic relief on some highly-levered, asset-heavy industries. These industries were the biggest casualties of the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bode well for banks. Chart 26China: Improving Growth Momentum China: Improving Growth Momentum China: Improving Growth Momentum Chart 27China: Real Interest Rates Dropping ##br## Thanks To Easing Deflation China: Real Interest Rates Dropping Thanks To Easing Deflation China: Real Interest Rates Dropping Thanks To Easing Deflation Unfortunately, the reflationary forces in China are masking deep underlying problems. Structural reform has been patchy at best; credit continues to expand much faster than GDP; and speculation in the real estate sector is rampant (Chart 28). Meanwhile, capital continues to flow out of the country, taking the PBOC's foreign exchange reserves down from a high of $4 trillion in June 2014 to $3.1 trillion at present. There are no easy solutions to these problems. Tightening monetary policy could help fend off capital flight, but this would hurt growth and potentially plunge the economy back into deflation. This week's spike in interbank rates is evidence of just how sensitive the economy has become to any withdrawal of monetary accommodation (Chart 29). Chart 28China: Credit Continues Expanding And The##br## Real Estate Sector Is Getting Frothy China: Credit Continues Expanding And The Real Estate Sector Is Getting Frothy China: Credit Continues Expanding And The Real Estate Sector Is Getting Frothy Chart 29China: Yet Another Spike In Interbank Rates China: Yet Another Spike In Interbank Rates China: Yet Another Spike In Interbank Rates As we controversially argued in "China Needs More Debt," China's underlying problem is a chronic excess of savings.4 This has kept aggregate demand below the level commensurate with the economy's productive capacity. In the past, China was able to export some of those excess savings abroad via a large current account surplus, which peaked at 10% of GDP in 2007 (Chart 30). However, China is now too large to export its way out of its problems. It was one thing for China to run a current account surplus of 10% of GDP when its economy represented 6% of global GDP. It is quite another to do so when the economy represents 15% of global GDP, as it does now. This is especially the case when other economies are also keen to have cheap currencies. Faced with this reality, the government has been trying to buttress aggregate demand by funneling a huge amount of credit towards state-owned companies, which have then used these funds to finance all sorts of investment projects. The problem is that China no longer needs as much new capacity as it once did. As trend GDP growth has slowed, the level of investment necessary to maintain a constant capital-to-output ratio has fallen by about 10% of GDP over the past decade.5 China's aging population will eventually lead to a drop in savings. Government plans to strengthen the social safety net should also help this transition along by reducing household precautionary savings. However, these are long-term developments. Over the next couple of years, China will have little choice but to let credit grow at a rapid pace. The good news is that China has ample domestic savings to continue financing credit expansion. The ratio of bank loans-to-deposits remains near all-time lows (Chart 31). The government also has plenty of fiscal resources to safeguard the banks from losses on nonperforming loans extended to local governments and state-owned enterprises. Chart 30China Used To Rely On Large ##br##Current Account Surplus To Export Excess Savings China Used To Rely On Large Current Account Surplus To Export Excess Savings China Used To Rely On Large Current Account Surplus To Export Excess Savings Chart 31China: Banks Have Ample Deposit Coverage China: Banks Have Ample Deposit Coverage China: Banks Have Ample Deposit Coverage All that may not be enough, however. Given the risks to financial stability from excessive investment by state-owned enterprises, the government may have little choice but to cajole households into spending more by suppressing bank deposit rates while purposely engineering higher inflation. The resulting decline in real rates will reduce the incentive to save while helping to inflate away the mountain of debt that has already been accumulated. II. Financial Markets Equities Chart 32Investors Are Optimistic Investors Are Optimistic Investors Are Optimistic Deflation is bad for equities, as is stagflation. But between deflation and stagflation there is reflation - and that is good for stocks. This reflationary window should remain open for the next two years. As such, we expect global equities to be higher in 12 months than they are today. However, the risks for stocks are tilted to the downside over both a shorter-term horizon of less than two months and a longer-term horizon exceeding two years. The near-term outlook is complicated by the fact that global equities are overbought, and hence vulnerable to a selloff. Chart 32 shows that bullish sentiment is stretched to the upside. Expectations of long-term U.S. earnings growth have also jumped to over 12%, something that strikes us as rather fanciful. Renewed rumblings in China could also spook the markets for a while. We expect global equities to correct 5%-to-10% from current levels, setting the stage for a more durable recovery. Once that recovery begins, higher-beta developed markets such as Japan and Europe should outperform the U.S. As my colleague, Mark McClellan, has shown, Europe and Japan are considerably cheaper than the U.S., even after adjusting for sector skews and structural valuation differences.6 The relative stance of monetary policy also favors Europe and Japan. Neither the ECB nor the BoJ is likely to hike rates anytime soon. This means that rising inflation expectations in these two economies will push down real rates, weakening their currencies in the process. Emerging markets are a tougher call. The combination of a strengthening dollar, growing protectionist sentiment in the developed world, and high debt levels are all bad news for emerging markets. EM equity valuations are also not especially cheap by historic standards (Chart 33). Nevertheless, a reflationary environment has typically been positive for EM equities. The tight correlation between EM and global cyclical stocks has broken down over the past three months (Chart 34). We suspect the relationship will reassert itself again over the course of 2017, giving EM stocks a bit of a boost. Chart 33EM Stocks Are Not Particularly Cheap EM Stocks Are Not Particularly Cheap EM Stocks Are Not Particularly Cheap Chart 34EM Stocks Are Lagging EM Stocks Are Lagging EM Stocks Are Lagging On balance, EM equities are likely in a bottoming phase where returns over the next 12 months will be positive but not spectacular. BCA's favored markets are Korea, Taiwan, China, India, Thailand, and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil, and Peru. Turning to global equity sectors, a bias towards cyclical names is appropriate in an environment of rising global growth. Longer term, our equity sector specialists like health care and technology names. The outlook for financial stocks remains a key area of debate within BCA. Most of my colleagues would still avoid banks. I am more partial to the sector. As I argued in September in "Three Controversial Calls: Global Banks Finally Outperform," steeper yield curves will boost net interest margins over the next few years while rising demand for credit will support top-line growth (Chart 35). On a price-to-earnings basis, global banks are quite cheap, despite being much better capitalized than they were in the past (Chart 36). Chart 35AHigher Yields Will Benefit Banks Higher Yields Will Benefit Banks Higher Yields Will Benefit Banks Chart 35BHigher Yields Will Benefit Banks Higher Yields Will Benefit Banks Higher Yields Will Benefit Banks Lastly, in terms of size exposure, we prefer small caps over large caps. Small capitalization stocks tend to do better in reflationary environments (Chart 37). The ongoing retreat from globalization will also benefit smaller domestically-focused firms at the expense of those with large global footprints. In the U.S. specifically, small caps face a potential additional benefit. If the new Trump administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Chart 36Global Banks Are Cheap ##br##And Better Capitalized Since The Crisis Global Banks Are Cheap And Better Capitalized Since The Crisis Global Banks Are Cheap And Better Capitalized Since The Crisis Chart 37Reflationary Backdrop ##br##Favors Small Caps Outperformance Reflationary Backdrop Favors Small Caps Outperformance Reflationary Backdrop Favors Small Caps Outperformance Fixed Income And Credit Back in March 2015, we predicted that the 10-year Treasury yield would fall to 1.5% even if the U.S. economy avoided a recession.7 The call was notably out of consensus at the time, but proved to be correct: The 10-year yield reached a record closing low of 1.37% on July 5th. As luck would have it, on that very same day, we sent out a note entitled "The End Of The 35-Year Bond Bull Market," advising clients to position for higher bond yields. Global bonds have sold off sharply since then, with the selloff intensifying after the U.S. presidential election. As discussed above, inflation in the U.S. and elsewhere will be slow to rise over the next two years. Hence, global bond yields are unlikely to move significantly higher from current levels. Indeed, the near-term path for yields is to the downside if our expectation of a global equity correction proves true. However, once the stagflationary forces described in this report begin to gather steam towards the end of the decade, bond yields could spike higher, imposing significant pain on fixed-income and equity investors alike. Regionally, we favor Japanese and euro area bonds relative to their U.S. counterparts over a 12-month horizon. Inflation in both Japan and the euro area remains well below target, suggesting that neither the BoJ nor the ECB will tighten monetary policy anytime soon. In contrast, the Fed is likely to raise rates three times in 2017, one more hike than the market is currently pricing in. In addition, we would underweight U.K. gilts. While U.K. growth will decelerate next year as uncertainty over the Brexit negotiations takes its toll, a weaker pound and some fiscal loosening will keep the economy from flying off the rails. In this light, the market's expectations that U.K. rates will rise to only 0.66% at end-2019 seems too pessimistic. Elsewhere in the developed world, our global fixed-income strategists are neutral on Canada and New Zealand bonds, but are underweight Australia. A modest underweight to EM government bonds is also warranted. Turning to credit, a reflationary backdrop is positive for spread product insofar as it will keep defaults in check, while also propping up the appetite for riskier assets. That said, U.S. high-yield credit is now quite expensive based on our fundamental models (Chart 38). Private-sector leverage remains at elevated levels and our Corporate Health Monitor is still in deteriorating territory (Chart 39). Rising government yields could also prompt yield-hungry investors to move some of their money back into sovereign debt. On balance, U.S. corporate spreads are likely to narrow slightly this year, but corporate credit will still underperform equities. Regionally, we see more upside in European credit, given the ECB's continued bond-buying program and greater scope for corporate profit margins to rise across the region. Chart 38U.S. High-Yield Valuations U.S. High-Yield Valuations U.S. High-Yield Valuations Chart 39U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating U.S. Corporate Health Keeps Deteriorating Currencies And Commodities BCA's Global Investment Strategy service has been bullish on the dollar since October 2014, a view that has generated a gain of nearly 17% for our long DXY trade recommendation. We reiterated this position last October in a note entitled "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"8 where we predicted that the dollar would rally a further 10%. Since that report was published, the real trade-weighted dollar has gained 4%, implying another 6% of upside from current levels. Chart 40Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Both economic and political forces have conspired to keep the dollar well bid. The resurgent U.S. economy has pushed up real rate expectations in the U.S. relative to its trading partners. Chart 40 shows the amazingly strong correlation between the trade-weighted dollar and real interest rate differentials. Rate differentials should widen further over the coming months as investors price in more Fed rate hikes, and rising inflation expectations abroad push down real rates in economies such as Japan and the euro area. As we predicted in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Wins And The Dollar Rallies," Donald Trump's triumph on November 8th has given the greenback an additional boost. Progress in implementing any of Trump's three signature policy proposals - fiscal stimulus, trade protectionism, and immigration restrictions - will cause the U.S. output gap to narrow more quickly than it otherwise would, forcing the Fed to pick up the pace of rate hikes. Chart 41The Pound Is A Bargain The Pound Is A Bargain The Pound Is A Bargain The adoption of a "destination-based tax system" would further strengthen the dollar. Under the existing corporate tax structure, taxes are assessed on corporate profits regardless of where they are derived. In contrast, under a destination-based system, taxes would be assessed only on the difference between domestic sales and domestic costs. In practice, this means that imports would be subject to taxes, while exports would receive a tax rebate. In the simplest economic models, the imposition of a destination-based tax has no effect on domestic economic activity, inflation, or the distribution of corporate profits across the various sectors of the economy. This is because the dollar is assumed to appreciate by precisely enough to keep net exports unchanged. For that to happen, however, the requisite change in the currency needs to be quite large. For example, if the Trump administration succeeds in bringing down effective corporate tax rates to 20%, the required appreciation would be 1/(1-tax rate)=25%. Under current law, the required appreciation would be over 30%! In reality, the dollar probably would not adjust that quickly, implying that the transition period to a destination-based tax system would disproportionately benefit exporters at the expense of importers. Partly for this reason, the proposal will probably be heavily watered down if it is ever passed. Nevertheless, overall U.S. policy will continue to be biased towards a stronger dollar. Looking at the various dollar crosses, we still see more downside for the yen. The BoJ's policy of pegging the 10-year nominal yield will result in ever-lower real yields as Japanese inflation expectations rise. The euro should also continue to drift lower, most likely reaching parity against the dollar later this year. The pound could dip further if an impasse is reached during Brexit negotiations, as is likely at some point this year. That said, sterling is now very cheap, which limits the downside for the currency (Chart 41). Chart 42The Dollar Has Weighed On Gold The Dollar Has Weighed On Gold The Dollar Has Weighed On Gold The Chinese yuan will continue to grind lower, in line with most other EM currencies. As we discussed in March 2015 in a report entitled "A Weaker RMB Ahead," China's excess savings problem necessitates a weaker currency. The real trade-weighted RMB has fallen by 7% since that report was written, but a bottom for the currency remains elusive.9 As noted above, the Chinese government may have no choice but to boost household spending by suppressing deposit rates while working to engineer higher inflation. Negative real borrowing rates will keep capital flowing out of the country, putting downward pressure on the yuan. The overall direction of the Canadian and Aussie dollars will be dictated by the path of commodity prices. A reflationary environment tends to be bullish for commodities. Nevertheless, an uncertain macro outlook in China muddies the waters. We prefer oil over metals, given that the former is more geared towards growth in developed economies while the latter is heavily dependent on Chinese demand. This also makes the Canadian dollar a more attractive currency than the Aussie dollar. Lastly, a few words on gold: The combination of political uncertainty, rising inflation expectations, and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar. The strengthening of the dollar clearly was a factor undermining gold prices in the second half of 2016 (Chart 42). On balance, we would maintain a modest position in gold for the time being, but would look to increase exposure later this year as the dollar peaks. Peter Berezin Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 John G. Fernald, "Productivity and Potential Output Before, During, and After the Great Recession," Federal Reserve Bank of San Francisco, Working Paper 2014-15, (June 2014), and John G. Fernald, "The Pre-Great Recession Slowdown in U.S. Productivity Growth," (November 16, 2015). 2 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com. 3 Please see Global Investment Strategy Weekly Report, "The Italian Bank Job," dated July 29, 2016, available at gis.bcaresearch.com 4 Please see Global Investment Strategy Weekly Report, "China Needs More Debt," dated May 20, 2016, available at gis.bcaresearch.com. 5 Back in 2007, trend growth was around 10%. Consistent with the empirical literature, let us assume that an appropriate capital-to-GDP ratio is 250% and that the capital stock depreciates at 5% a year. With a trend growth of 10%, China needs 2.5*10%=25% of GDP in new investment before depreciation to keep its capital-to-GDP ratio constant, and an additional 2.5*5%=12.5% of GDP in investment to cover depreciation, for a grand total of 37.5% of GDP in required investment. With a trend GDP growth rate of 6%, however, the required investment-to-GDP ratio would only be 2.5*6%+2.5*5%=27.5%. 6 Please see The Bank Credit Analyst Monthly Reports Section 2, "Are Eurozone Stocks Really That Cheap?" dated June 30, 2016, and "Japanese Equities: Good Value Or Value Trap?" dated November 24, 2016, available at bca.bcaresearch.com. 7 Please see Global Investment Strategy Weekly Report, "Seven Structural Reasons For A Lower Neutral Rate In The U.S.," dated March 13, 2015, available at gis.bcaresearch.com. 8 Please see Global Investment Strategy Weekly Report, "Better U.S. Economic Data Will Cause The Dollar To Strengthen," dated October 14, 2016, available at gis.bcaresearch.com. 9 Please see Global Investment Strategy Weekly Report, "A Weaker RMB Ahead," dated March 06, 2015, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In December, the model underperformed global equities and the S&P in USD and local-currency terms. For January, the model increased its allocation to stocks and reduced its allocation to bonds (Chart 1). Within the equity portfolio, the weighting to euro area stocks was increased. The model boosted its allocation to Canadian and Swedish bonds at the expense of other European markets. The risk index for stocks deteriorated in December, as did the bond risk index. Feature Performance In December, the recommended balanced portfolio gained 2.1% in local-currency terms and 0.8% in U.S. dollar terms (Chart 2). This compares with a gain of 2.9% for the global equity benchmark and a 3.4% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we provide other suggestions on currency risk exposure from time to time. The continued bonds selloff was a drag on the model's performance in December. Chart 1Model Weights bca.gis_taami_2016_12_23_c1 bca.gis_taami_2016_12_23_c1 Chart 2Portfolio Total Returns bca.gis_taami_2016_12_23_c2 bca.gis_taami_2016_12_23_c2 Weights The model increased its allocation to stocks from 53% to 57%, and trimmed its bond weighting from 47% to 43% (Table 1). The model boosted its equity allocation to Spain by 3 points, Germany by 2 points, Italy by 1 point, Japan by 1 point and France by 1 point. Meanwhile, weightings were reduced in Sweden by 3 points and New Zealand by 1 point. In the fixed-income space, the allocation to Canadian paper was boosted by 5 points, Sweden by 3 points, New Zealand by 2 points. The allocation to Italian bonds was reduced by 6 points, France by 4 points, U.K. by 3 points, and U.S. Treasurys by 1 point. Table 1Model Weights (As Of December 22, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar's attempt at consolidating its gains was cut short by the hawkish Fed. As a result, our Dollar Capitulation Index is back to levels that indicate the rally in the broad trade-weighted dollar could pause. However, unless the new administration pours cold water on expectations of a major fiscal boost, monetary policy divergence will underpin the dollar bull market (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation U.S. Trade-Weighted Dollar* And Capitulation Capital Market Indicators The risk index for commodities improved slightly reflecting a better reading from the momentum indicator. However, this asset class remains excluded from the portfolio (Chart 4). The risk index for global equities remains at the highest level in over two years. Despite this, our model slightly increased its allocation in equities following four consecutive months of reductions (Chart 5). Chart 4Commodity Index And Risk bca.gis_taami_2016_12_23_c4 bca.gis_taami_2016_12_23_c4 Chart 5Global Stock Market And Risk bca.gis_taami_2016_12_23_c5 bca.gis_taami_2016_12_23_c5 The deterioration in the value and liquidity indicators for U.S. stocks was offset by some improvement in the momentum reading. As a result, the risk index for U.S. stocks was flat in December (Chart 6). The risk index for euro area equities increased in December and is now at neutral levels. However, even after the latest increase, the risk index for euro area stocks is noticeably lower than the U.S. measure (Chart 7). Positive growth momentum and a weaker currency could provide support for the euro area equities. Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_12_23_c6 bca.gis_taami_2016_12_23_c6 Chart 7Euro Area Stock Market And Risk bca.gis_taami_2016_12_23_c7 bca.gis_taami_2016_12_23_c7 The model slightly increased its allocation to German equities despite the deterioration in the risk index (Chart 8). Unlike most of the equity risk indexes in the model's universe, the one for Emerging Asian stocks improved in December. The model kept its allocation to this asset unchanged (Chart 9). Chart 8German Stock Market And Risk bca.gis_taami_2016_12_23_c8 bca.gis_taami_2016_12_23_c8 Chart 9Emerging Asian Stock Market And Risk bca.gis_taami_2016_12_23_c9 bca.gis_taami_2016_12_23_c9 The risk index for bonds deteriorated in December, but remains at a historically low-risk level reflecting oversold readings from the momentum indicator. The model has trimmed its allocation to bonds a touch (Chart 10). The risk index for U.S. Treasurys was little changed in December. Despite its very low risk reading, the model is adding allocation to bond markets that feature more oversold conditions. (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_12_23_c10 bca.gis_taami_2016_12_23_c10 Chart 11U.S. Bond Yields And Risk U.S. Bond Yields And Risk U.S. Bond Yields And Risk Canadian bonds remain massively oversold based on our momentum measure, and the overall risk index is at extremely low-risk levels. The model boosted its allocation to this asset (Chart 12). With oversold conditions unwinding and the cyclical indicator moving in a more bond-negative direction, the overall risk index for Italian bonds has shifted back to neutral levels. The model has excluded this asset class from its allocation (Chart 13). Chart 12Canadian Bond Yields And Risk Canadian Bond Yields And Risk Canadian Bond Yields And Risk Chart 13Italian Bond Yields and Risk bca.gis_taami_2016_12_23_c13 bca.gis_taami_2016_12_23_c13 U.K. bonds remain deeply in low-risk territory, despite a small deterioration in its risk index. The oversold reading in the momentum measure is completely overshadowing the negative signal from the cyclical indicator. Allocation to gilts remains one of the highest in the bond universe, even after the model trimmed its exposure to this market (Chart 14). The risk index for Swedish bonds fell once again in December reflecting improved readings in all of its components. Extremely oversold conditions dominate the overall risk index and suggest that a pullback in yields is overdue. The model boosted its allocation to Swedish paper. (Chart 15). Chart 14U.K. Bond Yields And Risk U.K. Bond Yields And Risk U.K. Bond Yields And Risk Chart 15Swedish Bond Yields And Risk bca.gis_taami_2016_12_23_c15 bca.gis_taami_2016_12_23_c15 Currency Technicals The 13-week momentum measure indicates that the dollar's ascent could face near-term resistance. However, the continued recovery in the 40-week rate of change measure suggests that the dollar bull market has more upside. The latest round of central bank meetings reinforces the monetary divergence between the Fed on one side, and the ECB and BoJ on the other (Chart 16). With the prospect of the Bank of Canada staying put, while its southern peer gradually raises rates, the rate differential should exert downward pressure on the CAD/USD. Technically, the breakdown of the longer-term rate-of-change measure is pointing in that direction. In addition, the short-term rate of change metric is not stretched. However, the risk to this view is that the headwinds for the loonie arising from monetary policy divergences can be mitigated by higher oil prices (Chart 17). With the BoJ pegging nominal JGB yields, the differential in real rates is supportive of a stronger USD/JPY. This cyclical outlook for the yen is being confirmed by the 40-week rate of change measure. That said, the 13-week momentum measure is at levels that have signaled a pause in the yen weakening trend in both 2013 and 2015 (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_12_23_c16 bca.gis_taami_2016_12_23_c16 Chart 17Canadian Dollar Canadian Dollar Canadian Dollar Chart 18Yen bca.gis_taami_2016_12_23_c18 bca.gis_taami_2016_12_23_c18 Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Dear Client, This is our last report of the year. We will be back the first week of January with our 2017 Strategy Outlook. On behalf of BCA's Global Investment Strategy team, I would like to take this moment to wish you and your loved ones a Merry Christmas, Happy Holidays, and all the best for the coming year. Best regards, Peter Berezin, Senior Vice President Global Investment Strategy Highlights The global economy has entered a reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. Emerging markets should also gain from a more reflationary environment. However, a rising dollar and elevated debt levels will take the bloom off the rose. Chronically low productivity and labor force growth will make it difficult for central banks to contain inflation once it does begin to accelerate. Global bond yields will rise only modestly next year, but could begin to surge as the decade wears on. Feature Stagflation Is Coming, But Not Yet Bill Gates once noted that "We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten." This observation applies just as well to the risk of stagflation as it does to technology. For the next few years, the likelihood of a disorderly rise in inflation is extremely low. Beyond then, however, the risk is that inflation surprises to the upside, perhaps significantly so. Three factors will prevent global inflation from rising too rapidly over the next two-to-three years: The global economy still suffers from a fair amount of spare capacity; While spare capacity is likely to decline further, it will do so only gradually; Even when all remaining spare capacity is exhausted, the knock-on effect to inflation will initially be quite small. Spare Capacity Lingers Chart 1 shows that the global output gap has declined from its high in 2009, but is still larger than it has been at any time since the early 1990s. This can be seen in low industrial capacity utilization rates in some countries (Chart 2), as well as in the high levels of joblessness and involuntary part-time employment (Charts 3 and 4). Chart 1Mind The (Output) Gap Mind The (Output) Gap Mind The (Output) Gap Chart 2Global Capacity Utilization Remains Low Global Capacity Utilization Remains Low Global Capacity Utilization Remains Low Chart 3AJoblessness Still Elevated In Europe bca.gis_wr_2016_12_23_c3a bca.gis_wr_2016_12_23_c3a Chart 3BJoblessness Still Elevated In Europe bca.gis_wr_2016_12_23_c3b bca.gis_wr_2016_12_23_c3b Chart 4AHigher Incidence Of Involuntary ##br##Part-Time Employment bca.gis_wr_2016_12_23_c4a bca.gis_wr_2016_12_23_c4a Chart 4BHigher Incidence Of Involuntary ##br##Part-Time Employment bca.gis_wr_2016_12_23_c4b bca.gis_wr_2016_12_23_c4b Granted, the U.S. is much closer to full employment than most other economies. However, high levels of spare capacity abroad will still exert downward pressure on U.S. inflation. The reason for this was first laid out by Robert Mundell and Marcus Fleming in the early 1970s. The Mundell-Fleming model, as it is now called, posits that a country's interest rate will rise in response to stronger growth, thereby pushing up the value of its currency. Indeed, Mundell and Fleming showed that easier fiscal policy would not benefit a small open economy at all in a world of perfect capital mobility and flexible exchange rates because any gains from the stimulus would be entirely offset by a deterioration in the trade balance. Chart 5Real Rate Differentials ##br##Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar Real Rate Differentials Are Driving Up The Dollar While the Mundell-Fleming model is a gross oversimplification of how the global economy actually functions, it is still highly relevant for understanding today's macro environment. The real broad trade-weighted dollar has appreciated by 21% since mid-2014, largely due to the widening of interest rate differentials between the U.S. and its trading partners (Chart 5). We estimate that the stronger dollar has reduced the level of U.S. real GDP by 1% so far, and will reduce it by another 0.5% stemming from the lagged effects from the recent dollar rally. The buoyant greenback will keep a lid on U.S. inflation both directly, in the form of lower import prices and indirectly, in the form of slower employment growth. The analysis above leads to three important investment implications. First, it implies that the dollar will remain well bid as long as the Fed remains the only major central bank in hiking mode. We have been long the DXY since October 2014 - a trade that has gained 18.6%. We think there is another 5% of upside from current levels. Second, a stronger dollar will help redistribute growth to Europe and Japan, two economies that desperately need it. We are bullish on European and Japanese stocks and bearish on the euro and the yen. Third, Treasury yields will be hard-pressed to rise substantially from current levels until spare capacity outside the U.S. is extinguished. Only once other central banks start raising rates will the Fed be able to hike rates in a sustainable manner. Until then, any Fed tightening beyond what the market is currently expecting will put upward pressure on the dollar, reducing the need for further hikes. A Gradual Recovery Table 1Global Growth Will Improve Next Year The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation Global growth should pick up next year in line with the IMF's most recent projections (Table 1). Alongside stronger growth in Japan and continued above-trend growth in Europe, the U.S. economy will benefit from robust consumer spending on the back of rising real wages. In addition, residential investment should rise, as foreshadowed by the jump in homebuilder confidence in December. Tighter credit spreads, deregulation, and a modest recovery in energy sector investment should also boost business capex. Despite this welcome reflationary backdrop, a number of factors will hold back growth. Most prominently, debt levels are still high around the world (Chart 6). In fact, emerging market debt continues to rise more quickly than GDP. Even in the optimistic scenario where the ratio of EM debt-to-GDP merely stabilizes, this would still entail a negative credit impulse (Chart 7). Chart 6Global Debt Levels Are Still High Global Debt Levels Are Still High Global Debt Levels Are Still High Chart 7Negative EM Credit Impulse Looming Negative EM Credit Impulse Looming Negative EM Credit Impulse Looming Meanwhile, monetary policy continues to be constrained by the zero bound in a number of developed economies. Many EM central banks will also be reluctant to cut interest rates due to fears that this could precipitate a disorderly plunge in their currencies. And while fiscal policy around the world will no longer be restrictive, a major burst of government stimulus is not in the cards. Donald Trump's fiscal package may not boost aggregate demand by as much as the more optimistic estimates suggest. As we have noted before, most of America's infrastructure needs consist of basic maintenance. There simply are not enough marquee "shovel-ready" projects around that can make use of the public-private partnership structure that Trump's plan envisions. There is also a significant risk that Congressional Republicans will try to sneak through cuts to Social Security and Medicare, much to the annoyance of many of Trump's voters. As for Trump's proposed personal tax cuts, while they are hefty in size, their bang for the buck is likely to be modest, given that the benefits are tilted towards higher income groups that tend to save much of their earnings. Indeed, it is possible that cutting the estate tax would actually depress spending by reducing the incentive for older households to blow through their wealth before the Grim Reaper (and The Taxman) arrive. Likewise, corporate tax cuts will have only an incremental effect on business capex, given that companies are already flush with cash and effective tax rates are well below statutory levels. The bottom line is that global growth is likely to rise in 2017, but not by enough to cause inflation to surge. A Flat Phillips Curve ... For Now Chart 8The Phillips Curve Has Flattened The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation It might take a few more years for most of the developed world to claw its way back to something approximating full employment, but with any luck, it will get there. What happens to inflation then? The answer is probably not much. The relationship between economic slack and inflation is encapsulated by the so-called Phillips curve. As one would intuitively expect, inflation tends to rise when slack diminishes. However, this correlation has weakened over the past few decades (Chart 8). For example, U.S. core inflation declined only modestly during the Great Recession, and has been slow to bounce back, even as the output gap has shrunk. Economists have proposed a variety of reasons for why the Phillips curve may have flattened out over time. Globalization is often cited as one factor, but the empirical evidence for this view is rather shaky.1 True, free trade and capital mobility have helped keep inflation in check by diverting excess domestic demand into higher net imports via the Mundell-Fleming channel discussed above. However, this only implies that globalization may prevent economies from sliding too far along the Phillips curve. It says nothing about the slope of the curve itself. A fall in unionization rates and a decline in the use of inflation-indexed wage contracts are also often cited as reasons for why the correlation between inflation and economic slack has diminished. Here again, the evidence is rather mixed. While the U.S. has experienced a pronounced decline in unionization rates, Canada has not (Chart 9). Nevertheless, the sensitivity of inflation to economic fluctuations has fallen in both countries by roughly the same magnitude. Likewise, the increased use of inflation-index contracts in the 1970s appears mainly to have been a response to rising inflation, rather than a cause of it (Chart 10). The one point on which most economists agree is that long-term inflation expectations are much more stable now than they used to be, which has reduced the volatility of actual inflation. Central banks deserve some of the credit for this. The adoption of inflation targeting, coupled with more transparent communication policies, has helped anchor inflation expectations. A more sober assessment of economic conditions has also been a plus. Back in the 1970s, the Fed continuously overstated the degree of economic slack (Chart 11). This led it to keep interest rates too low for too long, thereby sowing the seeds for much higher inflation later on. Chart 9Inflation Fell In Canada, ##br##Despite A High Unionization Rate bca.gis_wr_2016_12_23_c9 bca.gis_wr_2016_12_23_c9 Chart 10When High Inflation ##br##Entailed Inflation-Indexed Contracts When High Inflation Entailed Inflation-Indexed Contracts When High Inflation Entailed Inflation-Indexed Contracts Chart 11The Fed Continuously Overstated ##br##The Magnitude Of Economic Slack The Fed Continuously Overstated The Magnitude Of Economic Slack The Fed Continuously Overstated The Magnitude Of Economic Slack Shifting Sands For Inflation The Fed has vowed not to make the same mistake again, but the temptation to exploit the flatness of the Phillips curve may be too great to resist. A flattish Phillips curve implies a low "sacrifice ratio." This means that the Fed could let the economy overheat without putting undue upward pressure on inflation. While the Fed would have reservations about pursuing such a strategy, Janet Yellen's musings about running a "high-pressure economy" suggest that it is at least willing to entertain the idea. The 25-year period of falling inflation that began in the early 1980s had a dark side. As Hyman Minsky first noted, economic stability can beget instability: The so-called "Great Moderation" that policymakers were patting themselves on the back for before the financial crisis created a fertile milieu for rising debt levels. Excessively high debt levels are deflationary at the outset because they limit the ability of overstretched borrowers to spend. However, high debt levels also reduce investment in new capacity - homes, office buildings, machinery, etc. This undermines the supply-side of the economy. Once the output gap is closed, high debt levels can become inflationary by increasing the incentive for central banks to keep rates low in order to suppress interest-servicing costs and reduce real debt burdens. The challenges posed by the zero-bound constraint could also justify efforts to raise inflation targets. After all, if inflation were higher, this would give central banks the ability to push down real rates further into negative territory in the event of an economic downturn. Such a step is unlikely to be taken anytime soon. That said, given that a number of well-regarded economists - including prominent policymakers such as Olivier Blanchard, the former chief economist at the IMF, San Francisco Fed President John Williams, and former Minneapolis Fed President Narayana Kocherlakota - have floated the idea of raising the inflation target, long-term investors should be open-minded about the possibility. In any event, as we discussed in great detail last week, underlying economic trends - ranging from the retreat from globalization to the slowdown in potential GDP growth - are all pushing the global economy in a more inflationary direction.2 This suggests that inflation could move appreciably higher towards the end of this decade. Investment Conclusions Chart 12Near-Term Inflation Risk Is Low Near-Term Inflation Risk Is Low Near-Term Inflation Risk Is Low Inflation is unlikely to rise significantly over the next few years. Indeed, the sharp appreciation in the dollar since the election will put downward pressure on U.S. inflation in the coming months. This view is supported by the Federal Reserve Bank of St. Louis Price Pressure gauge, which shows that there is less than an 8% chance that inflation will rise above 2.5% over the next 12 months (Chart 12). And even when the economy has reached full employment and the effects of a stronger dollar have washed through the system, inflation will be slow to increase. Consider how inflation evolved during the 1960s. As my colleague Mathieu Savary has pointed out, U.S. inflation did not reach 4% until mid-1968. By that time, the output gap had been positive for five years, hitting a whopping 6% of GDP in 1966 on the back of rising military expenditures on the Vietnam War and social spending on Lyndon Johnson's "Great Society" programs (Chart 13).3 The lesson is that it often takes a number of years for an overheated economy to generate meaningful inflation. This suggests that the global economy is entering a "goldilocks" reflationary window, where deflation risks are receding, but fears of excess inflation have yet to surface. This is obviously good news for global risk assets, and underpins our cyclically constructive view on global equities. Europe and Japan, two regions where central banks are in no hurry to raise rates and whose stock markets tend to have a cyclical tilt, are the most likely to benefit. In fact, both economies have seen a decline in real yields since the U.S. elections, as rising inflation expectations have outpaced the increase in nominal yields (Chart 14). Emerging markets should also gain from a more reflationary environment, but a rising dollar and elevated debt levels will take the bloom off the rose. Chart 13It Can Take A While For Inflation ##br##To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy It Can Take A While For Inflation To Rise In Response To An Overheated Economy Chart 14Europe And Japan: Rising Inflation ##br##Expectations Suppressing Real Yields Europe And Japan: Rising Inflation Expectations Suppressing Real Yields Europe And Japan: Rising Inflation Expectations Suppressing Real Yields While we have a positive cyclical (3-to-24 month) view on risk assets, we have significant concerns about both the near-term and longer-term outlooks. From a short-term tactical perspective, developed market equities - especially U.S. equities - are highly vulnerable to a correction. This is reflected in our sentiment indices, which have moved firmly into overbought territory (Chart 15). It can also be seen in the weak historic performance of global stocks following sharp spikes in bond yields (Table 2). Chart 15U.S. Equity Sentiment Is Stretched U.S. Equity Sentiment Is Stretched U.S. Equity Sentiment Is Stretched Table 2Stocks Tend To Suffer When Bond Yields Spike The Long And Winding Road To Stagflation The Long And Winding Road To Stagflation Over a longer-term horizon, the risks to global equities are also to the downside. Once inflation is on a firm upward trajectory, central banks may find it more difficult to arrest the trend. Against the backdrop of weak productivity and labor force growth, memories of stagflation may reappear. As Chart 16 shows, stagflation in the 1970s was devastating for equities, and this time may not be any different. The bottom line is that investors should lease the bull market in stocks, rather than own it. Chart 16Stagflation Was Devastating For Stocks Stagflation Was Devastating For Stocks Stagflation Was Devastating For Stocks From The Vault: Two "Big Picture" Holiday Reports Lastly, for those who would like to take their minds off the nitty-gritty of the financial world for the next two weeks and focus more on transcendent issues, let me recommend two special reports. The first, entitled A Smarter World is based on a speech I delivered at the 2014 BCA New York Investment Conference. I argue that genetic changes in the human population sowed the seeds for the Industrial Revolution. This development then unleashed a virtuous cycle where rising living standards led to better health and educational outcomes, generating even further gains in living standards. Many countries now appear to be at the end of this cycle, but new technologies could one day generate huge gains in IQs, sending humanity down a path towards immortality. Of course, before we get there, we have to contend with all sorts of existential pitfalls. With that in mind, the second report, Doomsday Risk, examines what is literally a life-and-death issue: the likelihood of human extinction. Drawing on insights from biology, history, cosmology, and probability theory, our analysis yields a number of surprising investment implications. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see Eddie Gerba and Corrado Macchiarelli, "Is Globalization Reducing The Ability Of Central Banks To Control Inflation?" European Parliament, Policy Department A: Economic and Scientific Policy, Brussels, Belgium (2015); Jane Ihrig, Steven B. Kamin, Deborah Lindner, and Jaime Marquez, "Some Simple Tests Of The Globalization And Inflation Hypothesis," International Finance Vol. 13, no. 3 (2010): pp. 343-375; and Laurence M. Ball, "Has Globalization Changed Inflation?" NBER Working Paper No. 12687 (2006). 2 Please see Global Investment Strategy Weekly Report, "Main Street Bonds, Wall Street Stocks," dated December 16, 2016, available at gis.bcaresearch.com. 3 Please see Foreign Exchange Strategy, "Outlook: 2017's Greatest Hits," dated December 16, 2016, available at fes.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights 1.How Will The European Economy Cope With Higher Interest Rates? 2. How Will The European Stock Market Cope With Higher Interest Rates? 3. How Will The EU Respond To The Start Of Brexit? 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? Feature Our strong sense is that the promised elixir of 'Trumponomics' has disoriented investors' concept of value. Suddenly thrown out of their comfort zone, long-term investors are struggling to assess: how much of Trumponomics is reality and how much is just fantasy? Chart of the WeekBrexit And Pound/Euro bca.eis_wr_2016_12_22_s1_c1 bca.eis_wr_2016_12_22_s1_c1 As rational and analytical long-term investors have become disoriented, emotional and impulsive short-term traders have been left unchecked to drive markets (Chart I-2). Chart I-2Markets Are Excessively Emotional Markets Are Excessively Emotional Markets Are Excessively Emotional Understand that the financial markets are an ecosystem in which long-term investors jostle with short-term traders. The stable equilibrium of this ecosystem relies on rationality and analysis ultimately checking emotion and impulse. And therein, perhaps, lies the essence of life itself. The descriptions "rationality and analysis" versus "emotion and impulse" are not judgements. They are simply the very different qualities needed to do very different jobs. Long-term investors must take time to rationalise and analyse the concept of fundamental value; whereas traders must use their immediate emotions and impulses to ride short-term market momentum. Therefore what happens in 2017 will depend on what the rational and analytical long-term investors conclude after their pause for reflection. This brings us to our five pressing questions for the coming year. 1. How Will The European Economy Cope With Higher Interest Rates? Now you could argue that the level of interest rates is very low by historical standards, even after last week's rate hike by the Federal Reserve. However, it is the change in interest rates that drives the change in credit growth (Chart I-3); and it is the change in credit growth that drives the change in GDP growth (Chart I-4). Chart I-3The Change In Bond Yield Drives##br## The Change In Credit Growth... bca.eis_wr_2016_12_22_s1_c3 bca.eis_wr_2016_12_22_s1_c3 Chart I-4...And The Change In Credit Growth Drives ##br##The Change In GDP Growth bca.eis_wr_2016_12_22_s1_c4 bca.eis_wr_2016_12_22_s1_c4 You could also argue that a 25bps hike in the Fed funds rate constitutes the tiniest of baby steps of monetary tightening. The problem is that bond yields have already jumped many multiples of this: the U.S. 15-year and 30-year bond yield and mortgage rate have spiked by over 75bps; the German 30-year bond yield is up 90bps; the Italian 30-year bond yield is up 100bps; and so on. It is these substantial increases in market interest rates that will weigh on credit-sensitive sectors and prospective 6-month GDP growth. Chart I-5Despite Dollar Strength, The Trade-Weighted##br## Euro Has Hardly Budged Despite Dollar Strength, The Trade-Weighted Euro Has Hardly Budged Despite Dollar Strength, The Trade-Weighted Euro Has Hardly Budged Another argument we hear is that higher bond yields are simply discounting better growth prospects ahead. The problem here is the inter-temporal distribution of growth. Higher market interest rates are a near-certain headwind to be felt within 3-6 months. Whereas Trumponomics is a very uncertain tailwind to be felt in 2018, or end 2017 at the earliest. Then there is the geographical distribution of growth. Trumponomics, at best, would boost U.S. growth. Yet market rates have also gone up aggressively in Europe, where there would be a minimal boost to growth. Bear in mind that despite dollar strength, the trade-weighted euro has depreciated just 3% from its October high (Chart I-5). Likewise, emerging market economies will see minimal growth benefits. Whereas higher dollar funding costs, stronger dollar-linked currencies, and the threat of protectionism constitute a meaningful headwind. The bigger question is: can a modern day King Canute1 single-handedly turn the tide of global deflation - the combined structural forces of over-indebtedness, demographics, technology, and globalization? There is much debate about this issue at BCA, but on balance this publication believes that the tide has not turned. 2. How Will The European Stock Market Cope With Higher Interest Rates? Trumponomics is not the structural game changer that the market seems to believe. But even if we are wrong on this, there is one over-arching relationship that will hold true irrespective: the relationship between stock market valuation and subsequent 10-year total nominal return (Chart I-6). This long-term relationship is independent of the economic backdrop: Keynesian, monetarist, neo-classical, deflationary, inflationary, or Trumponomics. Chart I-6Long-Term Returns Always Depend On Valuation Long-Term Returns Always Depend On Valuation Long-Term Returns Always Depend On Valuation The reason is that the 10-year total nominal stock market return comprises two components: the nominal income received through the next 10 years; and the terminal value of the market at the end of the 10 years. Crucially, an environment that boosts one component symmetrically depresses the second component, and vice-versa. For example, inflation boosts nominal income received, but depresses the terminal value (because the discount rate is then much higher). Deflation has the opposite effect. Therefore the relationship between valuation and subsequent 10-year total nominal return is environment-independent. Today, stock markets are priced to generate very low single-digit 10-year returns. But with the recent spike in long-term interest rates, investors can now obtain similar 10-year returns from bonds. In other words, the equity risk premium is dangerously compressed. Emotional and impulsive short-term traders do not care about this structural relationship, but rational and analytical long-term investors ultimately do. Bear in mind that the cross-asset and cross-sector moves over the past six weeks - whether in equity market, bond yield and dollar elevation, or bank outperformance, or yield-proxy and defensive underperformance - are all just various guises of the Trump reflation trade. We expect that rationality and analysis will conclude that Trumponomics is not the structural game changer that the market seems to believe right now. The trade: an unwinding of the various guises of the Trump reflation trade is likely, at least tactically. 3. How Will The EU Respond To The Start Of Brexit? Chart I-7Brexit Must Not Be A Gift To Le Pen Five Pressing Questions (And Four Trades) For 2017 Five Pressing Questions (And Four Trades) For 2017 The silence is deafening. While there is much daily noise from the U.K. about the type of Brexit it wants, the EU has been intentionally silent. Once the formal legal process of Brexit begins, it will be the EU that holds the balance of power on what Brexit ultimately looks like. The chatter from some U.K. government quarters is that it can negotiate advantageous Brexit terms. Good luck with that. Given the proximity of the French Presidential Election in April/May, the EU's opening position has to be uncompromising - so as to not hand Marine Le Pen any gifts (Chart I-7). The EU must make an example of the U.K. "pour encourager les autres". And if exiting the EU must come with a demonstrable cost, one casualty would be the pound. That said, 2017 will be an especially unpredictable year for U.K. politics and economics because Brexit creates a larger number of moving parts, complex interactions and feedback loops, both negative and positive. For example, if the Supreme Court grants the Scottish parliament a greater say in the terms of Brexit, it could compromise Theresa May's current strategy. The pound would rally on that tail-event possibility. The trade: the pound is unlikely to stay near today's €1.18. Expect a sharp move one way or the other (Chart of the Week). A good strategy might be to sell the middle of the distribution. There are many permutations of this but one example would be to short the pound and simultaneously buy call options at, say, €1.30. 4. Will The Bank of Japan's 0% Bond Yield Peg Undermine ECB Credibility? Chart I-8Pegs Get Broken bca.eis_wr_2016_12_22_s1_c8 bca.eis_wr_2016_12_22_s1_c8 2016 was the year when QE peaked. The ECB committed to lowering its monthly asset purchases. More significantly, the BoJ shifted its policy aim from targeting an amount of asset purchases to targeting a price (or yield) on the 10-year JGB. Thereby, the central bank policy experiment has moved into a more dangerous phase. As we explained in Dangers Of Linear-Thinking In A Non-Linear World 2 economies and markets are complex, non-linear systems. The inherent unpredictability of a non-linear system makes it futile and dangerous to aim for an over-precise point target in anything that we do. And that principle applies to central banks as much as to anybody else. Indeed, a 2% inflation target is a price target, albeit a price of a basket of goods and services, and the annual change of that price. The track record of any central bank achieving its self-imposed 2% inflation target in recent years is truly disastrous. Recall also that the Swiss National Bank had to break the franc's peg with the euro, one of the more recent in a long list of failed price pegs (Chart I-8). Our Fixed Income strategists believe the JGB 0% yield peg will hold. Nevertheless, the risk is underestimated that the BoJ will have to break the peg, in 2017 or beyond. The credibility of the ECB to suppress long-term bond yields would then be severely damaged. And the greatest danger would be to those euro area bond yields closest to zero. The trade: stay underweight French OATS. 5. What Does China's Debt Super Cycle Mean For Euro/Yuan? One defining feature of the last 40 years is a steady sequence of private sector credit booms which have inevitably turned to busts: notably, Japan in 1990, the Asian 'tigers' in 1998, the U.S. in 2007, and the U.K., Spain and other European countries in 2008 (Chart I-9). Chart I-9Credit Booms Sequentially Turned To Bust. Who's Next? Credit Booms Sequentially Turned To Bust. Who's Next? Credit Booms Sequentially Turned To Bust. Who's Next? In this defining feature, China's is the last of the major credit booms that hasn't turned to bust - yet. Admittedly, the ability of the Chinese authorities to 'extend and pretend' is probably greater than elsewhere in the world, and this might prevent another violent tipping point. Irrespective, the debt super cycle is over when the cost of malinvestment and misallocation of capital outweighs the benefit of good credit creation. With private sector indebtedness (including SOEs) now at, or beyond, the level where every other credit boom peaked, China appears to be approaching this point. One manifestation would be continued weakness in its currency against the major developed market crosses. The trade: go long euro/yuan. And with that, we are signing off for 2016. I do hope that this year's reports have provided some insight during particularly turbulent times, and that you might have even enjoyed the reading experience! It just remains for me to wish you a Merry Christmas and a successful and happy 2017. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 In fact, the story of King Canute has been misinterpreted. Rather than show that he could turn the tide, he wanted to show the opposite: that he was powerless against the tide. 2 Published on February 11, 2016 and available at eis.bcaresearch.com. Fractal Trading Model* Pleasingly, two of our open trades hit their profit targets: long platinum / short palladium and short the Greek 10-year bond. Given the extended break, we are not opening any new trades over the Christmas and New Year holiday period. 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-10 Long Platinum / Short Palladium Long Platinum / Short Palladium * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c1 bca.eis_wr_2016_12_22_s2_c1 Chart II-2Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c2 bca.eis_wr_2016_12_22_s2_c2 Chart II-3Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c3 bca.eis_wr_2016_12_22_s2_c3 Chart II-4Indicators To Watch - Bond Yields bca.eis_wr_2016_12_22_s2_c4 bca.eis_wr_2016_12_22_s2_c4 Interest Rate Chart II-5Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c5 bca.eis_wr_2016_12_22_s2_c5 Chart II-6Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c6 bca.eis_wr_2016_12_22_s2_c6 Chart II-7Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c7 bca.eis_wr_2016_12_22_s2_c7 Chart II-8Indicators To Watch##br## - Interest Rate Expectations bca.eis_wr_2016_12_22_s2_c8 bca.eis_wr_2016_12_22_s2_c8

Dear Clients, This is the final publication for the year, in which we recap some of the key developments in 2016 and their long-term implications. We will resume our regular publishing schedule on January 5, 2017. The China Investment Strategy team wishes you a very happy holiday season and a prosperous New Year! Best regards, Yan Wang, Senior Vice President China Investment Strategy Feature Senior Chinese policymakers conveyed in Beijing last week for their annual economic work conference - a high-profile gathering where top officials review the past year's economic performance and set the broad policy tone and development priorities for the coming year. The key messages from this year's meeting suggest that "stability and progress" remain a top priority, but that the importance of a GDP growth target appears less significant. Policymakers recognize the mounting challenges both globally and domestically, which suggests the policy environment will stay accommodative, especially on the fiscal front. Furthermore, the authorities intend to make material progress on "supply-side" reforms, which is both an admission of defeat in terms of progress this year and a pledge for more aggressive efforts going forward. We will be addressing China's policy orientation, growth outlook and asset prices in the New Year. As a year-end tradition, we dedicate this week's report to recapping some important developments of the past year and their long-term implications. A V-Shaped Recovery Under The Economic "New Normal" Chart 1V-Shaped Rebound##br## In The Economic New Normal bca.cis_wr_2016_12_22_c1 bca.cis_wr_2016_12_22_c1 The Chinese economy entered 2016 with worsening growth deceleration, but ended the year with a V-shaped rebound in industrial activity - even though GDP growth remained curiously stable1 (Chart 1). Destocking in the housing market and de-capacity in some industrial sectors were listed as two top priorities of the government for 2016, both of which were abruptly reversed as the year unfolded: strong home sales depleted housing inventories more quickly than expected, leading to a dramatic increase in home prices in major cities - prompting policymakers to re-impose restrictions on housing demand.2 Meanwhile, de-capacity in steel mills and coal mines greatly constrained domestic supply of related products, leading to both a massive increase in imports and a sharp rally in prices as demand improved. As a result, the authorities scrambled to remove some administrative constraints on domestic production on these two industries. The economy's V-shaped growth performance this year challenges some conventional thinking on China's growth fundamentals, particularly on the housing market and overcapacity. On housing, there is no doubt that some regions have abundant supply, which may take a long time to clear. On an aggregate level, however, the massive increase in home prices in some major cities suggest housing inventories may be much smaller than generally perceived.3 Similarly, overcapacity is widely regarded as a chronic feature of the Chinese economy inherent to its investment-heavy growth model - steelmakers and coalmines being two prime examples. However, the dramatic turnaround in these two industries this past year defies this widely held consensus.4 At minimum, China's overcapacity issue cannot be analyzed in isolation from a global context as well as from the current stage of the business cycle. Chart 2Monetary Conditions And ##br##Business Conditions Monetary Conditions And Business Conditions Monetary Conditions And Business Conditions Furthermore, while "supply-side" reforms were listed as a key theme for 2016, improvement in the industrial sector was to a large extent due to measures that boosted aggregate demand. Fiscal spending remained robust at the beginning of the year, following strong acceleration in 2015. More importantly, monetary conditions began to ease notably from the beginning of the year, leading to a notable improvement in business conditions among industrial enterprises (Chart 2). Nonetheless, the growth "new normal" envisioned by the Chinese leadership underlines the assumption of an "L-shaped" growth trajectory. Therefore, the V-shaped rebound in some key industrial indicators was both surprising and possibly unwelcome from the policymakers' point of view. The authorities will likely continue to switch priorities between supply side reforms and demand-side management going forward. Premature withdrawal of policy stimulus remains a key risk for the economy as well as financial markets. From Deflation To Inflation? 2016 marked a decisive end to Chinese producer price deflation, which lasted for more than four years. PPI, still falling at a 5% annual rate at the beginning of the year, turned up sharply toward the end of 2016, rising by over 3% in November, likely even higher this month. Investors' perception on Chinese producer prices and the broader inflation picture has also shifted dramatically. A mere few months ago China was widely blamed for exporting deflation to the rest of the world, which has quickly been replaced by a consensus that China is now exporting inflation. The sudden shift may have to some extent contributed to the bond market riot of late both globally and within China. The end of PPI deflation is a major positive development for the Chinese corporate sector, as it both improves its pricing power and also reduces its real cost of funding (Chart 3). Real bank lending rates deflated by PPI stayed at close to record highs early this year, and have since tumbled by a whopping 10 percentage points - largely due to easing deflation. This is a dramatic relief for some highly levered asset-heavy industries. Importantly, these industries were the biggest casualties in the growth slowdown and posed material risks to the banking sector due to their high debt levels. In this vein, rising PPI and easing financial stress among these firms also bodes well for the banking sector. Nonetheless, it is wrong to conclude that the end of PPI deflation in China means the country will export inflation going forward: Rising producer price inflation, measured as year-over-year growth, is to some extent due to the base effect. In terms of level, producer prices have clearly stopped falling, but gains have been rather mild and still remain at relatively low levels. It is too soon to worry about inflation (Chart 4, bottom panel). Easing deflation has also been attributable to the falling trade-weighted RMB this year (Chart 4, top panel), as producer prices typically follow exchange rate performance by about six months. While PPI may continue to follow the RMB higher in the coming several months, the trade-weighted RMB depreciation has already stalled, which may cap any additional upside in PPI. Unless the economy continues to recover strongly and/or the RMB resumes its depreciation, it is premature to expect PPI to continue to rise going forward. Chart 3Easing Deflation Helps Reduce##br## Real Interest Rates, Massively bca.cis_wr_2016_12_22_c3 bca.cis_wr_2016_12_22_c3 Chart 4PPI Inflation##br## In Perspective bca.cis_wr_2016_12_22_c4 bca.cis_wr_2016_12_22_c4 Domestic inflation does not necessarily lead to rising export prices, if a weaker RMB is the main factor to boost domestic prices (Chart 5). Indeed, rising Chinese domestic producer prices also means Chinese export prices in RMB terms have also been rising. Measured in U.S. dollar terms, however, Chinese export prices are still falling on a year-over-year basis. Similarly, U.S. import prices from China measured in RMB terms have been rising smartly, but in dollar terms are still been falling. This is positive for Chinese exporters' profitability, but is not inflating U.S. prices. Finally, a word on the sharp increase in Chinese bond yields. While growth improvement and easing deflation may have contributed to the sharp rebound in Chinese bond yields in recent weeks, global factors are likely more important. Chart 6 shows Chinese government bond yields have been increasingly synchronized with U.S. Treasurys in recent years, an interesting development considering China's still relatively closed capital markets. The rising correlation could be driven by economic fundamentals due to the tight connection between these two economies. Rising U.S. bond yields reflects changes in growth and inflation expectations in the U.S., which also impact the Chinese economy. Furthermore, the 123-basis-point spike in U.S. Treasurys since July 2016 has narrowed the yield gap with Chinese government bonds, which in turn has pushed up Chinese yields. This means that Chinese interest rates may remain under upward pressure should U.S. Treasury yields continue to grind higher. Chart 5End Of Chinese Deflation Does Not ##br## Necessarily Inflate The World bca.cis_wr_2016_12_22_c5 bca.cis_wr_2016_12_22_c5 Chart 6Chinese Bonds: ##br##The Global Connection bca.cis_wr_2016_12_22_c6 bca.cis_wr_2016_12_22_c6 Bottom Line: Easing deflation is good news for Chinese domestic firms, but it does not mean that China is about to export inflation to the rest of the world. Chinese government bond yields may have also made a cyclical low, and will likely continue to move higher along with global yields. The RMB's Bumpy Transition The RMB officially joined the Special Drawing Right (SDR) basket of the IMF in October, a historical moment marking an emerging country being admitted to the "elite currency" club. Joining the SDR helps promote the international status of the Chinese currency, which may offer some longer-term benefits.5 The immediate challenge for policymakers, however, is to fend off the constant downward pressure on the RMB against the dollar. More specifically, the People's Bank of China (PBoC) has clearly signaled its intention to allow the exchange rate to float, but has been deeply troubled by the potential of a downward spiral between capital outflows and outsized RMB depreciation. Overall, 2016 marks a tentative transition of the RMB exchange rate mechanism to a dirty float scheme. Indeed, the PBoC at the beginning of 2016 explicitly presented its formula of how the RMB's daily official fixing rate against the dollar is calculated. Strictly following this formula would lead to a largely stable trade-weighted RMB. In reality, however, the PBoC appears to have deliberately targeted a weaker exchange rate: the RMB was soft-pegged to the dollar whenever the dollar weakened against other currencies, and it was allowed to fall against the dollar whenever it strengthened broadly. As a result, the RMB depreciated by almost 10% in trade-weighted terms from its 2015 peak, which in no small part helped the economy reflate. However, this strategy also reinforced an already well-entrenched expectation of the RMB's one-way descent against the greenback. Shorting the RMB became a risk-free bet, which further encouraged capital outflows. There has been a rush to purchase foreign assets by the corporate sector, likely also incentivized by the RMB outlook.6 It is unclear how the PBoC will break this dilemma going forward. We expect the central bank will stay the course in further lowering the trade-weighted RMB, while at the same time tightening capital account controls to prevent capital flight.7 Its large current account surplus and official reserves should offer plenty of resources to maintain control. Its tight grip on the exchange rate may be progressively relaxed as it perceives the trade-weighted RMB to be "cheapened enough," which could generate two-way flows of capital. From this perspective, joining the SDR helps attract long-term foreign capital for Chinese risk-free assets. Bottom Line: Joining the SDR marks a historic milestone for the RMB, but the near-term significance is largely symbolic. The RMB's soft peg to the dollar is over. The PBoC is experimenting with a new exchange rate regime. Market Volatility And Financial Reforms Chart 7Policy Uncertainties And ##br##Equity Valuations bca.cis_wr_2016_12_22_c7 bca.cis_wr_2016_12_22_c7 The dramatic stock market rollercoaster ride in 2015 had already seriously damaged Chinese policymakers' credibility. The short-lived circuit-breaker system designed to curb market fluctuations in fact greatly exaggerated volatility at the beginning of the year, which further exposed the regulators' incompetency. Global investors' anxiety on China's macro situation has eased notably in recent months. However, Chinese stocks have ended the year largely flat, even though the industrial sector has staged a sharp recovery with strong earnings growth. Perceived high and rising policy uncertainty clearly dampens investors' appetite for Chinese assets, resulting in a large valuation discount to their global peers (Chart 7). Underneath, regulators' apparent policy blunders in the past two years represent a deeper and more systemic challenge than just incompetency. The country's rapidly developing financial system and capital markets have become increasingly complex, while the regulatory system lagged way behind. The current regulatory framework is poorly coordinated with sometimes conflicting priorities, leaving potentially systemically important developments falling through the cracks. The dramatic buildup of leverage in the stock market in 2015 outside of regulatory oversight was a prime example. This year, the leverage situation in commodities and bond markets has also been poorly scrutinized. A key reform initiative for the financial sector under the "reform blueprint" published a few years ago was to improve coordination among different regulators. The authorities plan to enhance supervision on systemically important financial institutions and systemically important financial infrastructure such as payment, clearing and custody systems to improve coordination of macro-prudential measures as well as collaboration on key financial statistics and information - all of which has yet to begin. The dramatic financial market volatility and policy blunders of late have created a pressing need to accelerate the process. In short, preventing financial risks has become an increasingly important priority of the government, and will remain a key task for 2017, as noted from last week's economic work conference. This necessarily involves fundamental reforms of the country's financial regulatory framework. We will follow up on these issues in the New Year. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "Chinese Growth, Cyclical Risks And The Rally In Commodities," dated December 1, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Housing Tightening: Now And 2010," dated October 13, 2016 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "The Chinese Housing Market Conundrum," dated May 25, 2016 available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Myth Of Chinese Overcapacity," dated October 6, 2016 available at cis.bcaresearch.com. 5 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition," dated October 20, 2016 available at cis.bcaresearch.com. 6 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets," dated December 15, 2016 available at cis.bcaresearch.com. 7 Please see China Investment Strategy Weekly Report, "How Will China Manage The Impossible Trinity," dated December 8, 2016 available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights The U.S. dollar will continue to appreciate while the RMB will depreciate further. This is a bad omen for EM risk assets, commodities, and global late cyclical equity sectors. Gold often leads oil and copper prices. Investors should heed the current downbeat message from gold. EM credit spreads have become detached from fundamentals and are unreasonably tight. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity trade: long Indian software stocks / short the EM overall index. Feature There are several major discrepancies in financial markets that in our view are unsustainable. 1. The gap between EM equity breadth, USD, RMB and EM share prices One way to measure equity market breadth is to compare performance of equal-weighted versus market cap-weighted stock price indexes. Based on this measure, EM stock market breadth has been deteriorating. Poor breadth often heralds a major selloff (Chart I-1). Chart I-1Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Poor EM Equity Breadth Heralds A Major Selloff Remarkably, the same measure for the U.S. stock market shows improving breadth. The relative performance of equally-weighted EM stocks against U.S. equity indexes - a measure of breadth in relative performance - can also be a reliable marker for the relative performance of market cap-weighted indexes. It has plummeted to a new low pointing to new lows in EM versus U.S. relative share prices. In addition, a surging U.S. dollar has historically meant lower EM share prices (Chart I-2). We doubt this time is different. Finally, EM risk assets have decoupled from the RMB/USD exchange rate as well. The RMB has been depreciating and China's domestic corporate and government bond yields have spiked. As a result, the on-shore bond prices in RMB terms have plummeted (Chart I-3). Chart I-2A Rising U.S. Dollar Is ##br##A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM A Rising U.S. Dollar Is A Bad Omen For EM Chart I-3China's On-Shore Corporate Bond##br## Prices Have Crashed bca.ems_wr_2016_12_21_s1_c3 bca.ems_wr_2016_12_21_s1_c3 Experiencing considerable losses on their favorite financial investment of the past year, bonds, Chinese investors, as well as households and companies, could opt to switch into U.S. dollars. The stampede into the U.S. dollar could start as early as January when the annual US$ 50,000 quota per person becomes available. It is hard to see what the government will do to preclude this rush and massive flight towards U.S. dollars. In China, households' and corporates' RMB deposits in the banking system amount to RMB 122 tn or US$17.5 tn. Hence, the PBoC's foreign exchange reserves including gold at US$ 3.2 tn are only equal to 18.5% of these deposits at the current exchange rate. Bottom Line: The U.S. dollar will appreciate and the RMB will depreciate. This is a bad omen for EM share prices and other risk assets. 2. Oil and copper prices deviating from gold prices Historically, when gold and oil prices have diverged, gold in most cases has proven more forward looking, with oil prices ultimately converging toward gold prices. Chart I-4A and Chart I-4B illustrate past episodes of gold and oil decoupling (in the 1980, 1990s and 2008), each of which were resolved via oil prices gravitating toward gold prices. Chart I-4AGold Led Oil Prices bca.ems_wr_2016_12_21_s1_c4a bca.ems_wr_2016_12_21_s1_c4a Chart I-4BGold Led Oil Prices Gold Led Oil Prices Gold Led Oil Prices In short, if history is any guide, the current gap between gold and oil prices will likely close via lower oil prices (Chart I-5, top panel). The same holds true for the recent divergence between gold and copper prices (Chart 5, bottom panel). We identified four historical periods when gold and copper prices diverged. In each case, it was copper prices that amended their trajectory and aligned with the direction of gold prices (Chart I-6A and 6B). Chart I-5Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Divergence Between Oil, Copper And Gold Chart I-6AGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6a bca.ems_wr_2016_12_21_s1_c6a Chart I-6BGold Led Copper Prices Too bca.ems_wr_2016_12_21_s1_c6b bca.ems_wr_2016_12_21_s1_c6b In sum, historically there have been a number of episodes when gold has led both oil and copper prices. Investors should heed the current downbeat message from gold. Chart I-7China: Dichotomies bca.ems_wr_2016_12_21_s1_c7 bca.ems_wr_2016_12_21_s1_c7 The underlying rationale could be that gold responds to monetary/liquidity conditions (gold is very sensitive to U.S. TIPS (real) yields) while oil and copper are more sensitive to growth conditions. Tightening in monetary/liquidity conditions often precedes a growth relapse. This could be the reason why gold has led oil and copper prices on several occasions in the past. 3. Dichotomies in China's industrial economy There are two types of dichotomies underway within China's industrial economy: The first is between industrial activity and industrial commodities prices. Commodities prices have surged, but the pace of manufacturing production has not improved at all (Chart I-7). There have been major discrepancies among various segments of China's industrial economy, with utilities surging and the technology sector remaining robust, and many others stagnating. The decoupling between industrial activity and industrial commodities prices can be explained by financial speculation and supply cutbacks. The former is unsustainable, while the latter is reversing as the government is gradually lifting restrictions on supply for coal and steel. The second is between the private- and state-owned parts of the industrial sector. The state-owned segment has experienced a meaningful improvement in output, while private companies in the industrial sector have seen their output growth weaken, albeit the growth rate is higher than in the SOE sector. (Chart I-7, bottom panel). As China's fiscal and credit impulses wane,1 activity in the state-owned industrial segment will relapse anew. 4. EM credit spreads diverging from EM currencies and credit fundamentals EM sovereign and corporate credit spreads (credit markets) are once again proving very resilient, despite the renewed selloff in EM currencies (Chart I-8). EM credit markets have defied deteriorating EM credit fundamentals in the past several years. Below we identify several divergences and anomalies within the EM credit space that give us confidence that EM credit markets have become detached from fundamentals, and that their risk-reward profile is poor. Chart I-8EM Credit Markets And EM Currencies:##br## A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy EM Credit Markets And EM Currencies: A Widening Dichotomy Chart I-9EM Corporate Financial Health:##br## Not Much Improvement bca.ems_wr_2016_12_21_s1_c9 bca.ems_wr_2016_12_21_s1_c9 The EM Corporate Financial Health (CFH) Indicator has stabilized, but remains at a very depressed level (Chart I-9, top panel). This amelioration is largely due to the profit margin component. The other three components have not improved (Chart I-9, second panel). The valuation model based on the EM CFH indicator shows that EM corporate spreads are far too tight (Chart I-10). Chart I-10EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive EM Corporate Bonds Are Expensive The strong performance of EM credit markets in recent years has been justified by the persistence of low bond yields in developed markets (DM). Yet the latest spike in DM bond yields has so far not caused EM credit spreads to widen. We expect U.S./DM government bond yields to rise further, and the U.S. dollar to continue to strengthen. This, along with potential broad-based declines in commodities prices, should lead to material widening in EM sovereign and corporate credit spreads in early 2017. With respect to unsustainable discrepancies, the case in point is Brazil. The country's sovereign and corporate spreads have tightened a lot this year, even though economic activity continues to shrink. The country has had numerous boom-bust cycles in the past 100 years, yet this depression is the worst on record. In fact, the nation's economic growth and public debt dynamics are worse than at any time during the past 20 years. Yet, at 300 basis points, sovereign spreads are well below the 1000-2500 basis point trading range that prevailed in the second half of 1990s and early 2000s (Chart I-11). Remarkably, the economy's pace of contraction has lately intensified (Chart I-12). This will likely worsen government revenues and lead to further widening in the fiscal deficit - making debt dynamics unsustainable. Another absurd credit market divergence is between China's sovereign CDS and Chinese offshore corporate spreads. Sovereign CDS spreads have been widening, but corporate credit spreads remain very tight (Chart I-13). Chart I-11Brazil: Dichotomy Between Sovereign ##br##Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Brazil: Dichotomy Between Sovereign Spreads And Fundamentals Chart I-12Brazil's Economy: ##br##No Improvement At All Brazil's Economy: No Improvement At All Brazil's Economy: No Improvement At All Chart I-13Chinese Sovereign CDS And ##br##Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Chinese Sovereign CDS And Off-Shore Corporate Spreads Yet there is much more risk in Chinese corporates than in government debt. The corporate sector commands record leverage of 165% of national GDP, while public debt stands at 46% of GDP. Besides, the central government in China will always have immediate access to domestic or foreign debt markets, while some corporations could lose access to financing if creditors question their creditworthiness and decide to tighten credit. There is no rational case to support the rise in sovereign CDS when corporate spreads are tame. The only feasible explanation is that investors - who are invested in Chinese corporate bonds, and are not interested in selling them - are buying sovereign CDS to tactically hedge their credit exposure. If and when market sentiment sours sufficiently, and credit spread widening is perceived durable and lasting, real money will sell corporate bonds, resulting in a major spike in corporate spreads. 5. Divergence between global late cyclicals and the U.S. dollar Another area where we detect that financial markets have lately become overly optimistic is in global late cyclicals - materials, machinery and energy stocks. Typically, the absolute share prices in these sectors correlate with the U.S. dollar exchange rate but they have lately diverged (Chart I-14). Furthermore, global machinery stocks in general, and Caterpillar's share price in particular, have lately staged significant gains, while their EPS and sales continue to plunge (Chart I-15). Notably, Caterpillar's sales have not improved, even on a rate-of-change basis. Chart I-14Global Late Cyclicals And The U.S. Dollar: ##br##Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Global Late Cyclicals And The U.S. Dollar: Unsustainable Decoupling Chart I-15Global Machinery Sales And##br## Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging Global Machinery Sales And Profits Continue Plunging EM including China capital spending in real terms is as large as the U.S. and EU capital spending combined (Chart I-16). If the EM and China capex cycle does not post a recovery, which is our baseline view, it will be hard for global late cyclical stocks to continue rallying based solely on the positive outlook for U.S. infrastructure spending and potential U.S. tax reforms. In short, global late cyclicals such as machinery, materials and energy stocks that performed quite well in 2016 are vulnerable to a major pullback as EM/Chinese capital spending disappoints on the back of credit growth deceleration. Notably, these global equity sectors have reached a major technical resistance that will likely become a ceiling for their share prices (Chart I-17). Chart I-16EM/China's Capex Is As Large As ##br##U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined EM/China's Capex Is As Large As U.S. And Euro Area Combined Chart I-17Global Late Cyclicals Are ##br##Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance Global Late Cyclicals Are Facing Technical Resistance 6. Decoupling between the South African rand and precious metals prices The South African rand's recent resilience - despite the considerable drop in precious metal prices - is unprecedented (Chart I-18, top panel). Similarly, the rand has also decoupled from the exchange rate of another major metals producer: Australia (Chart I-18, bottom panel). We cannot think of any reason why these discrepancies can or should persist. Rising global bond yields and a broadening selloff in commodities prices should hurt the rand. In fact, the trade-weighted rand is facing a major technical resistance (Chart I-19) and will likely relapse sooner than later. Chart I-18Rand, AUD And ##br##Precious Metals Rand, AUD And Precious Metals Rand, AUD And Precious Metals Chart I-19Trade-Weighted Rand Is ##br##Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance Trade-Weighted Rand Is Facing Technical Resistance We reiterate our structural short position in the rand versus the U.S. dollar, and on October 12, 2016 initiated a short ZAR / long MXN trade. Traders should consider putting on these trades. Investment Strategy Chart I-20EM Relative Equity Performance ##br##Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows EM Relative Equity Performance Is Heading To New Lows Emerging markets share prices and currencies have been doing poorly since October, despite U.S. equity shares breaking out to new highs. In fact, almost all relative outperformance has been wiped out (Chart I-20). BCA's Emerging Markets Strategy team expects further declines in EM share prices and currencies, as well as a selloff in domestic bonds and a widening of sovereign and corporate spreads. Absolute return investors should stay put, while asset allocators should maintain underweight positions in EM risk assets within respective global portfolios. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com India: Demonetization And Opportunities In Equities On November 8, India launched a demonetization program with the goal of removing the two most used banknotes - the 500 INR and 1000 INR banknotes - from circulation. Both banknotes accounted for roughly 85% of currency in circulation, which itself accounts for 13% of India's broad money supply. Moreover, almost 90%2 of retail transactions in India are cash-reliant. While around INR 13 trillion of notes (US$ 190 billion) have been deposited in the banking system as of December 10, only INR 5 trillion of new notes have been issued by the Reserve Bank of India (RBI). India is unlikely to turn cashless overnight. According to a Harvard Business Review article,3 less than 10% of Indians have ever used non-cash payment instruments. Likewise, less than 2% of Indians have used a cellular phone to receive a payment. This implies cash shortages could persist for a while and will have a significant impact on short-term economic activity. There are numerous reports that layoffs and business shutdowns have ensued in several industries, particularly in the informal economy (Chart II-1). The service sector PMI already dipped below 50 in November and the manufacturing PMI fell as well (Chart II-2). Chart II-1Very Weak Employment Outlook Very Weak Employment Outlook Very Weak Employment Outlook Chart II-2Indian PMIs Are Sinking Indian PMIs Are Sinking Indian PMIs Are Sinking Having boomed over the past year, motorcycle sales growth is now waning. Similarly, passenger and commercial vehicle sales - that have been anemic - will now dip. However, the consumption slowdown should not continue beyond the next couple of months. As more currency is supplied by the RBI, economic activity will rebound - particularly household spending. Pent-up demand will be unleashed as money circulation is restored. Nevertheless, investment expenditures are the key factors for improving productivity and, hence, as non-inflationary growth potential. Capital spending had been anemic in India well before the demonetization program was announced (Chart II-3). The reason for such lackluster investment expenditure lies in the fact that past investment projects taken on by highly leveraged Indian conglomerates have delivered poor performance. This translated into ever rising non-performing loans (NPLs) at state banks. Without debt restructuring and public bank recapitalization, a new capex cycle is unlikely in India. Consistently, credit to large industries is now contracting (Chart II-4) and foreign lending to Indian companies is declining. Chart II-3Indian Capex Is Anemic Indian Capex Is Anemic Indian Capex Is Anemic Chart II-4Banks Prefer Consumers bca.ems_wr_2016_12_21_s2_c4 bca.ems_wr_2016_12_21_s2_c4 We expect the demonetization program to hurt capital spending only mildly in the coming months, but do not expect a material bounce in investment afterward, unlike the one slated for household consumption. Indian share prices have more downside in absolute terms, as the market is still expensive and growth is slumping. Nevertheless, India will likely outperform the EM equity benchmark going forward (Chart II-5). Chart II-5Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge Indian Share Prices: A Tapering Wedge The rationale for our overweight on Indian equities within the EM stock universe is due to the nation's much better macro fundamentals relative to those in many other EM. In particular, deleveraging and NPL write-offs are more advanced, the current account deficit is small, and India will benefit from potentially lower commodities prices. Within the Indian bourse, we recommend overweighting software stocks that will benefit from a revival in advanced economies' growth and a weaker currency. Besides, Indian software stocks are not exposed to the currently weak domestic consumption cycle and in fact might benefit from the push toward digitalization in banking. Bottom Line: Indian consumption will weaken in the coming three months or so, but will rebound thereafter. The capex cycle is weak and will remain subdued. Continue overweighting the Indian bourse within an EM equity portfolio. A new equity recommendation: long Indian software stocks / short the EM overall index. Ayman Kawtharani, Research Analyst aymank@bcaresearch.com Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Report, titled "Key EM Issues Going Into 2017," dated December 14, 2016, available at ems.bcaresearch.com 2 Chakravorti, B., Mazzotta, B., Bijapurkar, R., Shukla, R., Ramesha, K., Bapat, D., &Roy, D. (2013). The cost of cash in India. Institute of Business in the Global Context, Fletcher School, Tufts University. 3 Chakravorti, B. (2016, December 14). India's Botched War on Cash. Retrieved from https://hbr.org Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Mr. X is a long-time BCA client who visits our offices towards the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: What a year it has been. The Brexit vote in the U.K. and the U.S. election result took me completely by surprise and have added to an already uncertain economic environment. A year ago, you adopted the theme of "Stuck In A Rut" to describe the economic and financial market environment and that turned out to be quite appropriate. Consistent with that rut, many issues concerning me for some time have yet to be resolved. Global economic growth has stayed mediocre, debt levels remain elevated almost everywhere, the outlook for China continues to be shrouded in fog, and stimulative monetary policies are still distorting markets. And now we face political shifts that will have major economic and financial effects. Some big changes are underway and I fear that we are more likely to head in a negative rather than positive direction. Therefore, I am very interested to learn how you see things developing. You have recommended a cautious investment stance during the past year and I was happy to go along with that given all my concerns about the economic and policy environment. While stocks have done rather better than I expected, it has all been based on flimsy foundations in my opinion. I have never been comfortable buying an asset just because prices are being supported by excessively easy money policies. The question now is whether looming changes in the policy and economic environment and in global politics will fuel further gains in risk assets or whether a significant setback is in prospect. I hope our discussion will give some clarity on this but, before talking about the future, let's quickly review what you predicted a year ago. BCA: It has indeed been a momentous year and we do seem to be at important turning points in many areas. For example, changing attitudes toward free trade and fiscal policy do have important implications for economic growth and interest rates. And this is being reinforced by cyclical economic trends as labor markets tighten in the U.S. However, it is too soon to know the extent to which political and policy uncertainties will diminish in the U.S. and Europe. You seek clarity on the investment outlook, but that will remain as challenging an objective as ever. You asked to start with a review of last year's predictions and this is always a moment of some trepidation. A year ago, our key conclusions were as follows: The current global economic malaise of slow growth and deflationary pressures reflects more than just a temporary hangover from the 2007-09 balance sheet recession. Powerful structural forces are at work, the effects of which will linger for a long time. These include an ongoing overhang of debt, the peak in globalization, adverse demographics in most major economies, monetary policy exhaustion, and low financial asset returns. Investor expectations have yet to adjust to the fact that sub-par growth and low inflation are likely to persist for many years. The Debt Supercycle is over, but weak nominal GDP growth has made it virtually impossible to reduce debt burdens. Nonetheless, a debt crisis in the advanced economies is not in prospect any time soon because low interest rates are keeping a lid on debt servicing costs. Perhaps high inflation and debt monetization will be the end-point, but that is many years away and would be preceded by a deflationary downturn. Despite ongoing exciting technological advances, the IT boom has lost its edge in terms of boosting economic growth. Even if productivity is understated, the corollary is that inflation is overstated, suggesting that central bankers will continue to face a policy dilemma. The Fed will raise interest rates by less than implied by their current projections. And the European Central Bank and Bank of Japan may expand their QE programs. Yet, monetary policy has become ineffective in boosting growth. Fiscal policy needs to play a bigger role, but it will require another recession to force a shift in political attitudes toward more stimulus. The U.S. economy will remain stuck in sub-2.5% growth in 2016, with risks to the downside. The euro zone's performance has improved recently, but 2016 growth will fall short of the IMF's 1.9% forecast. Japan's growth will continue to disappoint as it will in most other developed economies. China will continue to avoid a hard landing but growth will likely average below 6% in 2016 and beyond. Other emerging economies face a difficult environment of weak commodity prices, declining global trade. Those with excessive foreign-currency debt face additional pressures with weak exchange rates preventing an easing in monetary policy. Bonds offer poor long-term returns from current yields, but sovereign bonds in the major developed countries offer a hedge against downside macro risks and we recommend benchmark weightings. The fundamental backdrop to corporate and EM bonds remain bearish and spreads have not yet reached a level that discounts all of the risks. A buying opportunity in high-yield securities could emerge in the coming year but, for the moment, stay underweight spread product. We have turned more cautious on equities given a deterioration in the earnings outlook and in some technical indicators. No more than benchmark weighting is warranted and we would not argue against a modest underweight. The typical warning signs of a bear market are not in place but risks have risen. The U.S. equity market is expected to underperform that of Europe and Japan. Continue to stay away from emerging equities and commodity-oriented bourses. We continue to favor a defensive sector stance, favoring consumer staples and health care over cyclical sectors such as materials, energy and industrials. The bear market in commodities is not over. The sharp drop in oil prices will eventually restore balance to that market by undermining non-OPEC production and supporting demand, but this could take until the third quarter of 2016. The oil price is expected to average around $50 a barrel for the 2016-2018 period. The strong dollar and deflationary environment create a headwind for gold, offsetting the benefits of negative real interest rates. But modest positions are a hedge against a spike in risk aversion. The dollar is likely to gain further against emerging and commodity-oriented currencies. But the upside against the euro and the yen will be limited given the potential for disappointments about the U.S. economy. As was the case a year ago, geopolitical risks are concentrated in the emerging world. Meanwhile, the new world order of multipolarity and an increased incidence of military conflicts is not yet priced into markets. We do not expect the U.S. elections to have any major adverse impact on financial markets. On the economic front, we suggested that economic risks would stay tilted to the downside and this turned out to be correct with global growth, once again, falling short of expectations. A year ago, the IMF forecast global growth of 3.6% in 2016 and this has since been downgraded to 3.1%, the weakest number since the recovery began (Table 1). The U.S. economy fell particularly short of expectations (1.6% versus 2.8%). The downgrading of growth forecasts continued a pattern that has been in place since the end of the 2007-09 downturn (Chart 1). We cannot recall any other time when economic forecasts have been so wrong for such an extended period. The two big disappointments regarding growth have been the lackluster performance of global trade and the ongoing reluctance of businesses to expand capital spending. Not surprisingly, inflation remained low, as we expected. Table 1IMF Economic Forecasts January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 1Persistent Growth Downgrades Persistent Growth Downgrades Persistent Growth Downgrades Given the disappointing economic performance, we were correct in predicting that the Federal Reserve would not raise interest rates by as much as their earlier forecasts implied. When we met last year, the Fed had just raised the funds rate from 0.25% to 0.5% and the median expectation of FOMC members was that it would reach 1.4% by end-2016 and 2.4% by end-2017. As we now know, the Fed is now targeting a funds rate of 0.5% to 0.75% and median FOMC projections are for 1.4% by end-2017 (Chart 2). Meanwhile, as we expected, both the ECB and Bank of Japan expanded their quantitative easing programs in an attempt to stimulate growth. Chart 2Changes In the Fed's Expectations Changes in the Fed's Expectations Changes in the Fed's Expectations Our concerns about the poor prospects for emerging economies were validated. The median 2016 growth rate for 152 emerging economies tracked by the IMF was only 3.1%, a notch below the 2015 pace and, barring 2009, the weakest number since the late 1990s Asia crisis. The official Chinese data overstate growth, but there was no hard landing, as many commentators continued to predict. Turning to the markets, there was considerable volatility during the year (Table 2). For example, U.S. bond yields fell sharply during the first half then rebounded strongly towards the end of the year, leaving them modestly higher over the 12 months. Yields in Europe and Japan followed a similar pattern - falling in the first half and then rebounding, but the level continued to be held down by central bank purchases. Japanese bonds outperformed in common currency terms and we had not expected that to occur, although there was a huge difference between the first and second halves of the year, with the yen unwinding its earlier strength in the closing months of the year. Table 2Market Performance January 2017 - Shifting Regimes January 2017 - Shifting Regimes Our caution toward spread product - corporate and EM bonds - turned out to have been unjustified. Despite worsening fundamentals, most notably rising leverage, the search for yield remained a powerful force keeping spreads down and delivering solid returns for these securities. Spreads are back to very low levels, warning that further gains will be hard to achieve. Equity markets made moderate net gains over the course of the year, but it was a roller coaster journey. A nasty early-year downturn was followed by a rebound, an extended trading range and a late-year rally. While the all-country index delivered a total return of around 8% for the year in common currency terms, almost one-third of that was accounted for by the dividend yield. The price index rose by less than 6% in common currency and 7% in local currency. However, our recommendation to overweight Europe and Japan did not pan out. Once again, the U.S. was an outperformer with the financially-heavy European index weighed down by ongoing concerns about banks, and Japan held back by its lackluster economic performance. Oil prices moved much as we expected, with Brent averaging around $45 over the year. At this time in 2015, prices were below $40, but we argued that a gradual rebalancing would bring prices back into a $45-$60 range in the second half of 2016. We did not expect much of a rise in the gold price and it increased less than 7% over the year. However, we did not try to dissuade you from owning some gold given your long-standing attraction to the asset, subject to keeping the allocation to 5% or less of your portfolio. Industrial commodity prices have been much stronger than we predicted, benefiting from a weak dollar in the first half of the year and continued buoyant demand from China. Finally, the dollar moved up as we had predicted, with the gains concentrated in the second half of the year. The yen's first-half strength was a surprise, but this was largely unwound in the second half as U.S. bond yields climbed. Mr. X: Notably absent has been any mention of the two political shocks of 2016. BCA: We did tell you that the U.K. referendum on Brexit was the key risk facing Europe in 2016 and that the polls were too close to have a strong view. Yet, we did not anticipate that the vote to leave the EU would pass. And when you pushed us a year ago to pick a winner for the U.S. election we wrongly went with Clinton. Our Global Strategist, Peter Berezin, was on record predicting a Trump victory as long ago as September 2015. But it seemed such an outrageous idea that our consensus view stuck to the safer option of Clinton. Interestingly, during our discussion at the end of 2014, we did note that a retreat from globalization was one of the risks in the outlook and we re-emphasized that point last year, pointing to rising populist pressures. However, we underestimated the ability of Brexit campaigners and Donald Trump to capitalize on the anger of disaffected voters. Trade and immigration policies are not the only areas where policy appears to be at a turning point. For example, fiscal conservatism is giving way to stimulus in the U.S. and several other countries, inflation and interest rates are headed higher, at least temporarily, and 2017-2018 should finally arrest the multi-year spectacle of downgrades to global growth projections. Yet, markets have a tendency to overreact and that currently seems to be the case when it comes to discounting prospective changes in the economic environment for the coming year. Turning Points And Regime Shifts: How Much Will Really Change? Mr. X: The U.S. election result and Brexit vote obviously were seismic events with potentially major policy implications. But there seem to be more questions than answers in terms of how policies actually will evolve over the next few years and the extent to which they will be good or bad for growth. The markets are assuming that economic growth will get a big boost from changes in fiscal policy. Do you agree with that view? Chart 3Fiscal Austerity Ended In 2015 Fiscal Austerity Ended in 2015 Fiscal Austerity Ended in 2015 BCA: We need to begin by putting things into perspective. Fiscal austerity came to an end pretty much everywhere a couple of years ago. Data from the IMF show that the peak years for fiscal austerity in the advanced economies were 2011-2013, and the budget cutbacks in those years did not even fully offset the massive stimulus that occurred during the downturn in 2008-10. Since 2013, the fiscal drag on GDP has gradually diminished and policy shifts are estimated to have added to GDP in the U.S., euro area and Japan in 2016 (Chart 3). Nonetheless, with economic growth falling short of expectations and easy money losing its effectiveness, there have been widespread calls for fiscal policy to do more. President-elect Trump has made major tax cuts and increased spending an important part of his policy platform, so the issue is the extent to which he follows through on his plans. Inevitably, there are some challenges: The plan to boost U.S. infrastructure spending is welcome, but the intention seems to be to emphasize private/public partnerships rather than federally-funded projects. Setting up such agreements could take time. Meanwhile, although there is great scope to improve the infrastructure, it is far less clear that a number of "shovel-ready" projects are simply waiting for finance. The bottom line is that increased infrastructure spending is more a story for 2018 and beyond, rather than 2017. And the same also is true for defense, where it may take time to put new programs in place. Turning to the proposed tax cuts, history shows there can be a huge difference between election promises and what eventually is legislated. According to the Tax Policy Center, Trump's plans would add more than $6 trillion to outstanding federal debt over the next decade and more than $20 trillion over 20 years. And that excludes the impact of higher interest costs on the debt. Even if one were to take an optimistic view of a revenue boost from faster economic growth, there would still be a large increase in federal deficits and thus debt levels and this could be problematic for many Republicans. It seems inevitable that the tax plans will be watered down. An additional issue is the distributional impact of the proposed tax cuts. Eliminating the estate tax and proposed changes to marginal rates would disproportionally help the rich. Estimates show the lowest and second lowest quintile earners would receive a tax cut of less than 1% of income, compared to 6.5% for the top 1%. Given that the marginal propensity to consume is much higher for those with low incomes, this would dilute the economic impact. Moreover, there is again the issue of timing - the usual bargaining process means that tax changes will impact growth more in 2018 than 2017. Mr. X: You did not mention the plan to cut the corporate tax rate from 35% to 15%. Surely that will be very good for growth? BCA: According to the OECD, the U.S. has a marginal corporate tax rate of 38.9% (including state and local corporate taxes), making it by far the highest in the industrialized world. The median rate for 34 other OECD economies is 24.6%. However, the actual rate that U.S. companies pay after all the various deductions is not so high. According to national accounts data, the effective tax rate for domestic non-financial companies averaged 25% in the four quarters ended 2016 Q2. Data from the IRS show an average rate of around 21% for all corporations. And for those companies with significant overseas operations, the rate is lower. There certainly is a good case for lowering the marginal rate and simplifying the system by removing deductions and closing loopholes. But special interests always make such reforms a tough battle. Even so, there is widespread support to reduce corporate taxes so some moves are inevitable and this should be good for profits and, hopefully, capital spending. The bottom line is that you should not expect a major direct boost to growth in 2017 from changes in U.S. fiscal policy. The impact will be greater in 2018, perhaps adding between 0.5% and 1% to growth. However, don't forget that there could be an offset from any moves to erect trade barriers. Mr. X: What about fiscal developments in other countries? Chart 4Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare BCA: The Japanese government has boosted government spending again, but the IMF estimates that fiscal changes added only 0.3% to GDP in 2016, with an even smaller impact expected for 2017. And a renewed tightening is assumed to occur in 2018 as postponed efforts to reign in the deficit take hold. Of course, a sales tax hike could be delayed yet again if the economy continues to disappoint. But, with an overall budget deficit of 5% of GDP and gross government debt of more than 250% of GDP, Japan's room for additional stimulus is limited (Chart 4). Although the Bank of Japan owns around 40% of outstanding government debt, the authorities cannot openly admit that this will be written off. While more fiscal moves are possible in Japan, it is doubtful they would significantly alter the growth picture. The euro area peripheral countries have moved past the drastic fiscal austerity that was imposed on them a few years ago. Nevertheless, there is not much room for maneuver with regard to adopting an overtly reflationary stance. It is one thing to turn a blind eye to the fiscal constraints of the EU's Growth and Stability Pact and quite another to move aggressively in the opposite direction. Most of the region's economies have government debt-to-GDP ratios far above the 60% required under the Maastricht Treaty. In sum, a move to fiscal stimulus is not in the cards for the euro area. The U.K. is set to adopt more reflationary policies following the Brexit vote, but this would at most offset private sector retrenchment. In conclusion, looming shifts in fiscal policy will be positive for global growth in the next couple of years, but are unlikely to be game changers. Of course, fiscal policy is not the only thing that might change - especially in the U.S. There also are hopes that an easing in regulatory burdens will be very positive for growth. Mr. X: I am glad you raised that point. I have many business contacts in the U.S. who complain bitterly about regulatory overload and they are desperate for some relief. BCA: There certainly is a need for action on this front as regulatory burdens have increased dramatically in the U.S. in recent years. The monthly survey of small businesses carried out by the National Federation of Independent Business shows that rising health care costs, excessive regulation and income taxes are regarded as the top three problems. According to the Heritage Foundation, new regulations from the Obama administration have added more than $100 billion annually to costs for businesses and individuals since 2009. While the U.S. has a good score in the World Bank's Ease of Doing Business Index (8th best out of 190 countries), it is ranked 51st in the component that measures how easy it is to start a business, which puts it behind countries such as Jamaica, Mongolia and Albania. So we can hope that the new administration will act to improve that situation. We can be confident that there will be major reductions in regulations relating to energy and the environment. Other areas may be more challenging. It did not take long for Trump to back away from his pledge to repeal the Affordable Care Act (ACA) in its entirety. Returning to the previous status quo will not be politically acceptable and devising an alternative plan is no small task. The end result still will be a major modification of the ACA and this should ease health care costs for small businesses. With regard to the financial sector, it is no surprise that the pendulum swung massively toward increased regulation given the pre-crisis credit excesses. The economic and financial downturn of 2008-09 left a legacy of strong populist resentment of Wall Street and the banks, so a return to the previous laissez-faire model is not in the cards. At one stage, Trump indicated that he was in favor of replacing Dodd-Frank with a Glass-Steagall system, requiring commercial banks to divest themselves of their securities' businesses. The large banks would employ legions of lobbyists to prevent a new Glass-Steagall Act. The end result will be some watering down of the Dodd-Frank regulatory requirements, but again, a return to the pre-crisis status quo is not in the cards. The Retreat From Globalization Mr. X: You have challenged the consensus view that fiscal stimulus will deliver a meaningful boost to the global economy over the coming year. Having downplayed the main reason to be more positive about near-term growth, let's turn to global trade, the issue that causes most nervousness about the outlook. The Brexit vote in the U.K. was at least partly a vote against globalization and we are all familiar with Trump's threat to dramatically raise tariffs on imports from China and Mexico. What are the odds of an all-out trade war? BCA: At the risk of sounding complacent, we would give low odds to this. Again, there will be a large difference between campaign promises and actual outcomes. Let's start with China where the U.S. trade deficit ran at a $370 billion annual rate in the first nine months of 2016, up from around $230 billion a decade before (Chart 5). China now accounts for half of the total U.S. trade deficit compared to a 25% share a decade ago. On the face of it, the U.S. looks to have a good bargaining position, but the relationship is not one-sided. China has been a major financer of U.S. deficits and is the third largest importer of U.S. goods, after Canada and Mexico. Meanwhile, U.S. consumers have benefited enormously from the relative cheapness of imported Chinese goods. As for the threat to label China as a currency manipulator, it is interesting to note that its real effective exchange rate has increased by almost 20% since the mid-2000s, and since then, the country's current account surplus as a share of GDP has fallen from almost 10% to around 2.5% (Chart 6). The renminbi has fallen by around 10% against the dollar since mid-2015, but that has been due to the latter currency's broad-based rally, not Chinese manipulation. The fact that China's foreign-exchange reserves have declined in the past couple of years indicates that the country has intervened to hold its currency up, not push it down. Chart 5China-U.S. Trade: ##br##A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? Chart 6China Has Not Manipulated ##br##Its Currency Downward China Has Not Manipulated Its Currency Downward China Has Not Manipulated Its Currency Downward Of course, facts may not be the guiding factor when it comes to U.S. trade policy, and we can expect some tough talk from the U.S. This could well involve the imposition of some tariffs and perhaps some concessions from China in the form of increased imports from the U.S. Overall, we are hopeful that rational behavior will prevail and that an all-out trade war will not occur. Mr. X: I also would like to believe that, but nothing in the U.S. election process made me think that rationality is guaranteed. BCA: Of course it is not guaranteed, and we will have to monitor the situation carefully. We should also talk about Mexico - the other main target of Trump's attacks. The U.S. trade deficit with Mexico accounts for less than 10% of the total U.S. deficit and has changed little in the past decade. More than 80% of the U.S. trade deficit with Mexico is related to vehicles and Trump clearly will put pressure on U.S. companies to move production back over the border. Within a week of the election, Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. And Trump subsequently browbeat Carrier Corporation into cancelling some job transfers across the border. If other companies follow suit, it could forestall major changes to NAFTA. Ironically, the Mexican peso has plunged by 10% against the dollar since the election, boosting the competitiveness of Mexico and offsetting some of the impact of any tariff increase. Not all the news on global trade is bad. After seven years of negotiation, the EU and Canada agreed a free trade deal. This has bolstered the U.K.'s hopes that it can arrange new trade deals after it leaves the EU. However, this will not be easy given the sheer number of bi-country deals that will be required. The time it took to negotiate the EU-Canada deal should be a salutary warning given that there was no particular animosity toward Canada within the EU. That will not be the case when it comes to negotiations with the U.K. Mr. X: Let's try and pull all this together. You have downplayed the risk of an all-out trade war and I hope that you are right. But do you expect trade developments to be a drag on economic activity, perhaps offsetting any positive impact from fiscal stimulus? Chart 7Only Modest Growth In World Trade Only Modest Growth In World Trade Only Modest Growth In World Trade BCA: You might think that trade is a zero-sum game for the global economy because one country's exports simply are another's imports. But expanding trade does confer net benefits to growth in terms of allowing a more efficient use of resources and boosting related activities such as transportation and wholesaling. Thus, the rapid expansion in trade after the fall of the Berlin Wall was very good for the global economy. Trade ceased to be a net contributor to world growth several years ago, highlighted by the fact that global export volumes have been growing at a slower pace than GDP (Chart 7). This has not been due to trade barriers but is more a reflection of China's shift away from less import-intensive growth. A return to import-intensive growth in China is not likely, and technological innovations such as 3-D printing could further undermine trade. If we also add the chances of some increase in protectionist barriers then it is reasonable to assume that trends in global trade are more likely to hinder growth than boost it over the coming couple of years. It really is too soon to make hard and fast predictions about this topic as we need to see exactly what actions the new U.S. administration will take. Nevertheless, we lean toward the optimistic side, and assume the economic impact of fiscal reflation will exceed any drag from trade restrictions. Again, this is a more of a story for 2018 than 2017. What we can say with some confidence is that the previous laissez-faire approach to globalization is no longer politically acceptable. Policymakers are being forced to respond to voter perceptions that the costs of free trade outweigh the benefits and that points to a more interventionist approach. This can take the form of overt protectionism or attempts to influence corporate behavior along the lines of president-elect Trump's exhortations to U.S. companies. Mr. X: What about the issue of immigration? Both the Brexit vote and the U.S. election result partly reflected voter rebellion against unrestrained immigration. And we know that nationalist sentiments also are rising in a number of other European countries. How big a problem is this? Chart 8Immigration's Rising Contribution ##br##To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth BCA: In normal circumstances, immigration represents a win-win situation for all parties. The vast majority of immigrants are prepared to work hard to improve their economic position and in many cases take jobs that residents are not willing to accept. This all works well in a fast-growing economy, but difficulties arise when growth is weak: competition for jobs increases, especially among the unskilled, and the result is downward pressure on wages. The irony is that the U.S. and U.K. labor markets have tightened to the point where wage growth is accelerating. However, this all happened too late to affect the opinions of those who voted for tighter controls over immigration. There is an even more important issue from a big-picture perspective. As you know, an economy's potential growth rate comes from two sources: the growth in the labor force and productivity. According to the Census Bureau, U.S. population growth will average 0.8% a year over the next decade, slowing to 0.6% a year over the subsequent ten years. But more than half of this growth is assumed to come from net migration. Excluding net migration, population growth is predicted to slow to a mere 0.1% a year by the end of the 2030s (Chart 8). Thus, major curbs on immigration would directly lower potential GDP by a significant amount. In Europe, the demographic situation is even more precarious because birth rates are far below replacement levels. Europe desperately needs immigration to achieve even modest population increases. However, the migrant crisis is causing a backlash against cross-border population flows, again with negative implications for long-run economic growth. Even ignoring humanitarian considerations, major curbs on immigration would not be a good idea. Labor shortages would quickly become apparent in a number of industries. Some may welcome the resulting rise in wages, but the resulting pressure on inflation also would have adverse effects. So this is another area of policy that we will have to keep a close eye on. Inflation And Interest Rates Chart 9A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture Mr. X: I am glad that you mentioned inflation. There are good reasons to think that an important inflection point in inflation has been reached. And bond investors seem to agree, judging by the recent spike in yields. If true, this would indeed represent a significant regime shift because falling inflation and bond yields have been such a dominant trend for several decades. Do you agree that the era of disinflation is over, along with the secular bull market in bonds? BCA: Inflation and bond yields in the U.S. have passed a cyclical turning point, but this does not mean that a sustained major uptrend is imminent. Let's start with inflation. A good portion of the rise in the underlying U.S. inflation rate has been due to a rise in housing rental costs, and, more recently, a spike in medical care costs. Neither of these trends should last: changes to the ACA should arrest the rising cost of medical care while increased housing construction will cap the rise in rent inflation. The rental vacancy rate looks to be stabilizing while rent inflation is rolling over. Meanwhile, the inflation rate for core goods has held at a low level and likely will be pushed lower as a result of the dollar's ascent (Chart 9). Of course, this all assumes that we do not end up with sharply higher import tariffs and a trade war. The main reason to expect a further near-term rise in underlying U.S. inflation is the tightening labor market and resulting firming in wage growth. With the economy likely to grow above a 2% pace in 2017, the labor market should continue to tighten, pushing wage inflation higher. So the core PCE inflation rate has a good chance of hitting the Federal Reserve's 2% target before the year is out. And bond investors have responded accordingly, with one-year inflation expectations moving to their highest level since mid-2014, when oil prices were above $110 a barrel (Chart 10). Long-run inflation expectations also have spiked since the U.S. election, perhaps reflecting the risk of higher import tariffs and the risks of political interference with the Fed. When it comes to other developed economies, with the exception of the U.K., there is less reason to expect underlying inflation to accelerate much over the next year. Sluggish growth in the euro area and Japan will continue to keep a lid on corporate pricing power and the markets seem to agree, judging by the still-modest level of one-year and long-run inflation expectations (Chart 11). The U.K. will see some pickup in inflation in response to the sharp drop in sterling and this shows up in a marked rise in market expectations. Chart 10U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked Chart 11Inflation Expectations In Europe And Japan Inflation Expectations In Europe and Japan Inflation Expectations In Europe and Japan Turning back to the U.S., a key question regarding the longer-term inflation outlook is whether the supply side of the economy improves. If the new administration succeeds in boosting demand but there is no corresponding expansion in the supply capacity of the economy, then the result will be higher inflation. That will lead to continued monetary tightening and, as in past cycles, an eventual recession. But, if businesses respond to a demand boost with a marked increase in capital spending then the result hopefully would be faster productivity growth and a much more muted inflation response. Thus, it will be critical to monitor trends in business confidence and capital spending for signs that animal spirits are returning. Mr. X: So you don't think the Fed will be tempted to run a "hot" economy with inflation above the 2% target? BCA: That might have been a possibility if there was no prospect of fiscal stimulus, leaving all the economic risks on the downside. With easier fiscal policy on the horizon, the Fed can stick to a more orthodox policy approach. In other words, if the economy strengthens to the point where inflation appears to be headed sustainably above 2%, then the Fed will respond by raising rates. Unlike the situation a year ago, we do not have a strong disagreement with the Fed's rate hike expectations for the next couple of years. Nothing would please the Fed more than to return to a familiar world where the economy is behaving in a normal cyclical fashion, allowing a move away from unusually low interest rates. At the same time, the Fed believes, as we do, that the equilibrium real interest rate is far below historical levels and may be close to zero. Thus, interest rates may not need to rise that much to cool down the economy and ease inflationary pressures. This is especially true if the dollar continued to rise along with Fed tightening. Another potentially important issue is that the composition of the Federal Reserve Board could change dramatically in the next few years. There currently are two unfilled seats on the Board and it is very likely that both Janet Yellen and Stanley Fischer will leave in 2018 when their respective terms as Chair and Vice-Chair end (February 3 for Yellen and June 12 for Fischer). That means the incoming administration will be able to appoint four new Board members, and possibly more if other incumbents step down. Judging by the views of Trump's current economic advisers, he seems likely to choose people with a conservative approach to monetary policy. In sum, we do not rule out a rise in U.S. inflation to as much as 3%, but it would be a very short-lived blip. Steady Fed tightening would cap the rise, even at the cost of a renewed recession. Indeed, a recession would be quite likely because central banks typically overshoot on the side of restraint when trying to counter a late-cycle rise in inflation. Mr. X: I am more bearish than you on the inflation outlook. Central banks have been running what I regard as irresponsible policies for the past few years and we now also face some irresponsible fiscal policies in the U.S. That looks like a horrendously inflationary mix to me although I suppose inflation pressures would ease in the next recession. We can return to that possibility later when we discuss the economy in more detail. Where do you see U.S. short rates peaking in the current cycle and what does this mean for your view on long-term interest rates? To repeat my earlier question: is the secular bond bull market over? BCA: During the past 30 years, the fed funds rate tended to peak close to the level of nominal GDP growth (Chart 12). That would imply a fed funds rate of over 5% in the current cycle, assuming peak real GDP growth of around 3% and 2-3% inflation. However, that ignores the fact that debt burdens are higher than in the past and structural headwinds to growth are greater. Thus, the peak funds rate is likely to be well below 5%, perhaps not much above 3%. Chart 12The Fed Funds Rate And The Economic Cycle The Fed Funds Rate and the Economic Cycle The Fed Funds Rate and the Economic Cycle With regard to your question about the secular bull market in bonds, we believe it has ended, but the bottoming process likely will be protracted. We obviously are in the midst of a cyclical uptrend in U.S. yields that could last a couple of years. The combination of a modestly stronger economy, easier fiscal stance and monetary tightening are all consistent with rising bond yields. Although yields moved a lot in the second half of 2016, the level is still not especially high, so there is further upside. It would not be a surprise to see the 10-year Treasury yield reach 3% by this time next year. However, there could be a last-gasp renewed decline in yields at some point in the next few years. If the U.S. economy heads back into recession with the fed funds rate peaking at say 3.5%, then it is quite possible that long-term bond yields would revisit their 2016 lows - around 1.4% on the 10-year Treasury. There are no signs of recession at the moment, but a lot can change in the next three years. In any event, you should not be overly concerned with the secular outlook at this point. The cyclical outlook for yields is bearish and there should be plenty of advance notice if it is appropriate to switch direction. Update On The Debt Supercycle Mr. X: I would like to return to the issue of the Debt Supercycle - one of my favorite topics. You know that I have long regarded excessive debt levels as the biggest threat to economic and financial stability and nothing has occurred to ease my concerns. In the past, you noted that financial repression - keeping interest rates at very low levels - would be the policy response if faster economic growth could not achieve a reduction in debt burdens. But the recent rise in bond yields warns that governments cannot always control interest rate moves. Few people seem to worry anymore about high debt levels and I find that to be another reason for concern. BCA: You are correct that there has been very little progress in reducing debt burdens around the world. As we have noted in the past, it is extremely difficult for governments and the private sector to lower debt when economic activity and thus incomes are growing slowly. Debt-to-GDP ratios are at or close to all-time highs in virtually every region, even though debt growth itself has slowed (Chart 13A, Chart 13B). Chart 13ADebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High Chart 13BDebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High As a reminder, our End-of-Debt Supercycle thesis never meant that debt-to-GDP ratios would quickly decline. It reflected our belief that lenders and private sector borrowers had ended their love affair with debt and that we could no longer assume that strong credit growth would be a force boosting economic activity. And our view has not altered, even though government borrowing may show some acceleration. Chart 14The Credit Channel Is Impaired The Credit Channel Is Impaired The Credit Channel Is Impaired The failure of exceptionally low interest rates to trigger a vigorous rebound in private sector credit demand is consistent with our view. In the post-Debt Supercycle world, monetary policy has lost effectiveness because the credit channel - the key pillar of the monetary transmission process - is blocked. The drop in money multipliers and in the velocity of circulation is a stark reminder of the weakened money-credit-growth linkage (Chart 14). You always want to know what the end-point of higher debt levels will be, and we always give you a hedged answer. Nothing has changed on that front! A period of higher inflation may help bring down debt ratios for a while, but not to levels that would ease your concerns. This means that financial repression will be the fallback plan should markets rebel against debt levels. For the moment, there is still no problem because interest rates are still low and this is keeping debt-servicing costs at very low levels. If interest rates are rising simply because economic activity is strengthening, then that is not a serious concern. The danger time would be if rates were to rise while growth and inflation were weak. At that point, central banks would move aggressively to reduce market pressures with massive asset purchases. The ultimate end-point for dealing with excessive debt probably will be significantly higher inflation. But that is some time away. Central banks would not likely embrace a major sustained rise in inflation before we first suffered another serious deflationary downturn. At that point, attitudes toward inflation could change dramatically and a new generation of central bankers would probably be in charge with a very different view of the relative economic risks of inflation and deflation. However, it is premature to worry about a major sustained inflation rise if we must first go through a deflationary downturn. Mr. X: Perhaps you are right, but I won't stop worrying about debt. The buildup in debt was decades in the making and I am convinced that the consequences will extend beyond a few years of subdued economic growth. And central bank efforts to dampen the economic symptoms with unusually low interest rates have just created another set of problems in the form of distorted asset prices and an associated misallocation of capital. BCA: We agree that there may be a very unhappy ending to the debt excesses, but timing is everything. It has been wrong to bet against central banks during the past seven years and that will continue to be the case for a while longer. We will do our best to give you plenty of warning when we see signs that things are changing for the worse. Mr. X: I will hold you to that. Meanwhile, you talked earlier about the possibility of another recession in the U.S. Let's use that as a starting point to talk about the economic outlook in more detail. It seems strange to talk about the possibility of a recession in the U.S. when interest rates are still so low and we are about to get more fiscal stimulus. The Economic Outlook BCA: We do not expect a recession in the next year or two, absent some new major negative shock. But by the time we get to 2019, the recovery will be ten years old and normal late-cycle pressures should be increasingly apparent. The labor market already is quite tight, with wages growing at their fastest pace in eight years, according to the Atlanta Fed's wage tracker (Chart 15). Historically, most recessions were triggered by tight monetary policy with a flat or inverted yield curve being a reliable indicator (Chart 16). Obviously, that is extremely hard to achieve when short-term rates are at extremely low levels. However, if the Fed raises the funds rate to around 3% by the end of 2019, as it currently predicts, then it will be quite possible to again have a flat or inverted curve during that year. Chart 15U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend Chart 16No Sign Of A U.S. Recession No Sign Of A U.S. Recession No Sign Of A U.S. Recession The recent environment of modest growth has kept inflation low and forced the Fed to maintain a highly accommodative stance. As spare capacity is absorbed, the Fed will be forced to tighten, raising the odds of a policy overshoot. And this is all without taking account of the potential threat of a trade war. Mr. X: I have never believed that the business cycle has been abolished so it would not surprise me at all to have a U.S. recession in the next few years, but the timing is critical to getting the markets right. What will determine the timing of the next economic downturn? BCA: As we mentioned earlier, the key to stretching out the cycle will be improving the supply side of the economy, thereby suppressing the cyclical pressures on inflation. That means getting productivity growth up which, in turn will depend on a combination of increased capital spending, global competition and technological innovations. Chart 17Companies Still ##br##Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Thus far, there is no indication that U.S. companies are increasing their investment plans: the trend in capital goods orders remains very lackluster (Chart 17). Nonetheless, we have yet to see post-election data. The optimistic view is that the prospect of lower corporate taxes, reduced regulation and a repatriation of overseas earnings will all combine to revive the corporate sector's animal spirits and thus their willingness to invest. Only time will tell. The key point is that it is too soon for you to worry about a recession in the U.S. and for the next year or two, there is a good chance that near-term economic forecasts will be revised up rather than down. That will mark an important reversal of the experience of the past seven years when the economy persistently fell short of expectations. Mr. X: It would be indeed be a welcome change to have some positive rather than negative surprises on the economic front, but I remain somewhat skeptical. I suppose I can see some reasons to be more optimistic about the U.S., but the picture in most other countries seems as bleak as ever. The outlook for the U.K. has worsened following the Brexit vote, the euro area and Japan cannot seem to break out of a low-growth trap and China continues to skirt the edge of a precipice. BCA: The global economy still has lots of problems, and we are a long way from boom-like conditions. The IMF predicts that 2017 growth in the euro area and China will be below the 2016 level, and forecasts for the U.K. have been revised down sharply since the Brexit vote. On a more positive note, the firming in commodity prices should help some previously hard-hit emerging economies. Overall global growth may not pick up much over the coming year, but it would be a significant change for the better if we finally stop the cycle of endless forecast downgrades. Mr. X: Let's talk a bit more about the U.K. I know that it is too early to make strong predictions about the implications of Brexit, but where do you stand in terms of how damaging it will be? I am not convinced it will be that bad because I sympathize with the view that EU bureaucracy is a big drag on growth, and exiting the EU may force the U.K. government to pursue supply-side policies that ultimately will be very good for growth. BCA: The Brexit vote does not spell disaster for the U.K., but adds to downside risks at a time when the global economy is far from buoyant. The EU is not likely to cut a sweet deal for the U.K. To prevent copycat departures, the EU will demonstrate that exit comes with a clear cost. Perhaps, the U.K. can renegotiate new trade deals that do not leave it significantly worse off. But this will take time and, in the interlude, many businesses will put their plans on hold until new arrangements are made. Meanwhile, the financial sector - a big engine of growth in the past - could be adversely affected by a move of business away from London. Chart 18The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem Of course, the government will not simply stand on the sidelines, and it has already announced increased infrastructure spending that will fill some of the hole created by weaker business capital spending. And the post-vote drop in sterling has provided a boost to U.K. competitiveness. Nevertheless, it seems inevitable that there will be a hit to growth over the next couple of years. The optimistic view is that the U.K. will use the opportunity of its EU departure to launch a raft of supply-side reforms and tax cuts with the aim of creating a much more dynamic economy that will be very attractive to overseas investors. Some have made the comparison with Singapore. This seems a bit of a stretch. In contrast to the pre-vote rhetoric, EU membership did not turn the U.K. into a highly-regulated economy. For example, the U.K. already is in 7th place out of 190 countries in the World Bank's Ease Doing Business Index and one of the least regulated developed economies according to the OECD. Thus, the scope to boost growth by sweeping away regulations probably is limited. At the same time, the U.K.'s ability to engage in major fiscal stimulus via tax cuts or increased spending is limited by the country's large balance-of-payments deficit and the poor state of its government finances (Chart 18). Overall, the U.K. should be able to avoid a major downturn in the next couple of years, but we don't disagree with the OECD's latest forecasts that growth will slow to round 1% in 2017 and 2018 after 2% in 2016. And that implies the risks of one or two quarters of negative growth within that period. Mr. X: I am not a fan of the EU so am inclined to think that the U.K. will do better than the consensus believes. But, I am less confident about the rest of Europe. Euro area banks are in a mess, weighed down by inadequate capital, a poor return on assets, an overhang of bad loans in Italy and elsewhere, and little prospect of much revival in credit demand. At the same time, the political situation looks fragile with voters just as disenchanted with the establishment status quo as were the ones in the U.K. and U.S. Against this background, I can't see why any companies would want to increase their capital spending in the region. Chart 19Euro Area Optimism Improves Euro Area Optimism Improves Euro Area Optimism Improves BCA: We agree that euro area growth is unlikely to accelerate much from here. The structural problems of poor demographics, a weak banking system and constrained fiscal policy represent major headwinds for growth. And the political uncertainties related to elections in a number of countries in the coming year give consumers and companies good reason to stay cautious. Yet, we should note that the latest data show a modest improvement in the business climate index, breaking slightly above the past year's trading range (Chart 19). There are some positive developments to consider. The nomination of François Fillon as the conservative candidate in France's Presidential election to be held on April 2017 is very significant. We expect him to beat Marine Le Pen and this means France will have a leader who believes in free markets and deregulation - a marked change from previous statist policies. This truly could represent a major regime shift for that country. Meanwhile, the ECB has confirmed that it will continue its QE program through 2017, albeit at a slightly reduced pace. This has costs in terms of market distortions, but will help put a floor under growth. Mr. X: You noted the fragile state of the region's banks. How do you see that playing out? BCA: Euro area banks have more than €1 trillion of non-performing loans (NPLs) and have provisioned for only about half of that amount. Nevertheless, most countries' banking sectors have enough equity capital to adequately absorb losses from these un-provisioned NPLs. On the other hand, the high level of NPLs is a protracted drag on profitability and thereby increases the banks' cost of capital. The shortage of capital constrains new lending. The biggest concern is Italy, which we estimate needs to recapitalize its banks by close to €100 billion. Complicating matters is that the EU rules on state aid for banks changed at the start of 2016. Now, a government bailout can happen only after a first-loss 'bail-in' of the bank's equity and bond holders. So if an undercapitalized bank cannot raise the necessary funds privately in the markets, there is a danger that its investors could suffer heavy losses before the government is allowed to step in. But once investors have been bailed-in, the authorities will do "whatever it takes" to prevent banking problems turning into a systemic crisis that threaten to push the economy into another recession. Mr. X: I would now like to shift our attention to Asia, most notably Japan and China. Starting with Japan, that economy seems to perfectly describe the world of secular stagnation. Despite two decades of short-term interest rates near zero and major fiscal stimulus, real growth has struggled to get above 1% and deflation rather than inflation has been the norm. Prime Minister Shinzo Abe has made a big deal about his "three arrow" approach to getting the economy going again, but I don't see much evidence that it is working. Is there any prospect of breaking out of secular stagnation? BCA: Probably not. A big part of Japan's problem is demographics - an unfortunate combination of a declining labor force and a rapidly aging population. While this means that per capita GDP growth looks a lot better than the headline figures, it is not a growth-friendly situation. Twenty years ago there were 4.6 people of working age for everyone above 64. This has since dropped to 2.2 and within another 20 years it will be down to 1.6. That falling ratio of taxpayers to pensioners and major consumers of health care is horrendous for government finances. And an aging population typically is not a dynamic one which shows up in Japan's poor productivity performance relative to that of the U.S. (Chart 20). Of course, Japan can "solve" its public finances problem by having the Bank of Japan cancel its large holdings of JGBs. Yet that does nothing to deal with the underlying demographics issue and ongoing large budget deficits. Japan desperately needs a combination of increased immigration and major supply-side reforms, but we do not hold out much prospect of either changing by enough to dramatically alter the long-run growth picture. Mr. X: I will not disagree with you as I have not been positive about Japan for a long time. We should now turn to China. It is very suspicious that the economy continues to hum along at a 6% to 7% pace, despite all the excesses and imbalances that have developed. I really don't trust the data. We talked about China at our mid-2016 meeting and, if I remember correctly, you described China as like a tightrope walker, wobbling from time to time, but never quite falling off. Yet it would only take a gust of wind for that to change. I liked that description so my question is: are wind gusts likely to strengthen over the coming year? BCA: You are right to be suspicious of the official Chinese data, but it seems that the economy is expanding by at least a 5% pace. However, it continues to be propped up by unhealthy and unsustainable growth in credit. The increase in China's debt-to-GDP ratio over the past few years dwarves that during the ultimately disastrous credit booms of Japan in the 1980s and the U.S. in the 2000s (Chart 21). The debt increase has been matched by an even larger rise in assets, but the problem is that asset values can drop, while the value of the debt does not. Chart 20Japan's Structural Headwinds Japan's Structural Headwinds Japan's Structural Headwinds Chart 21China's Remarkable Credit Boom January 2017 - Shifting Regimes January 2017 - Shifting Regimes The government would like to rein in credit growth, but it fears the potential for a major economic slowdown, so it is trapped. The fact that the banking system is largely under state control does provide some comfort because it will be easy for the government to recapitalize the banks should problems occur. This means that a U.S.-style credit freeze is unlikely to develop. Of course, the dark side of that is that credit excesses never really get unwound. You asked whether wind gusts will increase, threating to blow the economy off its tightrope. One potential gust that we already talked about is the potential for trade fights with the new U.S. administration. As we mentioned earlier, we are hopeful that nothing serious will occur, but all we can do is carefully monitor the situation. Trends in China's real estate sector represent a good bellwether for the overall economic situation. The massive reflation of 2008-09 unleashed a powerful real estate boom, accompanied by major speculative excesses. The authorities eventually leaned against this with a tightening in lending standards and the sector cooled off. Policy then eased again in 2015/16 as worries about an excessive economic slowdown developed, unleashing yet another real estate revival. The stop-go environment has continued with policy now throttling back to try and cool things off again. It is not a sensible way to run an economy and we need to keep a close watch on the real estate sector as a leading indicator of any renewed policy shifts. Over time, the Chinese economy should gradually become less dependent on construction and other credit-intensive activities. However, in the near-term, there is no escaping the fact that the economy will remain unbalanced, creating challenges for policymakers and a fragile environment for the country's currency and asset markets. Fortunately, the authorities have enough room to maneuver that a hard landing remains unlikely over the next year or two. There are fewer grounds for optimism about the long-run unless the government can move away from its stop-go policy and pursue more supply-side reforms. Mr. X: What about other emerging economies? Are there any developments particularly worth noting? BCA: Emerging economies in general will not return to the rapid growth conditions of the first half of the 2000s. Slower growth in China has dampened export opportunities for other EM countries and global capital will no longer pour into these economies in its previous, indiscriminate way. Nevertheless, the growth outlook is stabilizing and 2017 should be a modestly better year than 2016 for most countries. Chart 22India Has A Long Way To Go India Has A Long Way To Go India Has A Long Way To Go The rebound in oil and other commodity prices has clearly been positive for Russia, Brazil and other resource-dependent countries. Commodity prices will struggle to rise further from current elevated levels but average 2017 prices should exceed those of 2016. On the negative side, a firm dollar and trade uncertainty will represent a headwind for capital flows to the EM universe. The bottom line is that the growth deceleration in emerging economies has run its course but a major new boom is not in prospect. The Indian economy grew by around 7½% in 2016, making it, by far, the star EM performer. Growth will take a hit from the government's recent decision to withdraw high-denomination bank notes from circulation - a move designed to combat corruption. Fortunately, the impact should be relatively short-lived and growth should return to the 7% area during the coming year. Still, India has a long way to go to catch up with China. In 1990, India's economy was almost 90% as big as China's in PPP terms, but 20 years later, it was only 40% as large. Even though India is expected to keep growing faster than China, its relative size will only climb to 45% within the next five years, according to the IMF (Chart 22). Mr. X: Let me try and summarize your economic views before we move on to talk about the markets. The growth benefit from fiscal stimulus in the U.S. is more a story for 2018 than 2017. Nevertheless, a modest improvement in global growth is likely over the coming year, following several years of economic disappointments. The key risks relate to increased trade protectionism and increased inflation in the U.S. if the rise in demand is not matched by an increase in the economy's supply-side capacity. In that event, tighter monetary policy could trigger a recession in 2019. You do not expect any major changes in the underlying economic picture for Europe, Japan or China, although political shifts in Europe represent another downside risk. BCA: That captures our views quite well. Going back to our broad theme of regime shifts, it is important to re-emphasize that shifting attitudes toward fiscal policy and trade in the U.S. raise a red flag over the longer-term inflation outlook. And this of course feeds into the outlook for interest rates. Bond Market Prospects Mr. X: That is the perfect segue for us to shift the discussion to the investment outlook, starting with bonds. You already noted that you believe the secular bull market in bonds has ended, albeit with a drawn-out bottoming process. Given my concerns about the long-run inflation outlook, I am happy to agree with that view. Yet, yields have risen a lot recently and I am wondering if this represents a short-term buying opportunity. BCA: The late-2016 sell-off in bonds was violent and yields rose too far, too fast. So we recently shifted our tactical bond recommendation from underweight (short duration) to neutral. But obviously that is not the same as telling you to buy. The underlying story for bonds - especially in the U.S. - is bearish. The prospect of fiscal stimulus, rising short rates and a pickup in inflation suggests that U.S. yields will be higher over the next 12 months. Although yields may decline somewhat in the very near-term, we doubt the move will be significant enough or last long enough to warrant an overweight position. The outlook is not quite so bad in the euro zone given the ECB's ongoing bond purchases and a continued benign inflation outlook. But, even there, the market will remain highly correlated with trends in U.S. Treasurys so yields are more likely to rise than fall over the coming year. The story is different in Japan given the central bank's new policy of pegging the 10-year yield at zero. That will be a static market for some time. Although global yields may have bottomed from a secular perspective, the upturn will be gradual in the years ahead. A post-Debt Supercycle environment implies that private sector credit growth will remain subdued, and during 2018, the market may start to attach growing odds of a U.S. recession within a year or two. A more powerful bear trend in bonds awaits the more significant upturn in inflation that likely will follow the next economic downturn. Chart 23Treasurys Are High Yielders Treasurys Are High Yielders Treasurys Are High Yielders Mr. X: I am somewhat surprised at how much the spread between U.S. and euro area bonds has widened - it is now at the highest level since the late 1980s. Obviously, a positive spread makes sense given the relative stance of monetary policy and economic outlook. Yet, it is quite amazing how investors have benefited from both higher yields in the U.S. and a stronger dollar. If the dollar stays firm in 2017, will the spread remain at current high levels? BCA: Most of the increased spread during the past year can be attributed to a widening gap in inflation expectations, although the spread in real yields also spiked after the U.S. election, reflecting the prospects for fiscal stimulus (Chart 23). While the spread is indeed at historical highs, the backdrop of a massive divergence in relative monetary and fiscal policies is not going to change any time soon. We are not expecting the spread to narrow over the next year. You might think that Japanese bonds would be a good place to hide from a global bond bear market given BoJ's policy to cap the 10-year yield at zero percent. Indeed, JGBs with a maturity of 10-years or less are likely to outperform Treasurys and bunds in local currency terms over the coming year. However, this means locking in a negative yield unless you are willing to move to the ultra-long end of the curve, where there is no BoJ support. Moreover, there is more upside for bond prices in the U.S. and Eurozone in the event of a counter-trend global bond rally, simply because there is not much room for JGB yields to decline. Mr. X: O.K., I get the message loud and clear - government bonds will remain an unattractive investment. As I need to own some bonds, should I focus on spread product? I know that value looks poor, but that was the case at the beginning of 2016 and, as you showed earlier, returns ended up being surprisingly good. Will corporate bonds remain a good investment in 2017, despite the value problem? BCA: This a tricky question to answer. On the one hand, you are right that value is not great. Corporate spreads are low in the U.S. at a time when balance sheet fundamentals have deteriorated, according to our Corporate Health Monitor (Chart 24). After adjusting the U.S. high-yield index for expected defaults, option-adjusted spreads are about 165 basis points. In the past, excess returns (i.e. returns relative to Treasurys) typically were barely positive when spreads were at this level. Valuation is also less than compelling for U.S. investment-grade bonds. One risk is that a significant amount of corporate bonds are held by "weak hands," such as retail investors who are not accustomed to seeing losses in their fixed-income portfolios. At some point, this could trigger some panic selling into illiquid markets, resulting in a sharp yield spike. On a more positive note, the search for yield that propped up the market in 2016 could remain a powerful force in 2017. The pressure to stretch for yield was intense in part because the supply of government bonds in the major markets available to the private sector shrank by around $547 billion in 2016 because so much was purchased by central banks and foreign official institutions (Chart 25). The stock will likely contract by another $754 billion in 2017, forcing investors to continue shifting into riskier assets such as corporate bonds. Chart 24U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated Chart 25Government Bonds In Short Supply Government Bonds In Short Supply Government Bonds In Short Supply Weighing the poor valuation and deteriorating credit quality trend against the ongoing pressure to search for yield, we recommend no more than a benchmark weighting in U.S. corporate investment-grade bonds and a modestly underweight position in high-yield. There are better relative opportunities in euro area corporates, where credit quality is improving and the ECB's asset purchase program is providing a nice tailwind. We are slightly overweight in both investment-grade and high-yield euro area corporates. Finally, we should mention emerging market bonds, although we do not have much good to say. The prospect of further declines in EM currencies versus the dollar is a major problem for these securities. There is a big risk that global dollar funding will dry up as the dollar moves higher along with U.S. bond yields, creating problems for EM economies running current account and fiscal deficits. You should stay clear of EM bonds. Mr. X: None of this is helping me much with my bond investments. Can you point to anything that will give me positive returns? Chart 26Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low BCA: Not in the fixed-income market. Your concerns about inflation might lead you to think that inflation-indexed bonds are a good place to be, but prices in that market have already adjusted. Moreover, the case for expecting higher inflation rests a lot on the assumption that economic growth is going to strengthen and that should imply a rise in real yields, which obviously is bad for inflation-indexed bonds. Real yields currently are still very low by historical standards (Chart 26). A world of stagflation - weak real growth and rising inflation - would be a good environment for these securities, but such conditions are not likely in the next couple of years. Mr. X: After what you have told me, I suppose I will concentrate my fixed-income holdings in short-term Treasurys. But I do worry more than you about stagflation so will hold on to my inflation-indexed bonds. At the same time, I do understand that bonds will represent a hedge against downside risks rather than providing positive returns. So let's talk about the stock market as a more attractive place to invest. Equity Market Outlook Mr. X: I like to invest in equities when the market offers good value, there is too much pessimism about earnings and investor sentiment is gloomy. That is not the picture at the moment in the case of the U.S. market. I must confess that the recent rally has taken me by surprise, but it looks to me like a major overshoot. As we discussed earlier, the new U.S. administration's fiscal platform should be good for 2018 economic growth but the U.S. equity market is not cheap and it seems to me that there is more euphoria than caution about the outlook. So I fear that the big surprise will be that the market does much worse than generally expected. BCA: Obviously, the current market environment is nothing like the situation that exists after a big sell-off. You are correct that valuations are not very appealing and there is too much optimism about the outlook for earnings and thus future returns. Analysts' expectations of long-run earnings growth for the S&P 500 universe have risen to 12%, which is at the high end of its range over the past decade (Chart 27). And, as you suggested, surveys show an elevated level of optimism on the part of investors and traders. The outlook for earnings is the most critical issue when it comes to the long-run outlook for stocks. Low interest rates provide an important base of support, but as we noted earlier, rates are more likely to rise than fall over the next couple of years, possibly reaching a level that precipitates a recession in 2019. Investors are excited about the prospect that U.S. earnings will benefit from both faster economic growth and a drop in corporate tax rates. We don't disagree that those trends would be positive, but there is another important issue to consider. One of the defining characteristics of the past several years has been the extraordinary performance of profit margins which have averaged record levels, despite the weak economic recovery (Chart 28). The roots of this rise lay in the fact that businesses rather than employees were able to capture most of the benefits of rising productivity. This showed up in the growing gap between real employee compensation and productivity. As a result, the owners of capital benefited, while the labor share of income - previously a very mean-reverting series - dropped to extremely low levels. The causes of this divergence are complex but include the impact of globalization, technology and a more competitive labor market. Chart 27Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Chart 28Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? With the U.S. unemployment back close to full-employment levels, the tide is now turning in favor of labor. The labor share of income is rising and this trend likely will continue as the economy strengthens. And any moves by the incoming administration to erect barriers to trade and/or immigration would underpin the trend. The implication is that profit margins are more likely to compress than expand in the coming years, suggesting that analysts are far too optimistic about earnings. Long-term growth will be closer to 5% than 12%. The turnaround in the corporate income shares going to labor versus capital represents another important element of our theme of regime changes. None of this means that the stock market faces an imminent plunge. Poor value and over-optimism about earnings raises a red flag over long-term return prospects, but says little about near-term moves. As we all know, market overshoots can move to much greater extremes and last for much longer than one can rationally predict. And the fact remains that the conditions for an overshoot could well persist for another 12 months or even longer. Optimism about the economic benefits of the new administration's policies should last for a while as proposals for tax cuts and increased fiscal spending get debated. Meanwhile, although the Fed plans to raise rates again over the next year, the level of interest rates will remain low by historical standards, sustaining the incentive to put money into stocks rather than interest-bearing assets. Mr. X: So are you telling me to buy U.S. stocks right now? BCA: No we are not. The stock market is vulnerable to a near-term setback following recent strong gains, so this is not a great time to increase exposure. However, we do expect prices to be higher in a year's time, so you could use setbacks as a buying opportunity. Of course, this is with the caveat that long-run returns are likely to be poor from current levels and we have the worry about a bear market some time in 2018 if recession risks are building. Playing market overshoots can be very profitable, but it is critical to remember that the fundamental foundations are weak and you need to be highly sensitive to signs that conditions are deteriorating. Mr. X: I am very well aware of the opportunities and risks of playing market overshoots. I completely underestimated the extent of the tech-driven overshoot in the second half of the 1990s and remained on the sidelines while the NASDAQ soared by 130% between end-1998 and March 2000. But my caution was validated when the market subsequently collapsed and it was not until 2006 that the market finally broke above its end-1998 level. I accept that the U.S. market is not in a crazy 1990s-style bubble, but I am inclined to focus on markets where the fundamentals are more supportive. BCA: The U.S. market is only modestly overvalued, based on an average of different measures. It is expensive based on both trailing and forward earnings and relative to book value, but cheap compared to interest rates and bond yields. A composite valuation index based on five components suggests that the S&P 500 currently is only modestly above its 60-year average (Chart 29). Valuation is not an impediment to further significant gains in U.S. equities over the coming year although it is more attractive in other markets. Chart 29The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive If we use the cyclically-adjusted price-earnings ratio for non-financial stocks as our metric, then Japan and a number of European markets are trading at valuations below their historical averages (Chart 30). The picture for Japan is muddied by the fact that the historical average is biased upwards by the extreme valuations that existed during the bubble years and in the aftermath when earnings were exceptionally weak. Nonetheless, even on a price-to-book basis, Japan is trading far below non-bubble historical averages (Chart 31). Chart 30Valuation Ranking Of Developed Equity Markets January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 31Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market With regard to Europe, the good value is found in the euro area periphery, rather than in the core countries of Germany, France and the Netherlands. In fact, these core countries are trading more expensively than the U.S., relative to their own history. As you know, valuation is not the only consideration when it comes to investing. Nonetheless, the direction of monetary policy also would support a better outlook for Japan and the euro area given that the Fed is raising rates while the ECB and BoJ are still implementing QE policies. Exchange rate moves complicate things a bit because further gains in the dollar would neutralize some of the relative outperformance when expressed in common currency. Even so, we would expect the euro area and Japan to outperform the U.S. over the next 12 months. The one important qualification is that we assume no new major political shocks come from Europe. A resurgence of political uncertainty in the euro area would poses the greatest threat to the peripheral countries, which partly explains why they are trading at more attractive valuations than the core. Mr. X: There seem to be political risks everywhere these days. It is a very long time since I could buy stocks when they offered great value and I felt very confident about the economic and political outlook. I agree that value looks better outside the U.S., but I do worry about political instability in the euro area and Brexit in the U.K. I know Japan looks cheap, but that has been a difficult and disappointing market for a long time and, as we already discussed, the structural outlook for the economy is very troubling. Turning to the emerging markets, you have not backed away from your bearish stance. The long-run underperformance of emerging markets relative to the U.S. and other developed bourses has been quite staggering and I am glad that I have followed your advice. Are you expecting to shift your negative stance any time soon? BCA: The global underperformance of EM has lasted for six years and may be close to ending. But the experience of the previous cycle of underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound (Chart 32). Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors - materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors (Chart 33). Chart 32A Long Period Of EM Underperformance A Long Period Of EM Underperformance A Long Period Of EM Underperformance Chart 33EM Fundamentals Still Poor EM Fundamentals Still Poor EM Fundamentals Still Poor More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year's rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces. In sum, we expect EM equities to underperform DM markets for a while longer. If you want to have some EM exposure then our favored markets are Korea, Taiwan, China, India, Thailand and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil and Peru. Mr. X: None of this makes very keen to invest in any equity market. However, even in poor markets, there usually are some areas that perform well. Do you have any strong sector views? Chart 34Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot BCA: Our near-term sector views reflect the expectation of a pullback in the broad equity market. The abrupt jump in the price of global cyclicals (industrials, materials & energy) versus defensives (health care, consumer staples & telecom services) has been driven solely by external forces - i.e. the sell-off in the bond market, rather than a shift in underlying profit drivers. For instance, emerging markets and the global cyclicals/defensives price ratio have tended to move hand-in-hand. The former is pro-cyclical, and outperforms when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the cyclical/defensive price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debts. Meanwhile, the growth impetus required to support profit outperformance for deep cyclicals may be elusive. As a result, we expect re-convergence to occur via a rebound in defensive relative to cyclical sectors (Chart 34). On a longer-term basis, one likely long-lasting effect of the retreat from globalization is that "small is beautiful." Companies with large global footprints will suffer relative to domestically focused firms. One way to position for this change is to emphasize small caps at the expense of large caps, a strategy applicable in almost every region. Small caps are traditionally domestically geared irrespective of their domicile. In the U.S. specifically, small caps face a potential additional benefit. If the new administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Moreover, small companies would benefit most from any cuts in regulations. When it comes to specifics, our overweight sectors in the U.S. are consumer discretionary, telecoms, consumer staples and health care. We would underweight industrials, technology and materials. For Europe, we also like health care and would overweight German real estate. We would stay away from European banks even though they are trading at historically cheap levels. Commodities And Currencies Mr. X: A year ago, you predicted that oil prices would average $50/bbl over the 2016-18 period. As that is where prices have now settled, do you still stick with that prediction? Chart 35Oil Market Trends Oil Market Trends Oil Market Trends BCA: We have moved our forecast up to an average of $55/bbl following the recent 1.8 million b/d production cuts agreed between OPEC, led by Saudi Arabia, and non-OPEC, led by Russia. The economic pain from the drop in prices finally forced Saudi Arabia to blink and abandon its previous strategy of maintaining output despite falling prices. Of course, OPEC has a very spotty record of sticking with its plans and we expect that we will end up with a more modest 1.1 to 1.2 million b/d in actual output reductions. Yet, given global demand growth of around 1.3 million b/d and weakness in other non-OPEC output, these cuts will be enough to require a drawdown in inventories from current record levels. Even with the lower level of cuts that we expect, OECD oil inventories could drop by around 300 million barrels by late 2017, enough to bring down stocks roughly to their five-year average level (Chart 35). That is the stated goal of Saudi Arabia and the odds are good that the level of compliance to the cuts will be better than the market expects. Mr. X: How does shale production factor into your analysis? What are the odds that a resurgence of U.S. shale production will undermine your price forecast? BCA: We expect U.S. shale-oil production to bottom in the first quarter of 2017, followed by a production increase of around 200,000 b/d in the second half. However, that will not be enough to drive prices back down. The bigger risk to oil prices over the next year or two is for a rise, not a decline given the industry's massive cutbacks in capital spending. More than $1 trillion of planned capex has been cut for the next several years, which translates into more than seven million b/d of oil-equivalent (oil and natural gas) production that will not be developed. And increased shale production cannot fully offset that. In addition to meeting demand growth, new production also must offset natural decline rates, which amount to 8% to 10% of production annually. Replacing these losses becomes more difficult as shale-oil output increases, given its very high decline rates. Shale technology appears to be gaining traction in Russia, which could end up significantly boosting production but capex cuts will constrain the global supply outlook until after 2018. Mr. X: Non-oil commodity prices have shown surprising strength recently, with copper surging almost 30% in the space of a few weeks. Is that just Chinese speculation, or is something more fundamental at work? You have had a cautious long-term view of commodities on the grounds that changing technology and reduced Chinese demand would keep a lid on prices. Do you see any reason to change that view? BCA: Developments in China remain critical for non-oil commodity prices. China's reflationary policies significantly boosted real estate and infrastructure spending and that was the main driver of the rally in metals prices in 2016. As we discussed earlier, China has eased back on reflation and that will take the edge off the commodity price boom. Indeed, given the speed and magnitude of the price increases in copper and other metals, it would not be surprising to see some near-term retrenchment. For the year as a whole, we expect a trading range for non-oil commodities. Longer-run, we would not bet against the long-term downtrend in real commodity prices and it really is a story about technology (Chart 36). Real estate booms notwithstanding, economies are shifting away from commodity-sensitive activities. Human capital is becoming more important relative to physical capital and price rises for resources encourages both conservation and the development of cheaper alternatives. In the post-WWII period, the pattern seems to have been for 10-year bull markets (1972 to 1982 and 2002 to 2012) and 20-year bear markets (1952 to 1972 and 1982 to 2002). The current bear phase is only six years old so it would be early to call an end to the downtrend from a long-term perspective. Chart 36The Long-Term Trend In Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down Mr. X: You know that I can't leave without asking you about gold. I continue to believe that bullion provides a good hedge at a time of extreme monetary policies, political uncertainty and, now, the prospect of fiscal reflation. Can you see bullion at least matching its past year's performance over the coming 12 months? Chart 37A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion BCA: It is still a gold-friendly environment. The combination of political uncertainty, rising inflation expectations and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar: the strengthening of the dollar clearly was a factor undermining the gold price in the second half of 2016 (Chart 37). Nevertheless, a modest position in gold - no more than 5% of your portfolio - will give you some protection in what is likely to remain a very unsettled geopolitical environment. Mr. X: You mentioned the dollar so let me now delve into your currency views in more detail. The dollar has been appreciating for a few years and it seems quite a consensus view to be bullish on the currency. I know the U.S. economy is growing faster than most other developed economies but it surprises me that markets are ignoring the negatives: an ongoing large trade deficit, a looming rise in the fiscal deficit and uncertainty about the policies of the incoming administration. BCA: It is true that if you just looked at the U.S. economic and financial situation in isolation, you would not be very bullish on the currency. As you noted, the current account remains in large deficit, an increased federal deficit seems inevitable given the new administration's policy platform, and the level of short-rates is very low, despite the Fed's recent move. However, currencies are all about relative positions, and, despite its problems, the U.S. looks in better shape than other countries. The optimism toward the dollar is a near-term concern and suggests that the currency is ripe for a pullback. However, it will not require a major sell-off to unwind current overbought conditions. The main reasons to stay positive on the dollar on a cyclical basis are the relative stance of monetary policy and the potential for positive U.S. economic surprises relative to other countries. Ironically, if the administration follows up on its threat to impose trade barriers, that also would be positive for the currency, at least for a while. Longer-run it would be dollar bearish, because the U.S. probably would lose competiveness via higher inflation. The dollar is enjoying its third major upcycle since the era of floating rates began in the early 1970s (Chart 38). There are similarities in all three cases. Policy divergences and thus real interest-rate differentials were in the dollar's favor and there was general optimism about the U.S. economy relative to its competitors. In the first half of the 1980s, the optimism reflected President Reagan's pro-growth supply-side platform, in the second half of the 1990s it was the tech bubble, and this time it is the poor state of other economies that makes the U.S. look relatively attractive. Chart 38The Dollar Bull Market In Perspective January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bull market in the first half of the 1980s was the strongest of the three but was cut short by the 1985 Plaza Accord when the leading industrial economies agreed to coordinated intervention to push the dollar back down in order to forestall a U.S. protectionist response to its soaring trade deficit. The second upturn ended when the tech bubble burst. There is no prospect of intervention to end the current cycle and policy divergences will widen not narrow over the next year. Thus, the dollar should continue to appreciate over the next 12 months, perhaps by around 5% on a trade-weighted basis. The fiscal policies being promoted by the Trump team promise to widen the U.S. trade deficit but that will not stand in the way of a dollar ascent. The problems will occur if, as we discussed earlier, an overheating economy in 2018 and a resulting Fed response trigger a recession in 2019. At that point, the dollar probably would plunge. But it is far too soon to worry about that possibility. Mr. X: I was very surprised with the yen's strength in the first half of 2016 given Japan's hyper-easy policy stance. What was driving that? Also, I would be interested in your views on sterling and commodity and emerging currencies. BCA: The yen often acts as a safe-haven at times of great economic and political uncertainty and that worked in the yen's favor for much of the year. However, it lost ground when U.S. bond yields headed higher. Also, the U.S. election result did not help because Japan would be a big loser if the U.S. imposed trade restrictions. The policy settings in Japan are indeed negative for the yen and while the currency is oversold in the very short run, we expect the structural bear market to persist in 2017 (Chart 39). Sterling's trade-weighted index fell to an all-time low after the Brexit vote so it does offer good value by historical standards. However, with so much uncertainty about how Brexit negotiations will proceed, we remain cautious on the currency. The economy has performed quite well since the vote, but it is far too soon to judge the long-term consequences of EU departure. And the prospect of increased government spending when the country already has a large trade deficit and high public debt poses an additional risk. Turning to the commodity currencies, the rebound in oil and metals prices has stabilized the Canadian and Australian dollars (Chart 40). With resource prices not expected to make much further headway over the next year, these currencies likely will be range bound, albeit with risks to the downside, especially versus the U.S. dollar. Chart 39More Downside In The Yen More Downside In The Yen More Downside In The Yen Chart 40Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Finally, we remain bearish on emerging currencies given relatively poor economic fundamentals. And this is particularly true for those countries with chronically high inflation and/or large current account deficits, largely outside of Asia. Mr. X: What about the Chinese currency? The renminbi has dropped by 13% against the dollar over the past three years and president-elect Trump has threatened to label China as a currency manipulator. You already noted that the Chinese authorities have intervened to prop the currency up, but this does not seem to be working. Chart 41Renminbi Weakness Renminbi Weakness Renminbi Weakness BCA: The trend in the USD/RMB rate exaggerates the weakness of the Chinese currency. On a trade-weighted basis, the currency has depreciated more modestly over the past year, and the recent trend has been up, in both real and nominal terms (Chart 41). In other words, a good part of the currency's move has reflected across-the-board strength in the dollar. The Chinese authorities are sensitive to U.S. pressures and have taken some measures to contain private capital outflows. The next step would be to raise interest rates but this would be a last resort. With the dollar expected to rise further in 2017, the RMB will drift lower, but policy interventions should limit the decline and we doubt the U.S. will follow through with its threat to label China as a manipulator. Geopolitics Mr. X: Last, but certainly not least, we must talk about geopolitics. In addition to the new political order in the U.S. we have a very unstable political situation in Europe, most notably in Italy. We cannot rule out an anti-euro party taking power in Italy which would presumably trigger massive volatility in the markets. With elections also due in France, Germany and the Netherlands, 2017 will be a crucial year for determining the future of the single currency and the EU. What is your take on the outlook? Chart 42Europeans Still Support The EU Europeans Still Support The EU Europeans Still Support The EU BCA: Europe's electoral calendar is indeed ominously packed with four of the euro area's five largest economies likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As BCA's Geopolitical Strategy has argued since 2011, global multipolarity increases the logic for European integration. Crises such as Russian assertiveness, Islamic terrorism, and the migration wave are easier to deal with when countries act together rather than individually. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro or the EU (Chart 42). Despite all of its problems, the single currency should hold together, at least over the next five years. Take the recent Spanish and Austrian elections. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the more-establishment candidate for president, Alexander Van der Bellen, won the election despite fears to the contrary. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. We expect more of the same in the three crucial elections in the Netherlands, France, and Germany. Mr. X: What about Italy? BCA: The country certainly has its problems: it has lagged badly in implementing structural reforms and support for the euro is low compared to the euro area average. Yet, if elections were held today, polls show that the ruling Democratic Party would gain a narrow victory. There are three key points to consider regarding Italy: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum. The market will punish Italy the moment it sniffs out even a whiff of a potential "Itexit" referendum. This will bring forward the future pain of redenomination, influencing voters' choices. Benefits of EU membership for Italy are considerable, especially as it allows the country to integrate its unproductive, poor, and expensive southern regions. Outside the EU, the Mezzogiorno is Rome's problem, and it is a big one. The larger question is whether other euro area countries will be content for Italy to remain mired in its fragile and troubling status quo. We think the answer is yes, given that Italy is the definition of "too-big-to-fail." Mr. X: During the past few years you have emphasized the importance of the shift from a unipolar to multipolar world, reflecting the growing power of China, renewed Russian activism and a decline in U.S. influence. How does the policy platform of the incoming Trump administration affect your view of the outlook? It seems as if the U.S. may end up antagonizing China at the same time as it tries to improve relations with Russia. How would that play out? Chart 43Asia Sells, America Rules Asia Sells, America Rules Asia Sells, America Rules BCA: The media is overemphasizing the role of president-elect Trump in Sino-American relations. Tensions have been building between the two countries for several years. The two countries have fundamental, structural, problems and Trump has just catalyzed what, in our mind, has been an inevitable conflict. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were instrumental: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 43). For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its umbrella. Japan's economic model and large trade surpluses led it into a confrontation with the U.S. in the 1980s. President Ronald Reagan's economic team forced Japan to reform, but the result ultimately was a financial crisis as the artificial supports of its economic model fell away. Many investors have long suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it hinders U.S. access to its vast consumer market. There is a critical difference between the "Japan bashing" of the 1980s and the increasingly potent "China bashing" of today. In the 1980s, the U.S. had already achieved strategic supremacy over Japan as a result of WWII, but that is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the U.S. to preserve its security. Far from it - China has no greater security threat than the U.S. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. That means that when the Trump administration tries to "get tough" on long-standing American demands, these demands will not be taken as well-intentioned or trustworthy. Sino-American rivalry will be the chief geopolitical risk to investors in 2017. Mr. X: Are there any other geopolitical issues that might affect financial markets during the coming year? BCA: Investors are underestimating the risks that the defeat of the Islamic State Caliphate in the Middle East will pose. While the obvious consequence is a spread of terrorism as militants return home, the bigger question is what happens to the regional disequilibrium. In particular, we fear that Turkey will become embroiled in a conflict in both Syria and Iraq, potentially in a proxy war with Iran and Russia. The defeat of Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. The Turkish foray into the Middle East poses the chief risk of a shooting war that could impact global markets in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. Conclusions Mr. X: I think we should end our discussions here before you make me more depressed. A year ago, I was very troubled about the economic and financial outlook, and you did not say very much at that time to ease my concerns. And I feel in a similar situation again this year. I do not believe we are at the edge of a major economic or financial crisis, so that is not the issue. The problem for me is that policymakers continue to distort things with excessively easy monetary policies. And now we face fiscal expansion in the U.S., even though the economy is approaching full employment and wages are picking up. Meanwhile, nobody seems worried about debt anymore despite debt-to-GDP ratios that are at all-time highs throughout the world. And if that was not enough, we face the most uncertain political environment that I can remember, both in the U.S. and Europe. It would not be so bad if markets were cheap to compensate for the various risks and uncertainties that we face. But, as we discussed, that is not the case. So I am left with the same dilemma as last year: where to invest when most assets are fully valued. I am sure that you are right when you say that stock prices are well placed to overshoot over the coming year, but that is not a game I like to play. So I am inclined to stay with a cautious investment stance for a while longer, hoping for a better entry point into equities and other risk assets. BCA: We understand your caution, but you risk missing out on some decent gains in equities over the coming year if you remain on the sidelines. The equity market is due for a near-term pullback, but we would use that as a buying opportunity. Markets are not expensive everywhere and the policy backdrop will remain supportive of risk assets. And although we talked about an overshoot, there is plenty of upside before we need to be concerned that valuations have become a major constraint. We are certainly not trying to persuade you to throw caution to the wind. We have not changed our view that long-term returns from financial assets will be a pale shadow of their historical performance. The past 33 years have delivered compound returns of 10.3% a year from a balanced portfolio and we cannot find any comparable period in history that comes even close (Table 3). As we discussed at length in the past, these excellent returns reflected a powerful combination of several largely interrelated forces: falling inflation and interest rates, rising profit margins, a starting point of cheap valuations and strong credit growth. None of these conditions exist now: inflation and interest rates are headed up, profit margins are likely to compress, valuations are not cheap, and in a post-Debt Supercycle world, the days of rapid credit growth are over. Thus, that same balanced portfolio is likely to deliver compound returns of only 4% over the coming decade. Table 3The Past Is Not A Guide To The Future January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bottom line is that the economic and policy regime that delivered exceptional markets is shifting. The end of the Debt Supercycle a few years ago represented one element of regime shift and now we face several other elements such as the end of the era of falling inflation and interest rates, a rebalancing of the income shares going to labor and capital, and politically, in attitudes and thus policies regarding globalization. A world of modest returns is one where it is very important to get the right country and sector allocation, and ideally, catch shorter-term market swings. Of course, that is much more challenging than simply enjoying a rising tide that lifts all boats. As the year progresses, we will update you with our latest thinking on market trends and investment ideas. Mr. X: I am sure we are about to have a very interesting year and I will rely on your research to highlight investment opportunities and to keep me out of trouble. Once again, many thanks for spending the time to take me through your views and let's end with a summary of your main views. BCA: That will be our pleasure. The key points are as follows: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end-point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time-lags in implementing policy mean that the fiscal plans of president-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. They key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely to avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given president-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors December 20, 2016

Mr. X is a long-time BCA client who visits our offices towards the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: What a year it has been. The Brexit vote in the U.K. and the U.S. election result took me completely by surprise and have added to an already uncertain economic environment. A year ago, you adopted the theme of "Stuck In A Rut" to describe the economic and financial market environment and that turned out to be quite appropriate. Consistent with that rut, many issues concerning me for some time have yet to be resolved. Global economic growth has stayed mediocre, debt levels remain elevated almost everywhere, the outlook for China continues to be shrouded in fog, and stimulative monetary policies are still distorting markets. And now we face political shifts that will have major economic and financial effects. Some big changes are underway and I fear that we are more likely to head in a negative rather than positive direction. Therefore, I am very interested to learn how you see things developing. You have recommended a cautious investment stance during the past year and I was happy to go along with that given all my concerns about the economic and policy environment. While stocks have done rather better than I expected, it has all been based on flimsy foundations in my opinion. I have never been comfortable buying an asset just because prices are being supported by excessively easy money policies. The question now is whether looming changes in the policy and economic environment and in global politics will fuel further gains in risk assets or whether a significant setback is in prospect. I hope our discussion will give some clarity on this but, before talking about the future, let's quickly review what you predicted a year ago. BCA: It has indeed been a momentous year and we do seem to be at important turning points in many areas. For example, changing attitudes toward free trade and fiscal policy do have important implications for economic growth and interest rates. And this is being reinforced by cyclical economic trends as labor markets tighten in the U.S. However, it is too soon to know the extent to which political and policy uncertainties will diminish in the U.S. and Europe. You seek clarity on the investment outlook, but that will remain as challenging an objective as ever. You asked to start with a review of last year's predictions and this is always a moment of some trepidation. A year ago, our key conclusions were as follows: The current global economic malaise of slow growth and deflationary pressures reflects more than just a temporary hangover from the 2007-09 balance sheet recession. Powerful structural forces are at work, the effects of which will linger for a long time. These include an ongoing overhang of debt, the peak in globalization, adverse demographics in most major economies, monetary policy exhaustion, and low financial asset returns. Investor expectations have yet to adjust to the fact that sub-par growth and low inflation are likely to persist for many years. The Debt Supercycle is over, but weak nominal GDP growth has made it virtually impossible to reduce debt burdens. Nonetheless, a debt crisis in the advanced economies is not in prospect any time soon because low interest rates are keeping a lid on debt servicing costs. Perhaps high inflation and debt monetization will be the end-point, but that is many years away and would be preceded by a deflationary downturn. Despite ongoing exciting technological advances, the IT boom has lost its edge in terms of boosting economic growth. Even if productivity is understated, the corollary is that inflation is overstated, suggesting that central bankers will continue to face a policy dilemma. The Fed will raise interest rates by less than implied by their current projections. And the European Central Bank and Bank of Japan may expand their QE programs. Yet, monetary policy has become ineffective in boosting growth. Fiscal policy needs to play a bigger role, but it will require another recession to force a shift in political attitudes toward more stimulus. The U.S. economy will remain stuck in sub-2.5% growth in 2016, with risks to the downside. The euro zone's performance has improved recently, but 2016 growth will fall short of the IMF's 1.9% forecast. Japan's growth will continue to disappoint as it will in most other developed economies. China will continue to avoid a hard landing but growth will likely average below 6% in 2016 and beyond. Other emerging economies face a difficult environment of weak commodity prices, declining global trade. Those with excessive foreign-currency debt face additional pressures with weak exchange rates preventing an easing in monetary policy. Bonds offer poor long-term returns from current yields, but sovereign bonds in the major developed countries offer a hedge against downside macro risks and we recommend benchmark weightings. The fundamental backdrop to corporate and EM bonds remain bearish and spreads have not yet reached a level that discounts all of the risks. A buying opportunity in high-yield securities could emerge in the coming year but, for the moment, stay underweight spread product. We have turned more cautious on equities given a deterioration in the earnings outlook and in some technical indicators. No more than benchmark weighting is warranted and we would not argue against a modest underweight. The typical warning signs of a bear market are not in place but risks have risen. The U.S. equity market is expected to underperform that of Europe and Japan. Continue to stay away from emerging equities and commodity-oriented bourses. We continue to favor a defensive sector stance, favoring consumer staples and health care over cyclical sectors such as materials, energy and industrials. The bear market in commodities is not over. The sharp drop in oil prices will eventually restore balance to that market by undermining non-OPEC production and supporting demand, but this could take until the third quarter of 2016. The oil price is expected to average around $50 a barrel for the 2016-2018 period. The strong dollar and deflationary environment create a headwind for gold, offsetting the benefits of negative real interest rates. But modest positions are a hedge against a spike in risk aversion. The dollar is likely to gain further against emerging and commodity-oriented currencies. But the upside against the euro and the yen will be limited given the potential for disappointments about the U.S. economy. As was the case a year ago, geopolitical risks are concentrated in the emerging world. Meanwhile, the new world order of multipolarity and an increased incidence of military conflicts is not yet priced into markets. We do not expect the U.S. elections to have any major adverse impact on financial markets. On the economic front, we suggested that economic risks would stay tilted to the downside and this turned out to be correct with global growth, once again, falling short of expectations. A year ago, the IMF forecast global growth of 3.6% in 2016 and this has since been downgraded to 3.1%, the weakest number since the recovery began (Table 1). The U.S. economy fell particularly short of expectations (1.6% versus 2.8%). The downgrading of growth forecasts continued a pattern that has been in place since the end of the 2007-09 downturn (Chart 1). We cannot recall any other time when economic forecasts have been so wrong for such an extended period. The two big disappointments regarding growth have been the lackluster performance of global trade and the ongoing reluctance of businesses to expand capital spending. Not surprisingly, inflation remained low, as we expected. Table 1IMF Economic Forecasts January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 1Persistent Growth Downgrades Persistent Growth Downgrades Persistent Growth Downgrades Given the disappointing economic performance, we were correct in predicting that the Federal Reserve would not raise interest rates by as much as their earlier forecasts implied. When we met last year, the Fed had just raised the funds rate from 0.25% to 0.5% and the median expectation of FOMC members was that it would reach 1.4% by end-2016 and 2.4% by end-2017. As we now know, the Fed is now targeting a funds rate of 0.5% to 0.75% and median FOMC projections are for 1.4% by end-2017 (Chart 2). Meanwhile, as we expected, both the ECB and Bank of Japan expanded their quantitative easing programs in an attempt to stimulate growth. Chart 2Changes In the Fed's Expectations Changes in the Fed's Expectations Changes in the Fed's Expectations Our concerns about the poor prospects for emerging economies were validated. The median 2016 growth rate for 152 emerging economies tracked by the IMF was only 3.1%, a notch below the 2015 pace and, barring 2009, the weakest number since the late 1990s Asia crisis. The official Chinese data overstate growth, but there was no hard landing, as many commentators continued to predict. Turning to the markets, there was considerable volatility during the year (Table 2). For example, U.S. bond yields fell sharply during the first half then rebounded strongly towards the end of the year, leaving them modestly higher over the 12 months. Yields in Europe and Japan followed a similar pattern - falling in the first half and then rebounding, but the level continued to be held down by central bank purchases. Japanese bonds outperformed in common currency terms and we had not expected that to occur, although there was a huge difference between the first and second halves of the year, with the yen unwinding its earlier strength in the closing months of the year. Table 2Market Performance January 2017 - Shifting Regimes January 2017 - Shifting Regimes Our caution toward spread product - corporate and EM bonds - turned out to have been unjustified. Despite worsening fundamentals, most notably rising leverage, the search for yield remained a powerful force keeping spreads down and delivering solid returns for these securities. Spreads are back to very low levels, warning that further gains will be hard to achieve. Equity markets made moderate net gains over the course of the year, but it was a roller coaster journey. A nasty early-year downturn was followed by a rebound, an extended trading range and a late-year rally. While the all-country index delivered a total return of around 8% for the year in common currency terms, almost one-third of that was accounted for by the dividend yield. The price index rose by less than 6% in common currency and 7% in local currency. However, our recommendation to overweight Europe and Japan did not pan out. Once again, the U.S. was an outperformer with the financially-heavy European index weighed down by ongoing concerns about banks, and Japan held back by its lackluster economic performance. Oil prices moved much as we expected, with Brent averaging around $45 over the year. At this time in 2015, prices were below $40, but we argued that a gradual rebalancing would bring prices back into a $45-$60 range in the second half of 2016. We did not expect much of a rise in the gold price and it increased less than 7% over the year. However, we did not try to dissuade you from owning some gold given your long-standing attraction to the asset, subject to keeping the allocation to 5% or less of your portfolio. Industrial commodity prices have been much stronger than we predicted, benefiting from a weak dollar in the first half of the year and continued buoyant demand from China. Finally, the dollar moved up as we had predicted, with the gains concentrated in the second half of the year. The yen's first-half strength was a surprise, but this was largely unwound in the second half as U.S. bond yields climbed. Mr. X: Notably absent has been any mention of the two political shocks of 2016. BCA: We did tell you that the U.K. referendum on Brexit was the key risk facing Europe in 2016 and that the polls were too close to have a strong view. Yet, we did not anticipate that the vote to leave the EU would pass. And when you pushed us a year ago to pick a winner for the U.S. election we wrongly went with Clinton. Our Global Strategist, Peter Berezin, was on record predicting a Trump victory as long ago as September 2015. But it seemed such an outrageous idea that our consensus view stuck to the safer option of Clinton. Interestingly, during our discussion at the end of 2014, we did note that a retreat from globalization was one of the risks in the outlook and we re-emphasized that point last year, pointing to rising populist pressures. However, we underestimated the ability of Brexit campaigners and Donald Trump to capitalize on the anger of disaffected voters. Trade and immigration policies are not the only areas where policy appears to be at a turning point. For example, fiscal conservatism is giving way to stimulus in the U.S. and several other countries, inflation and interest rates are headed higher, at least temporarily, and 2017-2018 should finally arrest the multi-year spectacle of downgrades to global growth projections. Yet, markets have a tendency to overreact and that currently seems to be the case when it comes to discounting prospective changes in the economic environment for the coming year. Turning Points And Regime Shifts: How Much Will Really Change? Mr. X: The U.S. election result and Brexit vote obviously were seismic events with potentially major policy implications. But there seem to be more questions than answers in terms of how policies actually will evolve over the next few years and the extent to which they will be good or bad for growth. The markets are assuming that economic growth will get a big boost from changes in fiscal policy. Do you agree with that view? Chart 3Fiscal Austerity Ended In 2015 Fiscal Austerity Ended in 2015 Fiscal Austerity Ended in 2015 BCA: We need to begin by putting things into perspective. Fiscal austerity came to an end pretty much everywhere a couple of years ago. Data from the IMF show that the peak years for fiscal austerity in the advanced economies were 2011-2013, and the budget cutbacks in those years did not even fully offset the massive stimulus that occurred during the downturn in 2008-10. Since 2013, the fiscal drag on GDP has gradually diminished and policy shifts are estimated to have added to GDP in the U.S., euro area and Japan in 2016 (Chart 3). Nonetheless, with economic growth falling short of expectations and easy money losing its effectiveness, there have been widespread calls for fiscal policy to do more. President-elect Trump has made major tax cuts and increased spending an important part of his policy platform, so the issue is the extent to which he follows through on his plans. Inevitably, there are some challenges: The plan to boost U.S. infrastructure spending is welcome, but the intention seems to be to emphasize private/public partnerships rather than federally-funded projects. Setting up such agreements could take time. Meanwhile, although there is great scope to improve the infrastructure, it is far less clear that a number of "shovel-ready" projects are simply waiting for finance. The bottom line is that increased infrastructure spending is more a story for 2018 and beyond, rather than 2017. And the same also is true for defense, where it may take time to put new programs in place. Turning to the proposed tax cuts, history shows there can be a huge difference between election promises and what eventually is legislated. According to the Tax Policy Center, Trump's plans would add more than $6 trillion to outstanding federal debt over the next decade and more than $20 trillion over 20 years. And that excludes the impact of higher interest costs on the debt. Even if one were to take an optimistic view of a revenue boost from faster economic growth, there would still be a large increase in federal deficits and thus debt levels and this could be problematic for many Republicans. It seems inevitable that the tax plans will be watered down. An additional issue is the distributional impact of the proposed tax cuts. Eliminating the estate tax and proposed changes to marginal rates would disproportionally help the rich. Estimates show the lowest and second lowest quintile earners would receive a tax cut of less than 1% of income, compared to 6.5% for the top 1%. Given that the marginal propensity to consume is much higher for those with low incomes, this would dilute the economic impact. Moreover, there is again the issue of timing - the usual bargaining process means that tax changes will impact growth more in 2018 than 2017. Mr. X: You did not mention the plan to cut the corporate tax rate from 35% to 15%. Surely that will be very good for growth? BCA: According to the OECD, the U.S. has a marginal corporate tax rate of 38.9% (including state and local corporate taxes), making it by far the highest in the industrialized world. The median rate for 34 other OECD economies is 24.6%. However, the actual rate that U.S. companies pay after all the various deductions is not so high. According to national accounts data, the effective tax rate for domestic non-financial companies averaged 25% in the four quarters ended 2016 Q2. Data from the IRS show an average rate of around 21% for all corporations. And for those companies with significant overseas operations, the rate is lower. There certainly is a good case for lowering the marginal rate and simplifying the system by removing deductions and closing loopholes. But special interests always make such reforms a tough battle. Even so, there is widespread support to reduce corporate taxes so some moves are inevitable and this should be good for profits and, hopefully, capital spending. The bottom line is that you should not expect a major direct boost to growth in 2017 from changes in U.S. fiscal policy. The impact will be greater in 2018, perhaps adding between 0.5% and 1% to growth. However, don't forget that there could be an offset from any moves to erect trade barriers. Mr. X: What about fiscal developments in other countries? Chart 4Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare Japan Is A Fiscal Nightmare BCA: The Japanese government has boosted government spending again, but the IMF estimates that fiscal changes added only 0.3% to GDP in 2016, with an even smaller impact expected for 2017. And a renewed tightening is assumed to occur in 2018 as postponed efforts to reign in the deficit take hold. Of course, a sales tax hike could be delayed yet again if the economy continues to disappoint. But, with an overall budget deficit of 5% of GDP and gross government debt of more than 250% of GDP, Japan's room for additional stimulus is limited (Chart 4). Although the Bank of Japan owns around 40% of outstanding government debt, the authorities cannot openly admit that this will be written off. While more fiscal moves are possible in Japan, it is doubtful they would significantly alter the growth picture. The euro area peripheral countries have moved past the drastic fiscal austerity that was imposed on them a few years ago. Nevertheless, there is not much room for maneuver with regard to adopting an overtly reflationary stance. It is one thing to turn a blind eye to the fiscal constraints of the EU's Growth and Stability Pact and quite another to move aggressively in the opposite direction. Most of the region's economies have government debt-to-GDP ratios far above the 60% required under the Maastricht Treaty. In sum, a move to fiscal stimulus is not in the cards for the euro area. The U.K. is set to adopt more reflationary policies following the Brexit vote, but this would at most offset private sector retrenchment. In conclusion, looming shifts in fiscal policy will be positive for global growth in the next couple of years, but are unlikely to be game changers. Of course, fiscal policy is not the only thing that might change - especially in the U.S. There also are hopes that an easing in regulatory burdens will be very positive for growth. Mr. X: I am glad you raised that point. I have many business contacts in the U.S. who complain bitterly about regulatory overload and they are desperate for some relief. BCA: There certainly is a need for action on this front as regulatory burdens have increased dramatically in the U.S. in recent years. The monthly survey of small businesses carried out by the National Federation of Independent Business shows that rising health care costs, excessive regulation and income taxes are regarded as the top three problems. According to the Heritage Foundation, new regulations from the Obama administration have added more than $100 billion annually to costs for businesses and individuals since 2009. While the U.S. has a good score in the World Bank's Ease of Doing Business Index (8th best out of 190 countries), it is ranked 51st in the component that measures how easy it is to start a business, which puts it behind countries such as Jamaica, Mongolia and Albania. So we can hope that the new administration will act to improve that situation. We can be confident that there will be major reductions in regulations relating to energy and the environment. Other areas may be more challenging. It did not take long for Trump to back away from his pledge to repeal the Affordable Care Act (ACA) in its entirety. Returning to the previous status quo will not be politically acceptable and devising an alternative plan is no small task. The end result still will be a major modification of the ACA and this should ease health care costs for small businesses. With regard to the financial sector, it is no surprise that the pendulum swung massively toward increased regulation given the pre-crisis credit excesses. The economic and financial downturn of 2008-09 left a legacy of strong populist resentment of Wall Street and the banks, so a return to the previous laissez-faire model is not in the cards. At one stage, Trump indicated that he was in favor of replacing Dodd-Frank with a Glass-Steagall system, requiring commercial banks to divest themselves of their securities' businesses. The large banks would employ legions of lobbyists to prevent a new Glass-Steagall Act. The end result will be some watering down of the Dodd-Frank regulatory requirements, but again, a return to the pre-crisis status quo is not in the cards. The Retreat From Globalization Mr. X: You have challenged the consensus view that fiscal stimulus will deliver a meaningful boost to the global economy over the coming year. Having downplayed the main reason to be more positive about near-term growth, let's turn to global trade, the issue that causes most nervousness about the outlook. The Brexit vote in the U.K. was at least partly a vote against globalization and we are all familiar with Trump's threat to dramatically raise tariffs on imports from China and Mexico. What are the odds of an all-out trade war? BCA: At the risk of sounding complacent, we would give low odds to this. Again, there will be a large difference between campaign promises and actual outcomes. Let's start with China where the U.S. trade deficit ran at a $370 billion annual rate in the first nine months of 2016, up from around $230 billion a decade before (Chart 5). China now accounts for half of the total U.S. trade deficit compared to a 25% share a decade ago. On the face of it, the U.S. looks to have a good bargaining position, but the relationship is not one-sided. China has been a major financer of U.S. deficits and is the third largest importer of U.S. goods, after Canada and Mexico. Meanwhile, U.S. consumers have benefited enormously from the relative cheapness of imported Chinese goods. As for the threat to label China as a currency manipulator, it is interesting to note that its real effective exchange rate has increased by almost 20% since the mid-2000s, and since then, the country's current account surplus as a share of GDP has fallen from almost 10% to around 2.5% (Chart 6). The renminbi has fallen by around 10% against the dollar since mid-2015, but that has been due to the latter currency's broad-based rally, not Chinese manipulation. The fact that China's foreign-exchange reserves have declined in the past couple of years indicates that the country has intervened to hold its currency up, not push it down. Chart 5China-U.S. Trade: ##br##A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? China-U.S. Trade: A Symbiotic Relationship? Chart 6China Has Not Manipulated ##br##Its Currency Downward China Has Not Manipulated Its Currency Downward China Has Not Manipulated Its Currency Downward Of course, facts may not be the guiding factor when it comes to U.S. trade policy, and we can expect some tough talk from the U.S. This could well involve the imposition of some tariffs and perhaps some concessions from China in the form of increased imports from the U.S. Overall, we are hopeful that rational behavior will prevail and that an all-out trade war will not occur. Mr. X: I also would like to believe that, but nothing in the U.S. election process made me think that rationality is guaranteed. BCA: Of course it is not guaranteed, and we will have to monitor the situation carefully. We should also talk about Mexico - the other main target of Trump's attacks. The U.S. trade deficit with Mexico accounts for less than 10% of the total U.S. deficit and has changed little in the past decade. More than 80% of the U.S. trade deficit with Mexico is related to vehicles and Trump clearly will put pressure on U.S. companies to move production back over the border. Within a week of the election, Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. And Trump subsequently browbeat Carrier Corporation into cancelling some job transfers across the border. If other companies follow suit, it could forestall major changes to NAFTA. Ironically, the Mexican peso has plunged by 10% against the dollar since the election, boosting the competitiveness of Mexico and offsetting some of the impact of any tariff increase. Not all the news on global trade is bad. After seven years of negotiation, the EU and Canada agreed a free trade deal. This has bolstered the U.K.'s hopes that it can arrange new trade deals after it leaves the EU. However, this will not be easy given the sheer number of bi-country deals that will be required. The time it took to negotiate the EU-Canada deal should be a salutary warning given that there was no particular animosity toward Canada within the EU. That will not be the case when it comes to negotiations with the U.K. Mr. X: Let's try and pull all this together. You have downplayed the risk of an all-out trade war and I hope that you are right. But do you expect trade developments to be a drag on economic activity, perhaps offsetting any positive impact from fiscal stimulus? Chart 7Only Modest Growth In World Trade Only Modest Growth In World Trade Only Modest Growth In World Trade BCA: You might think that trade is a zero-sum game for the global economy because one country's exports simply are another's imports. But expanding trade does confer net benefits to growth in terms of allowing a more efficient use of resources and boosting related activities such as transportation and wholesaling. Thus, the rapid expansion in trade after the fall of the Berlin Wall was very good for the global economy. Trade ceased to be a net contributor to world growth several years ago, highlighted by the fact that global export volumes have been growing at a slower pace than GDP (Chart 7). This has not been due to trade barriers but is more a reflection of China's shift away from less import-intensive growth. A return to import-intensive growth in China is not likely, and technological innovations such as 3-D printing could further undermine trade. If we also add the chances of some increase in protectionist barriers then it is reasonable to assume that trends in global trade are more likely to hinder growth than boost it over the coming couple of years. It really is too soon to make hard and fast predictions about this topic as we need to see exactly what actions the new U.S. administration will take. Nevertheless, we lean toward the optimistic side, and assume the economic impact of fiscal reflation will exceed any drag from trade restrictions. Again, this is a more of a story for 2018 than 2017. What we can say with some confidence is that the previous laissez-faire approach to globalization is no longer politically acceptable. Policymakers are being forced to respond to voter perceptions that the costs of free trade outweigh the benefits and that points to a more interventionist approach. This can take the form of overt protectionism or attempts to influence corporate behavior along the lines of president-elect Trump's exhortations to U.S. companies. Mr. X: What about the issue of immigration? Both the Brexit vote and the U.S. election result partly reflected voter rebellion against unrestrained immigration. And we know that nationalist sentiments also are rising in a number of other European countries. How big a problem is this? Chart 8Immigration's Rising Contribution ##br##To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth Immigration's Rising Contribution To U.S. Population Growth BCA: In normal circumstances, immigration represents a win-win situation for all parties. The vast majority of immigrants are prepared to work hard to improve their economic position and in many cases take jobs that residents are not willing to accept. This all works well in a fast-growing economy, but difficulties arise when growth is weak: competition for jobs increases, especially among the unskilled, and the result is downward pressure on wages. The irony is that the U.S. and U.K. labor markets have tightened to the point where wage growth is accelerating. However, this all happened too late to affect the opinions of those who voted for tighter controls over immigration. There is an even more important issue from a big-picture perspective. As you know, an economy's potential growth rate comes from two sources: the growth in the labor force and productivity. According to the Census Bureau, U.S. population growth will average 0.8% a year over the next decade, slowing to 0.6% a year over the subsequent ten years. But more than half of this growth is assumed to come from net migration. Excluding net migration, population growth is predicted to slow to a mere 0.1% a year by the end of the 2030s (Chart 8). Thus, major curbs on immigration would directly lower potential GDP by a significant amount. In Europe, the demographic situation is even more precarious because birth rates are far below replacement levels. Europe desperately needs immigration to achieve even modest population increases. However, the migrant crisis is causing a backlash against cross-border population flows, again with negative implications for long-run economic growth. Even ignoring humanitarian considerations, major curbs on immigration would not be a good idea. Labor shortages would quickly become apparent in a number of industries. Some may welcome the resulting rise in wages, but the resulting pressure on inflation also would have adverse effects. So this is another area of policy that we will have to keep a close eye on. Chart 9A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture A Mixed U.S. Inflation Picture Inflation And Interest Rates Mr. X: I am glad that you mentioned inflation. There are good reasons to think that an important inflection point in inflation has been reached. And bond investors seem to agree, judging by the recent spike in yields. If true, this would indeed represent a significant regime shift because falling inflation and bond yields have been such a dominant trend for several decades. Do you agree that the era of disinflation is over, along with the secular bull market in bonds? BCA: Inflation and bond yields in the U.S. have passed a cyclical turning point, but this does not mean that a sustained major uptrend is imminent. Let's start with inflation. A good portion of the rise in the underlying U.S. inflation rate has been due to a rise in housing rental costs, and, more recently, a spike in medical care costs. Neither of these trends should last: changes to the ACA should arrest the rising cost of medical care while increased housing construction will cap the rise in rent inflation. The rental vacancy rate looks to be stabilizing while rent inflation is rolling over. Meanwhile, the inflation rate for core goods has held at a low level and likely will be pushed lower as a result of the dollar's ascent (Chart 9). Of course, this all assumes that we do not end up with sharply higher import tariffs and a trade war. The main reason to expect a further near-term rise in underlying U.S. inflation is the tightening labor market and resulting firming in wage growth. With the economy likely to grow above a 2% pace in 2017, the labor market should continue to tighten, pushing wage inflation higher. So the core PCE inflation rate has a good chance of hitting the Federal Reserve's 2% target before the year is out. And bond investors have responded accordingly, with one-year inflation expectations moving to their highest level since mid-2014, when oil prices were above $110 a barrel (Chart 10). Long-run inflation expectations also have spiked since the U.S. election, perhaps reflecting the risk of higher import tariffs and the risks of political interference with the Fed. When it comes to other developed economies, with the exception of the U.K., there is less reason to expect underlying inflation to accelerate much over the next year. Sluggish growth in the euro area and Japan will continue to keep a lid on corporate pricing power and the markets seem to agree, judging by the still-modest level of one-year and long-run inflation expectations (Chart 11). The U.K. will see some pickup in inflation in response to the sharp drop in sterling and this shows up in a marked rise in market expectations. Chart 10U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked U.S. Inflation Expectations Have Spiked Chart 11Inflation Expectations In Europe And Japan Inflation Expectations In Europe and Japan Inflation Expectations In Europe and Japan Turning back to the U.S., a key question regarding the longer-term inflation outlook is whether the supply side of the economy improves. If the new administration succeeds in boosting demand but there is no corresponding expansion in the supply capacity of the economy, then the result will be higher inflation. That will lead to continued monetary tightening and, as in past cycles, an eventual recession. But, if businesses respond to a demand boost with a marked increase in capital spending then the result hopefully would be faster productivity growth and a much more muted inflation response. Thus, it will be critical to monitor trends in business confidence and capital spending for signs that animal spirits are returning. Mr. X: So you don't think the Fed will be tempted to run a "hot" economy with inflation above the 2% target? BCA: That might have been a possibility if there was no prospect of fiscal stimulus, leaving all the economic risks on the downside. With easier fiscal policy on the horizon, the Fed can stick to a more orthodox policy approach. In other words, if the economy strengthens to the point where inflation appears to be headed sustainably above 2%, then the Fed will respond by raising rates. Unlike the situation a year ago, we do not have a strong disagreement with the Fed's rate hike expectations for the next couple of years. Nothing would please the Fed more than to return to a familiar world where the economy is behaving in a normal cyclical fashion, allowing a move away from unusually low interest rates. At the same time, the Fed believes, as we do, that the equilibrium real interest rate is far below historical levels and may be close to zero. Thus, interest rates may not need to rise that much to cool down the economy and ease inflationary pressures. This is especially true if the dollar continued to rise along with Fed tightening. Another potentially important issue is that the composition of the Federal Reserve Board could change dramatically in the next few years. There currently are two unfilled seats on the Board and it is very likely that both Janet Yellen and Stanley Fischer will leave in 2018 when their respective terms as Chair and Vice-Chair end (February 3 for Yellen and June 12 for Fischer). That means the incoming administration will be able to appoint four new Board members, and possibly more if other incumbents step down. Judging by the views of Trump's current economic advisers, he seems likely to choose people with a conservative approach to monetary policy. In sum, we do not rule out a rise in U.S. inflation to as much as 3%, but it would be a very short-lived blip. Steady Fed tightening would cap the rise, even at the cost of a renewed recession. Indeed, a recession would be quite likely because central banks typically overshoot on the side of restraint when trying to counter a late-cycle rise in inflation. Mr. X: I am more bearish than you on the inflation outlook. Central banks have been running what I regard as irresponsible policies for the past few years and we now also face some irresponsible fiscal policies in the U.S. That looks like a horrendously inflationary mix to me although I suppose inflation pressures would ease in the next recession. We can return to that possibility later when we discuss the economy in more detail. Where do you see U.S. short rates peaking in the current cycle and what does this mean for your view on long-term interest rates? To repeat my earlier question: is the secular bond bull market over? BCA: During the past 30 years, the fed funds rate tended to peak close to the level of nominal GDP growth (Chart 12). That would imply a fed funds rate of over 5% in the current cycle, assuming peak real GDP growth of around 3% and 2-3% inflation. However, that ignores the fact that debt burdens are higher than in the past and structural headwinds to growth are greater. Thus, the peak funds rate is likely to be well below 5%, perhaps not much above 3%. Chart 12The Fed Funds Rate And The Economic Cycle The Fed Funds Rate and the Economic Cycle The Fed Funds Rate and the Economic Cycle With regard to your question about the secular bull market in bonds, we believe it has ended, but the bottoming process likely will be protracted. We obviously are in the midst of a cyclical uptrend in U.S. yields that could last a couple of years. The combination of a modestly stronger economy, easier fiscal stance and monetary tightening are all consistent with rising bond yields. Although yields moved a lot in the second half of 2016, the level is still not especially high, so there is further upside. It would not be a surprise to see the 10-year Treasury yield reach 3% by this time next year. However, there could be a last-gasp renewed decline in yields at some point in the next few years. If the U.S. economy heads back into recession with the fed funds rate peaking at say 3.5%, then it is quite possible that long-term bond yields would revisit their 2016 lows - around 1.4% on the 10-year Treasury. There are no signs of recession at the moment, but a lot can change in the next three years. In any event, you should not be overly concerned with the secular outlook at this point. The cyclical outlook for yields is bearish and there should be plenty of advance notice if it is appropriate to switch direction. Update On The Debt Supercycle Mr. X: I would like to return to the issue of the Debt Supercycle - one of my favorite topics. You know that I have long regarded excessive debt levels as the biggest threat to economic and financial stability and nothing has occurred to ease my concerns. In the past, you noted that financial repression - keeping interest rates at very low levels - would be the policy response if faster economic growth could not achieve a reduction in debt burdens. But the recent rise in bond yields warns that governments cannot always control interest rate moves. Few people seem to worry anymore about high debt levels and I find that to be another reason for concern. BCA: You are correct that there has been very little progress in reducing debt burdens around the world. As we have noted in the past, it is extremely difficult for governments and the private sector to lower debt when economic activity and thus incomes are growing slowly. Debt-to-GDP ratios are at or close to all-time highs in virtually every region, even though debt growth itself has slowed (Chart 13A, Chart 13B). Chart 13ADebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High Chart 13BDebt Growth Slows, ##br##But Levels Remain High Debt Growth Slows, But Levels Remain High Debt Growth Slows, But Levels Remain High As a reminder, our End-of-Debt Supercycle thesis never meant that debt-to-GDP ratios would quickly decline. It reflected our belief that lenders and private sector borrowers had ended their love affair with debt and that we could no longer assume that strong credit growth would be a force boosting economic activity. And our view has not altered, even though government borrowing may show some acceleration. Chart 14The Credit Channel Is Impaired The Credit Channel Is Impaired The Credit Channel Is Impaired The failure of exceptionally low interest rates to trigger a vigorous rebound in private sector credit demand is consistent with our view. In the post-Debt Supercycle world, monetary policy has lost effectiveness because the credit channel - the key pillar of the monetary transmission process - is blocked. The drop in money multipliers and in the velocity of circulation is a stark reminder of the weakened money-credit-growth linkage (Chart 14). You always want to know what the end-point of higher debt levels will be, and we always give you a hedged answer. Nothing has changed on that front! A period of higher inflation may help bring down debt ratios for a while, but not to levels that would ease your concerns. This means that financial repression will be the fallback plan should markets rebel against debt levels. For the moment, there is still no problem because interest rates are still low and this is keeping debt-servicing costs at very low levels. If interest rates are rising simply because economic activity is strengthening, then that is not a serious concern. The danger time would be if rates were to rise while growth and inflation were weak. At that point, central banks would move aggressively to reduce market pressures with massive asset purchases. The ultimate end-point for dealing with excessive debt probably will be significantly higher inflation. But that is some time away. Central banks would not likely embrace a major sustained rise in inflation before we first suffered another serious deflationary downturn. At that point, attitudes toward inflation could change dramatically and a new generation of central bankers would probably be in charge with a very different view of the relative economic risks of inflation and deflation. However, it is premature to worry about a major sustained inflation rise if we must first go through a deflationary downturn. Mr. X: Perhaps you are right, but I won't stop worrying about debt. The buildup in debt was decades in the making and I am convinced that the consequences will extend beyond a few years of subdued economic growth. And central bank efforts to dampen the economic symptoms with unusually low interest rates have just created another set of problems in the form of distorted asset prices and an associated misallocation of capital. BCA: We agree that there may be a very unhappy ending to the debt excesses, but timing is everything. It has been wrong to bet against central banks during the past seven years and that will continue to be the case for a while longer. We will do our best to give you plenty of warning when we see signs that things are changing for the worse. Mr. X: I will hold you to that. Meanwhile, you talked earlier about the possibility of another recession in the U.S. Let's use that as a starting point to talk about the economic outlook in more detail. It seems strange to talk about the possibility of a recession in the U.S. when interest rates are still so low and we are about to get more fiscal stimulus. The Economic Outlook BCA: We do not expect a recession in the next year or two, absent some new major negative shock. But by the time we get to 2019, the recovery will be ten years old and normal late-cycle pressures should be increasingly apparent. The labor market already is quite tight, with wages growing at their fastest pace in eight years, according to the Atlanta Fed's wage tracker (Chart 15). Historically, most recessions were triggered by tight monetary policy with a flat or inverted yield curve being a reliable indicator (Chart 16). Obviously, that is extremely hard to achieve when short-term rates are at extremely low levels. However, if the Fed raises the funds rate to around 3% by the end of 2019, as it currently predicts, then it will be quite possible to again have a flat or inverted curve during that year. Chart 15U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend U.S. Wage Growth In A Clear Uptrend Chart 16No Sign Of A U.S. Recession No Sign Of A U.S. Recession No Sign Of A U.S. Recession The recent environment of modest growth has kept inflation low and forced the Fed to maintain a highly accommodative stance. As spare capacity is absorbed, the Fed will be forced to tighten, raising the odds of a policy overshoot. And this is all without taking account of the potential threat of a trade war. Mr. X: I have never believed that the business cycle has been abolished so it would not surprise me at all to have a U.S. recession in the next few years, but the timing is critical to getting the markets right. What will determine the timing of the next economic downturn? BCA: As we mentioned earlier, the key to stretching out the cycle will be improving the supply side of the economy, thereby suppressing the cyclical pressures on inflation. That means getting productivity growth up which, in turn will depend on a combination of increased capital spending, global competition and technological innovations. Chart 17Companies Still ##br##Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Companies Still Cautious Re: Capital Spending Thus far, there is no indication that U.S. companies are increasing their investment plans: the trend in capital goods orders remains very lackluster (Chart 17). Nonetheless, we have yet to see post-election data. The optimistic view is that the prospect of lower corporate taxes, reduced regulation and a repatriation of overseas earnings will all combine to revive the corporate sector's animal spirits and thus their willingness to invest. Only time will tell. The key point is that it is too soon for you to worry about a recession in the U.S. and for the next year or two, there is a good chance that near-term economic forecasts will be revised up rather than down. That will mark an important reversal of the experience of the past seven years when the economy persistently fell short of expectations. Mr. X: It would be indeed be a welcome change to have some positive rather than negative surprises on the economic front, but I remain somewhat skeptical. I suppose I can see some reasons to be more optimistic about the U.S., but the picture in most other countries seems as bleak as ever. The outlook for the U.K. has worsened following the Brexit vote, the euro area and Japan cannot seem to break out of a low-growth trap and China continues to skirt the edge of a precipice. BCA: The global economy still has lots of problems, and we are a long way from boom-like conditions. The IMF predicts that 2017 growth in the euro area and China will be below the 2016 level, and forecasts for the U.K. have been revised down sharply since the Brexit vote. On a more positive note, the firming in commodity prices should help some previously hard-hit emerging economies. Overall global growth may not pick up much over the coming year, but it would be a significant change for the better if we finally stop the cycle of endless forecast downgrades. Mr. X: Let's talk a bit more about the U.K. I know that it is too early to make strong predictions about the implications of Brexit, but where do you stand in terms of how damaging it will be? I am not convinced it will be that bad because I sympathize with the view that EU bureaucracy is a big drag on growth, and exiting the EU may force the U.K. government to pursue supply-side policies that ultimately will be very good for growth. BCA: The Brexit vote does not spell disaster for the U.K., but adds to downside risks at a time when the global economy is far from buoyant. The EU is not likely to cut a sweet deal for the U.K. To prevent copycat departures, the EU will demonstrate that exit comes with a clear cost. Perhaps, the U.K. can renegotiate new trade deals that do not leave it significantly worse off. But this will take time and, in the interlude, many businesses will put their plans on hold until new arrangements are made. Meanwhile, the financial sector - a big engine of growth in the past - could be adversely affected by a move of business away from London. Chart 18The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem The U.K. Has A Twin Deficit Problem Of course, the government will not simply stand on the sidelines, and it has already announced increased infrastructure spending that will fill some of the hole created by weaker business capital spending. And the post-vote drop in sterling has provided a boost to U.K. competitiveness. Nevertheless, it seems inevitable that there will be a hit to growth over the next couple of years. The optimistic view is that the U.K. will use the opportunity of its EU departure to launch a raft of supply-side reforms and tax cuts with the aim of creating a much more dynamic economy that will be very attractive to overseas investors. Some have made the comparison with Singapore. This seems a bit of a stretch. In contrast to the pre-vote rhetoric, EU membership did not turn the U.K. into a highly-regulated economy. For example, the U.K. already is in 7th place out of 190 countries in the World Bank's Ease Doing Business Index and one of the least regulated developed economies according to the OECD. Thus, the scope to boost growth by sweeping away regulations probably is limited. At the same time, the U.K.'s ability to engage in major fiscal stimulus via tax cuts or increased spending is limited by the country's large balance-of-payments deficit and the poor state of its government finances (Chart 18). Overall, the U.K. should be able to avoid a major downturn in the next couple of years, but we don't disagree with the OECD's latest forecasts that growth will slow to round 1% in 2017 and 2018 after 2% in 2016. And that implies the risks of one or two quarters of negative growth within that period. Mr. X: I am not a fan of the EU so am inclined to think that the U.K. will do better than the consensus believes. But, I am less confident about the rest of Europe. Euro area banks are in a mess, weighed down by inadequate capital, a poor return on assets, an overhang of bad loans in Italy and elsewhere, and little prospect of much revival in credit demand. At the same time, the political situation looks fragile with voters just as disenchanted with the establishment status quo as were the ones in the U.K. and U.S. Against this background, I can't see why any companies would want to increase their capital spending in the region. Chart 19Euro Area Optimism Improves Euro Area Optimism Improves Euro Area Optimism Improves BCA: We agree that euro area growth is unlikely to accelerate much from here. The structural problems of poor demographics, a weak banking system and constrained fiscal policy represent major headwinds for growth. And the political uncertainties related to elections in a number of countries in the coming year give consumers and companies good reason to stay cautious. Yet, we should note that the latest data show a modest improvement in the business climate index, breaking slightly above the past year's trading range (Chart 19). There are some positive developments to consider. The nomination of François Fillon as the conservative candidate in France's Presidential election to be held on April 2017 is very significant. We expect him to beat Marine Le Pen and this means France will have a leader who believes in free markets and deregulation - a marked change from previous statist policies. This truly could represent a major regime shift for that country. Meanwhile, the ECB has confirmed that it will continue its QE program through 2017, albeit at a slightly reduced pace. This has costs in terms of market distortions, but will help put a floor under growth. Mr. X: You noted the fragile state of the region's banks. How do you see that playing out? BCA: Euro area banks have more than €1 trillion of non-performing loans (NPLs) and have provisioned for only about half of that amount. Nevertheless, most countries' banking sectors have enough equity capital to adequately absorb losses from these un-provisioned NPLs. On the other hand, the high level of NPLs is a protracted drag on profitability and thereby increases the banks' cost of capital. The shortage of capital constrains new lending. The biggest concern is Italy, which we estimate needs to recapitalize its banks by close to €100 billion. Complicating matters is that the EU rules on state aid for banks changed at the start of 2016. Now, a government bailout can happen only after a first-loss 'bail-in' of the bank's equity and bond holders. So if an undercapitalized bank cannot raise the necessary funds privately in the markets, there is a danger that its investors could suffer heavy losses before the government is allowed to step in. But once investors have been bailed-in, the authorities will do "whatever it takes" to prevent banking problems turning into a systemic crisis that threaten to push the economy into another recession. Mr. X: I would now like to shift our attention to Asia, most notably Japan and China. Starting with Japan, that economy seems to perfectly describe the world of secular stagnation. Despite two decades of short-term interest rates near zero and major fiscal stimulus, real growth has struggled to get above 1% and deflation rather than inflation has been the norm. Prime Minister Shinzo Abe has made a big deal about his "three arrow" approach to getting the economy going again, but I don't see much evidence that it is working. Is there any prospect of breaking out of secular stagnation? BCA: Probably not. A big part of Japan's problem is demographics - an unfortunate combination of a declining labor force and a rapidly aging population. While this means that per capita GDP growth looks a lot better than the headline figures, it is not a growth-friendly situation. Twenty years ago there were 4.6 people of working age for everyone above 64. This has since dropped to 2.2 and within another 20 years it will be down to 1.6. That falling ratio of taxpayers to pensioners and major consumers of health care is horrendous for government finances. And an aging population typically is not a dynamic one which shows up in Japan's poor productivity performance relative to that of the U.S. (Chart 20). Of course, Japan can "solve" its public finances problem by having the Bank of Japan cancel its large holdings of JGBs. Yet that does nothing to deal with the underlying demographics issue and ongoing large budget deficits. Japan desperately needs a combination of increased immigration and major supply-side reforms, but we do not hold out much prospect of either changing by enough to dramatically alter the long-run growth picture. Mr. X: I will not disagree with you as I have not been positive about Japan for a long time. We should now turn to China. It is very suspicious that the economy continues to hum along at a 6% to 7% pace, despite all the excesses and imbalances that have developed. I really don't trust the data. We talked about China at our mid-2016 meeting and, if I remember correctly, you described China as like a tightrope walker, wobbling from time to time, but never quite falling off. Yet it would only take a gust of wind for that to change. I liked that description so my question is: are wind gusts likely to strengthen over the coming year? BCA: You are right to be suspicious of the official Chinese data, but it seems that the economy is expanding by at least a 5% pace. However, it continues to be propped up by unhealthy and unsustainable growth in credit. The increase in China's debt-to-GDP ratio over the past few years dwarves that during the ultimately disastrous credit booms of Japan in the 1980s and the U.S. in the 2000s (Chart 21). The debt increase has been matched by an even larger rise in assets, but the problem is that asset values can drop, while the value of the debt does not. Chart 20Japan's Structural Headwinds Japan's Structural Headwinds Japan's Structural Headwinds Chart 21China's Remarkable Credit Boom January 2017 - Shifting Regimes January 2017 - Shifting Regimes The government would like to rein in credit growth, but it fears the potential for a major economic slowdown, so it is trapped. The fact that the banking system is largely under state control does provide some comfort because it will be easy for the government to recapitalize the banks should problems occur. This means that a U.S.-style credit freeze is unlikely to develop. Of course, the dark side of that is that credit excesses never really get unwound. You asked whether wind gusts will increase, threating to blow the economy off its tightrope. One potential gust that we already talked about is the potential for trade fights with the new U.S. administration. As we mentioned earlier, we are hopeful that nothing serious will occur, but all we can do is carefully monitor the situation. Trends in China's real estate sector represent a good bellwether for the overall economic situation. The massive reflation of 2008-09 unleashed a powerful real estate boom, accompanied by major speculative excesses. The authorities eventually leaned against this with a tightening in lending standards and the sector cooled off. Policy then eased again in 2015/16 as worries about an excessive economic slowdown developed, unleashing yet another real estate revival. The stop-go environment has continued with policy now throttling back to try and cool things off again. It is not a sensible way to run an economy and we need to keep a close watch on the real estate sector as a leading indicator of any renewed policy shifts. Over time, the Chinese economy should gradually become less dependent on construction and other credit-intensive activities. However, in the near-term, there is no escaping the fact that the economy will remain unbalanced, creating challenges for policymakers and a fragile environment for the country's currency and asset markets. Fortunately, the authorities have enough room to maneuver that a hard landing remains unlikely over the next year or two. There are fewer grounds for optimism about the long-run unless the government can move away from its stop-go policy and pursue more supply-side reforms. Mr. X: What about other emerging economies? Are there any developments particularly worth noting? BCA: Emerging economies in general will not return to the rapid growth conditions of the first half of the 2000s. Slower growth in China has dampened export opportunities for other EM countries and global capital will no longer pour into these economies in its previous, indiscriminate way. Nevertheless, the growth outlook is stabilizing and 2017 should be a modestly better year than 2016 for most countries. Chart 22India Has A Long Way To Go India Has A Long Way To Go India Has A Long Way To Go The rebound in oil and other commodity prices has clearly been positive for Russia, Brazil and other resource-dependent countries. Commodity prices will struggle to rise further from current elevated levels but average 2017 prices should exceed those of 2016. On the negative side, a firm dollar and trade uncertainty will represent a headwind for capital flows to the EM universe. The bottom line is that the growth deceleration in emerging economies has run its course but a major new boom is not in prospect. The Indian economy grew by around 7½% in 2016, making it, by far, the star EM performer. Growth will take a hit from the government's recent decision to withdraw high-denomination bank notes from circulation - a move designed to combat corruption. Fortunately, the impact should be relatively short-lived and growth should return to the 7% area during the coming year. Still, India has a long way to go to catch up with China. In 1990, India's economy was almost 90% as big as China's in PPP terms, but 20 years later, it was only 40% as large. Even though India is expected to keep growing faster than China, its relative size will only climb to 45% within the next five years, according to the IMF (Chart 22). Mr. X: Let me try and summarize your economic views before we move on to talk about the markets. The growth benefit from fiscal stimulus in the U.S. is more a story for 2018 than 2017. Nevertheless, a modest improvement in global growth is likely over the coming year, following several years of economic disappointments. The key risks relate to increased trade protectionism and increased inflation in the U.S. if the rise in demand is not matched by an increase in the economy's supply-side capacity. In that event, tighter monetary policy could trigger a recession in 2019. You do not expect any major changes in the underlying economic picture for Europe, Japan or China, although political shifts in Europe represent another downside risk. BCA: That captures our views quite well. Going back to our broad theme of regime shifts, it is important to re-emphasize that shifting attitudes toward fiscal policy and trade in the U.S. raise a red flag over the longer-term inflation outlook. And this of course feeds into the outlook for interest rates. Bond Market Prospects Mr. X: That is the perfect segue for us to shift the discussion to the investment outlook, starting with bonds. You already noted that you believe the secular bull market in bonds has ended, albeit with a drawn-out bottoming process. Given my concerns about the long-run inflation outlook, I am happy to agree with that view. Yet, yields have risen a lot recently and I am wondering if this represents a short-term buying opportunity. BCA: The late-2016 sell-off in bonds was violent and yields rose too far, too fast. So we recently shifted our tactical bond recommendation from underweight (short duration) to neutral. But obviously that is not the same as telling you to buy. The underlying story for bonds - especially in the U.S. - is bearish. The prospect of fiscal stimulus, rising short rates and a pickup in inflation suggests that U.S. yields will be higher over the next 12 months. Although yields may decline somewhat in the very near-term, we doubt the move will be significant enough or last long enough to warrant an overweight position. The outlook is not quite so bad in the euro zone given the ECB's ongoing bond purchases and a continued benign inflation outlook. But, even there, the market will remain highly correlated with trends in U.S. Treasurys so yields are more likely to rise than fall over the coming year. The story is different in Japan given the central bank's new policy of pegging the 10-year yield at zero. That will be a static market for some time. Although global yields may have bottomed from a secular perspective, the upturn will be gradual in the years ahead. A post-Debt Supercycle environment implies that private sector credit growth will remain subdued, and during 2018, the market may start to attach growing odds of a U.S. recession within a year or two. A more powerful bear trend in bonds awaits the more significant upturn in inflation that likely will follow the next economic downturn. Chart 23Treasurys Are High Yielders Treasurys Are High Yielders Treasurys Are High Yielders Mr. X: I am somewhat surprised at how much the spread between U.S. and euro area bonds has widened - it is now at the highest level since the late 1980s. Obviously, a positive spread makes sense given the relative stance of monetary policy and economic outlook. Yet, it is quite amazing how investors have benefited from both higher yields in the U.S. and a stronger dollar. If the dollar stays firm in 2017, will the spread remain at current high levels? BCA: Most of the increased spread during the past year can be attributed to a widening gap in inflation expectations, although the spread in real yields also spiked after the U.S. election, reflecting the prospects for fiscal stimulus (Chart 23). While the spread is indeed at historical highs, the backdrop of a massive divergence in relative monetary and fiscal policies is not going to change any time soon. We are not expecting the spread to narrow over the next year. You might think that Japanese bonds would be a good place to hide from a global bond bear market given BoJ's policy to cap the 10-year yield at zero percent. Indeed, JGBs with a maturity of 10-years or less are likely to outperform Treasurys and bunds in local currency terms over the coming year. However, this means locking in a negative yield unless you are willing to move to the ultra-long end of the curve, where there is no BoJ support. Moreover, there is more upside for bond prices in the U.S. and Eurozone in the event of a counter-trend global bond rally, simply because there is not much room for JGB yields to decline. Mr. X: O.K., I get the message loud and clear - government bonds will remain an unattractive investment. As I need to own some bonds, should I focus on spread product? I know that value looks poor, but that was the case at the beginning of 2016 and, as you showed earlier, returns ended up being surprisingly good. Will corporate bonds remain a good investment in 2017, despite the value problem? BCA: This a tricky question to answer. On the one hand, you are right that value is not great. Corporate spreads are low in the U.S. at a time when balance sheet fundamentals have deteriorated, according to our Corporate Health Monitor (Chart 24). After adjusting the U.S. high-yield index for expected defaults, option-adjusted spreads are about 165 basis points. In the past, excess returns (i.e. returns relative to Treasurys) typically were barely positive when spreads were at this level. Valuation is also less than compelling for U.S. investment-grade bonds. One risk is that a significant amount of corporate bonds are held by "weak hands," such as retail investors who are not accustomed to seeing losses in their fixed-income portfolios. At some point, this could trigger some panic selling into illiquid markets, resulting in a sharp yield spike. On a more positive note, the search for yield that propped up the market in 2016 could remain a powerful force in 2017. The pressure to stretch for yield was intense in part because the supply of government bonds in the major markets available to the private sector shrank by around $547 billion in 2016 because so much was purchased by central banks and foreign official institutions (Chart 25). The stock will likely contract by another $754 billion in 2017, forcing investors to continue shifting into riskier assets such as corporate bonds. Chart 24U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated U.S. Corporate Health Has Deteriorated Chart 25Government Bonds In Short Supply Government Bonds In Short Supply Government Bonds In Short Supply Weighing the poor valuation and deteriorating credit quality trend against the ongoing pressure to search for yield, we recommend no more than a benchmark weighting in U.S. corporate investment-grade bonds and a modestly underweight position in high-yield. There are better relative opportunities in euro area corporates, where credit quality is improving and the ECB's asset purchase program is providing a nice tailwind. We are slightly overweight in both investment-grade and high-yield euro area corporates. Finally, we should mention emerging market bonds, although we do not have much good to say. The prospect of further declines in EM currencies versus the dollar is a major problem for these securities. There is a big risk that global dollar funding will dry up as the dollar moves higher along with U.S. bond yields, creating problems for EM economies running current account and fiscal deficits. You should stay clear of EM bonds. Mr. X: None of this is helping me much with my bond investments. Can you point to anything that will give me positive returns? Chart 26Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low Real Yields Remain Exceptionally Low BCA: Not in the fixed-income market. Your concerns about inflation might lead you to think that inflation-indexed bonds are a good place to be, but prices in that market have already adjusted. Moreover, the case for expecting higher inflation rests a lot on the assumption that economic growth is going to strengthen and that should imply a rise in real yields, which obviously is bad for inflation-indexed bonds. Real yields currently are still very low by historical standards (Chart 26). A world of stagflation - weak real growth and rising inflation - would be a good environment for these securities, but such conditions are not likely in the next couple of years. Mr. X: After what you have told me, I suppose I will concentrate my fixed-income holdings in short-term Treasurys. But I do worry more than you about stagflation so will hold on to my inflation-indexed bonds. At the same time, I do understand that bonds will represent a hedge against downside risks rather than providing positive returns. So let's talk about the stock market as a more attractive place to invest. Equity Market Outlook Mr. X: I like to invest in equities when the market offers good value, there is too much pessimism about earnings and investor sentiment is gloomy. That is not the picture at the moment in the case of the U.S. market. I must confess that the recent rally has taken me by surprise, but it looks to me like a major overshoot. As we discussed earlier, the new U.S. administration's fiscal platform should be good for 2018 economic growth but the U.S. equity market is not cheap and it seems to me that there is more euphoria than caution about the outlook. So I fear that the big surprise will be that the market does much worse than generally expected. BCA: Obviously, the current market environment is nothing like the situation that exists after a big sell-off. You are correct that valuations are not very appealing and there is too much optimism about the outlook for earnings and thus future returns. Analysts' expectations of long-run earnings growth for the S&P 500 universe have risen to 12%, which is at the high end of its range over the past decade (Chart 27). And, as you suggested, surveys show an elevated level of optimism on the part of investors and traders. The outlook for earnings is the most critical issue when it comes to the long-run outlook for stocks. Low interest rates provide an important base of support, but as we noted earlier, rates are more likely to rise than fall over the next couple of years, possibly reaching a level that precipitates a recession in 2019. Investors are excited about the prospect that U.S. earnings will benefit from both faster economic growth and a drop in corporate tax rates. We don't disagree that those trends would be positive, but there is another important issue to consider. One of the defining characteristics of the past several years has been the extraordinary performance of profit margins which have averaged record levels, despite the weak economic recovery (Chart 28). The roots of this rise lay in the fact that businesses rather than employees were able to capture most of the benefits of rising productivity. This showed up in the growing gap between real employee compensation and productivity. As a result, the owners of capital benefited, while the labor share of income - previously a very mean-reverting series - dropped to extremely low levels. The causes of this divergence are complex but include the impact of globalization, technology and a more competitive labor market. Chart 27Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Too Much Optimism On Wall Street? Chart 28Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? Profit Margins: Another Regme Shift Underway? With the U.S. unemployment back close to full-employment levels, the tide is now turning in favor of labor. The labor share of income is rising and this trend likely will continue as the economy strengthens. And any moves by the incoming administration to erect barriers to trade and/or immigration would underpin the trend. The implication is that profit margins are more likely to compress than expand in the coming years, suggesting that analysts are far too optimistic about earnings. Long-term growth will be closer to 5% than 12%. The turnaround in the corporate income shares going to labor versus capital represents another important element of our theme of regime changes. None of this means that the stock market faces an imminent plunge. Poor value and over-optimism about earnings raises a red flag over long-term return prospects, but says little about near-term moves. As we all know, market overshoots can move to much greater extremes and last for much longer than one can rationally predict. And the fact remains that the conditions for an overshoot could well persist for another 12 months or even longer. Optimism about the economic benefits of the new administration's policies should last for a while as proposals for tax cuts and increased fiscal spending get debated. Meanwhile, although the Fed plans to raise rates again over the next year, the level of interest rates will remain low by historical standards, sustaining the incentive to put money into stocks rather than interest-bearing assets. Mr. X: So are you telling me to buy U.S. stocks right now? BCA: No we are not. The stock market is vulnerable to a near-term setback following recent strong gains, so this is not a great time to increase exposure. However, we do expect prices to be higher in a year's time, so you could use setbacks as a buying opportunity. Of course, this is with the caveat that long-run returns are likely to be poor from current levels and we have the worry about a bear market some time in 2018 if recession risks are building. Playing market overshoots can be very profitable, but it is critical to remember that the fundamental foundations are weak and you need to be highly sensitive to signs that conditions are deteriorating. Mr. X: I am very well aware of the opportunities and risks of playing market overshoots. I completely underestimated the extent of the tech-driven overshoot in the second half of the 1990s and remained on the sidelines while the NASDAQ soared by 130% between end-1998 and March 2000. But my caution was validated when the market subsequently collapsed and it was not until 2006 that the market finally broke above its end-1998 level. I accept that the U.S. market is not in a crazy 1990s-style bubble, but I am inclined to focus on markets where the fundamentals are more supportive. BCA: The U.S. market is only modestly overvalued, based on an average of different measures. It is expensive based on both trailing and forward earnings and relative to book value, but cheap compared to interest rates and bond yields. A composite valuation index based on five components suggests that the S&P 500 currently is only modestly above its 60-year average (Chart 29). Valuation is not an impediment to further significant gains in U.S. equities over the coming year although it is more attractive in other markets. Chart 29The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive The U.S. Market Is Modestly Expensive If we use the cyclically-adjusted price-earnings ratio for non-financial stocks as our metric, then Japan and a number of European markets are trading at valuations below their historical averages (Chart 30). The picture for Japan is muddied by the fact that the historical average is biased upwards by the extreme valuations that existed during the bubble years and in the aftermath when earnings were exceptionally weak. Nonetheless, even on a price-to-book basis, Japan is trading far below non-bubble historical averages (Chart 31). Chart 30Valuation Ranking Of Developed Equity Markets January 2017 - Shifting Regimes January 2017 - Shifting Regimes Chart 31Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market Japan Looks Like A Cheap Market With regard to Europe, the good value is found in the euro area periphery, rather than in the core countries of Germany, France and the Netherlands. In fact, these core countries are trading more expensively than the U.S., relative to their own history. As you know, valuation is not the only consideration when it comes to investing. Nonetheless, the direction of monetary policy also would support a better outlook for Japan and the euro area given that the Fed is raising rates while the ECB and BoJ are still implementing QE policies. Exchange rate moves complicate things a bit because further gains in the dollar would neutralize some of the relative outperformance when expressed in common currency. Even so, we would expect the euro area and Japan to outperform the U.S. over the next 12 months. The one important qualification is that we assume no new major political shocks come from Europe. A resurgence of political uncertainty in the euro area would poses the greatest threat to the peripheral countries, which partly explains why they are trading at more attractive valuations than the core. Mr. X: There seem to be political risks everywhere these days. It is a very long time since I could buy stocks when they offered great value and I felt very confident about the economic and political outlook. I agree that value looks better outside the U.S., but I do worry about political instability in the euro area and Brexit in the U.K. I know Japan looks cheap, but that has been a difficult and disappointing market for a long time and, as we already discussed, the structural outlook for the economy is very troubling. Turning to the emerging markets, you have not backed away from your bearish stance. The long-run underperformance of emerging markets relative to the U.S. and other developed bourses has been quite staggering and I am glad that I have followed your advice. Are you expecting to shift your negative stance any time soon? BCA: The global underperformance of EM has lasted for six years and may be close to ending. But the experience of the previous cycle of underperformance suggests we could have a drawn-out bottoming process rather than a quick rebound (Chart 32). Emerging equities look like decent value on the simple basis of relative price-earnings ratios (PER), but the comparison continues to be flattered by the valuations of just two sectors - materials and financials. Valuations are less compelling if you look at relative PERs on the basis of equally-weighted sectors (Chart 33). Chart 32A Long Period Of EM Underperformance A Long Period Of EM Underperformance A Long Period Of EM Underperformance Chart 33EM Fundamentals Still Poor EM Fundamentals Still Poor EM Fundamentals Still Poor More importantly, the cyclical and structural issues undermining EM equities have yet to be resolved. The deleveraging cycle is still at an early stage, the return on equity remains extremely low, and earnings revisions are still negative. The failure of the past year's rebound in non-oil commodity prices to be matched by strong gains in EM equities highlights the drag from more fundamental forces. In sum, we expect EM equities to underperform DM markets for a while longer. If you want to have some EM exposure then our favored markets are Korea, Taiwan, China, India, Thailand and Russia. We would avoid Malaysia, Indonesia, Turkey, Brazil and Peru. Mr. X: None of this makes very keen to invest in any equity market. However, even in poor markets, there usually are some areas that perform well. Do you have any strong sector views? Chart 34Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot Cyclical Stocks Have Overshot BCA: Our near-term sector views reflect the expectation of a pullback in the broad equity market. The abrupt jump in the price of global cyclicals (industrials, materials & energy) versus defensives (health care, consumer staples & telecom services) has been driven solely by external forces - i.e. the sell-off in the bond market, rather than a shift in underlying profit drivers. For instance, emerging markets and the global cyclicals/defensives price ratio have tended to move hand-in-hand. The former is pro-cyclical, and outperforms when economic growth prospects are perceived to be improving. Recent sharp EM underperformance has created a large negative divergence with the cyclical/defensive price ratio. The surging U.S. dollar is a growth impediment for many developing countries with large foreign debts. Meanwhile, the growth impetus required to support profit outperformance for deep cyclicals may be elusive. As a result, we expect re-convergence to occur via a rebound in defensive relative to cyclical sectors (Chart 34). On a longer-term basis, one likely long-lasting effect of the retreat from globalization is that "small is beautiful." Companies with large global footprints will suffer relative to domestically focused firms. One way to position for this change is to emphasize small caps at the expense of large caps, a strategy applicable in almost every region. Small caps are traditionally domestically geared irrespective of their domicile. In the U.S. specifically, small caps face a potential additional benefit. If the new administration follows through with promised corporate tax cuts, then small caps will benefit disproportionately given that the effective tax rate of multinationals is already low. Moreover, small companies would benefit most from any cuts in regulations. When it comes to specifics, our overweight sectors in the U.S. are consumer discretionary, telecoms, consumer staples and health care. We would underweight industrials, technology and materials. For Europe, we also like health care and would overweight German real estate. We would stay away from European banks even though they are trading at historically cheap levels. Commodities And Currencies Mr. X: A year ago, you predicted that oil prices would average $50/bbl over the 2016-18 period. As that is where prices have now settled, do you still stick with that prediction? Chart 35Oil Market Trends Oil Market Trends Oil Market Trends BCA: We have moved our forecast up to an average of $55/bbl following the recent 1.8 million b/d production cuts agreed between OPEC, led by Saudi Arabia, and non-OPEC, led by Russia. The economic pain from the drop in prices finally forced Saudi Arabia to blink and abandon its previous strategy of maintaining output despite falling prices. Of course, OPEC has a very spotty record of sticking with its plans and we expect that we will end up with a more modest 1.1 to 1.2 million b/d in actual output reductions. Yet, given global demand growth of around 1.3 million b/d and weakness in other non-OPEC output, these cuts will be enough to require a drawdown in inventories from current record levels. Even with the lower level of cuts that we expect, OECD oil inventories could drop by around 300 million barrels by late 2017, enough to bring down stocks roughly to their five-year average level (Chart 35). That is the stated goal of Saudi Arabia and the odds are good that the level of compliance to the cuts will be better than the market expects. Mr. X: How does shale production factor into your analysis? What are the odds that a resurgence of U.S. shale production will undermine your price forecast? BCA: We expect U.S. shale-oil production to bottom in the first quarter of 2017, followed by a production increase of around 200,000 b/d in the second half. However, that will not be enough to drive prices back down. The bigger risk to oil prices over the next year or two is for a rise, not a decline given the industry's massive cutbacks in capital spending. More than $1 trillion of planned capex has been cut for the next several years, which translates into more than seven million b/d of oil-equivalent (oil and natural gas) production that will not be developed. And increased shale production cannot fully offset that. In addition to meeting demand growth, new production also must offset natural decline rates, which amount to 8% to 10% of production annually. Replacing these losses becomes more difficult as shale-oil output increases, given its very high decline rates. Shale technology appears to be gaining traction in Russia, which could end up significantly boosting production but capex cuts will constrain the global supply outlook until after 2018. Mr. X: Non-oil commodity prices have shown surprising strength recently, with copper surging almost 30% in the space of a few weeks. Is that just Chinese speculation, or is something more fundamental at work? You have had a cautious long-term view of commodities on the grounds that changing technology and reduced Chinese demand would keep a lid on prices. Do you see any reason to change that view? BCA: Developments in China remain critical for non-oil commodity prices. China's reflationary policies significantly boosted real estate and infrastructure spending and that was the main driver of the rally in metals prices in 2016. As we discussed earlier, China has eased back on reflation and that will take the edge off the commodity price boom. Indeed, given the speed and magnitude of the price increases in copper and other metals, it would not be surprising to see some near-term retrenchment. For the year as a whole, we expect a trading range for non-oil commodities. Longer-run, we would not bet against the long-term downtrend in real commodity prices and it really is a story about technology (Chart 36). Real estate booms notwithstanding, economies are shifting away from commodity-sensitive activities. Human capital is becoming more important relative to physical capital and price rises for resources encourages both conservation and the development of cheaper alternatives. In the post-WWII period, the pattern seems to have been for 10-year bull markets (1972 to 1982 and 2002 to 2012) and 20-year bear markets (1952 to 1972 and 1982 to 2002). The current bear phase is only six years old so it would be early to call an end to the downtrend from a long-term perspective. Chart 36The Long-Term Trend In Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down The Long-Term Trend in Real Commodity Prices Is Down Mr. X: You know that I can't leave without asking you about gold. I continue to believe that bullion provides a good hedge at a time of extreme monetary policies, political uncertainty and, now, the prospect of fiscal reflation. Can you see bullion at least matching its past year's performance over the coming 12 months? Chart 37A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion A Strong Dollar Hurts Bullion BCA: It is still a gold-friendly environment. The combination of political uncertainty, rising inflation expectations and continued easy money policies should provide support to bullion prices over the next year. The main negative is the potential for a further rise in the dollar: the strengthening of the dollar clearly was a factor undermining the gold price in the second half of 2016 (Chart 37). Nevertheless, a modest position in gold - no more than 5% of your portfolio - will give you some protection in what is likely to remain a very unsettled geopolitical environment. Mr. X: You mentioned the dollar so let me now delve into your currency views in more detail. The dollar has been appreciating for a few years and it seems quite a consensus view to be bullish on the currency. I know the U.S. economy is growing faster than most other developed economies but it surprises me that markets are ignoring the negatives: an ongoing large trade deficit, a looming rise in the fiscal deficit and uncertainty about the policies of the incoming administration. BCA: It is true that if you just looked at the U.S. economic and financial situation in isolation, you would not be very bullish on the currency. As you noted, the current account remains in large deficit, an increased federal deficit seems inevitable given the new administration's policy platform, and the level of short-rates is very low, despite the Fed's recent move. However, currencies are all about relative positions, and, despite its problems, the U.S. looks in better shape than other countries. The optimism toward the dollar is a near-term concern and suggests that the currency is ripe for a pullback. However, it will not require a major sell-off to unwind current overbought conditions. The main reasons to stay positive on the dollar on a cyclical basis are the relative stance of monetary policy and the potential for positive U.S. economic surprises relative to other countries. Ironically, if the administration follows up on its threat to impose trade barriers, that also would be positive for the currency, at least for a while. Longer-run it would be dollar bearish, because the U.S. probably would lose competiveness via higher inflation. The dollar is enjoying its third major upcycle since the era of floating rates began in the early 1970s (Chart 38). There are similarities in all three cases. Policy divergences and thus real interest-rate differentials were in the dollar's favor and there was general optimism about the U.S. economy relative to its competitors. In the first half of the 1980s, the optimism reflected President Reagan's pro-growth supply-side platform, in the second half of the 1990s it was the tech bubble, and this time it is the poor state of other economies that makes the U.S. look relatively attractive. Chart 38The Dollar Bull Market In Perspective January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bull market in the first half of the 1980s was the strongest of the three but was cut short by the 1985 Plaza Accord when the leading industrial economies agreed to coordinated intervention to push the dollar back down in order to forestall a U.S. protectionist response to its soaring trade deficit. The second upturn ended when the tech bubble burst. There is no prospect of intervention to end the current cycle and policy divergences will widen not narrow over the next year. Thus, the dollar should continue to appreciate over the next 12 months, perhaps by around 5% on a trade-weighted basis. The fiscal policies being promoted by the Trump team promise to widen the U.S. trade deficit but that will not stand in the way of a dollar ascent. The problems will occur if, as we discussed earlier, an overheating economy in 2018 and a resulting Fed response trigger a recession in 2019. At that point, the dollar probably would plunge. But it is far too soon to worry about that possibility. Mr. X: I was very surprised with the yen's strength in the first half of 2016 given Japan's hyper-easy policy stance. What was driving that? Also, I would be interested in your views on sterling and commodity and emerging currencies. BCA: The yen often acts as a safe-haven at times of great economic and political uncertainty and that worked in the yen's favor for much of the year. However, it lost ground when U.S. bond yields headed higher. Also, the U.S. election result did not help because Japan would be a big loser if the U.S. imposed trade restrictions. The policy settings in Japan are indeed negative for the yen and while the currency is oversold in the very short run, we expect the structural bear market to persist in 2017 (Chart 39). Sterling's trade-weighted index fell to an all-time low after the Brexit vote so it does offer good value by historical standards. However, with so much uncertainty about how Brexit negotiations will proceed, we remain cautious on the currency. The economy has performed quite well since the vote, but it is far too soon to judge the long-term consequences of EU departure. And the prospect of increased government spending when the country already has a large trade deficit and high public debt poses an additional risk. Turning to the commodity currencies, the rebound in oil and metals prices has stabilized the Canadian and Australian dollars (Chart 40). With resource prices not expected to make much further headway over the next year, these currencies likely will be range bound, albeit with risks to the downside, especially versus the U.S. dollar. Chart 39More Downside In The Yen More Downside In The Yen More Downside In The Yen Chart 40Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Commodity Currencies Have Stabilized Finally, we remain bearish on emerging currencies given relatively poor economic fundamentals. And this is particularly true for those countries with chronically high inflation and/or large current account deficits, largely outside of Asia. Mr. X: What about the Chinese currency? The renminbi has dropped by 13% against the dollar over the past three years and president-elect Trump has threatened to label China as a currency manipulator. You already noted that the Chinese authorities have intervened to prop the currency up, but this does not seem to be working. Chart 41Renminbi Weakness Renminbi Weakness Renminbi Weakness BCA: The trend in the USD/RMB rate exaggerates the weakness of the Chinese currency. On a trade-weighted basis, the currency has depreciated more modestly over the past year, and the recent trend has been up, in both real and nominal terms (Chart 41). In other words, a good part of the currency's move has reflected across-the-board strength in the dollar. The Chinese authorities are sensitive to U.S. pressures and have taken some measures to contain private capital outflows. The next step would be to raise interest rates but this would be a last resort. With the dollar expected to rise further in 2017, the RMB will drift lower, but policy interventions should limit the decline and we doubt the U.S. will follow through with its threat to label China as a manipulator. Geopolitics Mr. X: Last, but certainly not least, we must talk about geopolitics. In addition to the new political order in the U.S. we have a very unstable political situation in Europe, most notably in Italy. We cannot rule out an anti-euro party taking power in Italy which would presumably trigger massive volatility in the markets. With elections also due in France, Germany and the Netherlands, 2017 will be a crucial year for determining the future of the single currency and the EU. What is your take on the outlook? Chart 42Europeans Still Support The EU Europeans Still Support The EU Europeans Still Support The EU BCA: Europe's electoral calendar is indeed ominously packed with four of the euro area's five largest economies likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As BCA's Geopolitical Strategy has argued since 2011, global multipolarity increases the logic for European integration. Crises such as Russian assertiveness, Islamic terrorism, and the migration wave are easier to deal with when countries act together rather than individually. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro or the EU (Chart 42). Despite all of its problems, the single currency should hold together, at least over the next five years. Take the recent Spanish and Austrian elections. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the more-establishment candidate for president, Alexander Van der Bellen, won the election despite fears to the contrary. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. We expect more of the same in the three crucial elections in the Netherlands, France, and Germany. Mr. X: What about Italy? BCA: The country certainly has its problems: it has lagged badly in implementing structural reforms and support for the euro is low compared to the euro area average. Yet, if elections were held today, polls show that the ruling Democratic Party would gain a narrow victory. There are three key points to consider regarding Italy: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum. The market will punish Italy the moment it sniffs out even a whiff of a potential "Itexit" referendum. This will bring forward the future pain of redenomination, influencing voters' choices. Benefits of EU membership for Italy are considerable, especially as it allows the country to integrate its unproductive, poor, and expensive southern regions. Outside the EU, the Mezzogiorno is Rome's problem, and it is a big one. The larger question is whether other euro area countries will be content for Italy to remain mired in its fragile and troubling status quo. We think the answer is yes, given that Italy is the definition of "too-big-to-fail." Mr. X: During the past few years you have emphasized the importance of the shift from a unipolar to multipolar world, reflecting the growing power of China, renewed Russian activism and a decline in U.S. influence. How does the policy platform of the incoming Trump administration affect your view of the outlook? It seems as if the U.S. may end up antagonizing China at the same time as it tries to improve relations with Russia. How would that play out? Chart 43Asia Sells, America Rules Asia Sells, America Rules Asia Sells, America Rules BCA: The media is overemphasizing the role of president-elect Trump in Sino-American relations. Tensions have been building between the two countries for several years. The two countries have fundamental, structural, problems and Trump has just catalyzed what, in our mind, has been an inevitable conflict. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were instrumental: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 43). For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its umbrella. Japan's economic model and large trade surpluses led it into a confrontation with the U.S. in the 1980s. President Ronald Reagan's economic team forced Japan to reform, but the result ultimately was a financial crisis as the artificial supports of its economic model fell away. Many investors have long suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it hinders U.S. access to its vast consumer market. There is a critical difference between the "Japan bashing" of the 1980s and the increasingly potent "China bashing" of today. In the 1980s, the U.S. had already achieved strategic supremacy over Japan as a result of WWII, but that is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the U.S. to preserve its security. Far from it - China has no greater security threat than the U.S. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. That means that when the Trump administration tries to "get tough" on long-standing American demands, these demands will not be taken as well-intentioned or trustworthy. Sino-American rivalry will be the chief geopolitical risk to investors in 2017. Mr. X: Are there any other geopolitical issues that might affect financial markets during the coming year? BCA: Investors are underestimating the risks that the defeat of the Islamic State Caliphate in the Middle East will pose. While the obvious consequence is a spread of terrorism as militants return home, the bigger question is what happens to the regional disequilibrium. In particular, we fear that Turkey will become embroiled in a conflict in both Syria and Iraq, potentially in a proxy war with Iran and Russia. The defeat of Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. The Turkish foray into the Middle East poses the chief risk of a shooting war that could impact global markets in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. Conclusions Mr. X: I think we should end our discussions here before you make me more depressed. A year ago, I was very troubled about the economic and financial outlook, and you did not say very much at that time to ease my concerns. And I feel in a similar situation again this year. I do not believe we are at the edge of a major economic or financial crisis, so that is not the issue. The problem for me is that policymakers continue to distort things with excessively easy monetary policies. And now we face fiscal expansion in the U.S., even though the economy is approaching full employment and wages are picking up. Meanwhile, nobody seems worried about debt anymore despite debt-to-GDP ratios that are at all-time highs throughout the world. And if that was not enough, we face the most uncertain political environment that I can remember, both in the U.S. and Europe. It would not be so bad if markets were cheap to compensate for the various risks and uncertainties that we face. But, as we discussed, that is not the case. So I am left with the same dilemma as last year: where to invest when most assets are fully valued. I am sure that you are right when you say that stock prices are well placed to overshoot over the coming year, but that is not a game I like to play. So I am inclined to stay with a cautious investment stance for a while longer, hoping for a better entry point into equities and other risk assets. BCA: We understand your caution, but you risk missing out on some decent gains in equities over the coming year if you remain on the sidelines. The equity market is due for a near-term pullback, but we would use that as a buying opportunity. Markets are not expensive everywhere and the policy backdrop will remain supportive of risk assets. And although we talked about an overshoot, there is plenty of upside before we need to be concerned that valuations have become a major constraint. We are certainly not trying to persuade you to throw caution to the wind. We have not changed our view that long-term returns from financial assets will be a pale shadow of their historical performance. The past 33 years have delivered compound returns of 10.3% a year from a balanced portfolio and we cannot find any comparable period in history that comes even close (Table 3). As we discussed at length in the past, these excellent returns reflected a powerful combination of several largely interrelated forces: falling inflation and interest rates, rising profit margins, a starting point of cheap valuations and strong credit growth. None of these conditions exist now: inflation and interest rates are headed up, profit margins are likely to compress, valuations are not cheap, and in a post-Debt Supercycle world, the days of rapid credit growth are over. Thus, that same balanced portfolio is likely to deliver compound returns of only 4% over the coming decade. Table 3The Past Is Not A Guide To The Future January 2017 - Shifting Regimes January 2017 - Shifting Regimes The bottom line is that the economic and policy regime that delivered exceptional markets is shifting. The end of the Debt Supercycle a few years ago represented one element of regime shift and now we face several other elements such as the end of the era of falling inflation and interest rates, a rebalancing of the income shares going to labor and capital, and politically, in attitudes and thus policies regarding globalization. A world of modest returns is one where it is very important to get the right country and sector allocation, and ideally, catch shorter-term market swings. Of course, that is much more challenging than simply enjoying a rising tide that lifts all boats. As the year progresses, we will update you with our latest thinking on market trends and investment ideas. Mr. X: I am sure we are about to have a very interesting year and I will rely on your research to highlight investment opportunities and to keep me out of trouble. Once again, many thanks for spending the time to take me through your views and let's end with a summary of your main views. BCA: That will be our pleasure. The key points are as follows: A number of important regime shifts will impact the economic and investment outlook over the next few years. These include the end of the era of falling inflation and interest rates, a move away from fiscal conservatism, a policy pushback against globalization, and a rise in the labor share of income at the expense of profit margins. Together with an earlier regime shift when the Debt Supercycle ended, these trends are consistent with very modest returns from financial assets over the next decade. The failure of low interest rates to trigger a vigorous rebound in private credit growth is consistent with our end-of-Debt Supercycle thesis. The end-point for dealing with high debt levels may ultimately be sharply higher inflation, but only after the next downturn triggers a new deflationary scare. The potential for trade restrictions by the incoming U.S. administration poses a threat to the outlook, but the odds of a global trade war are low. Time-lags in implementing policy mean that the fiscal plans of president-elect Trump will boost U.S. growth in 2018 more than 2017. This raises the risk of an overheated economy in 2018 leading to a monetary squeeze and recession in 2019. They key issue will be whether the supply side of the economy expands alongside increased demand and it will be critical to monitor business capital spending. Lingering structural problems will prevent any growth acceleration outside the U.S. The euro area and emerging economies are still in the midst of a deleveraging cycle and demographics remain a headwind for Japan. Not many countries will follow the U.S. example of fiscal stimulus. Nevertheless, for the first time since the recovery began, global growth forecasts are likely to avoid a downgrade over the next couple of years. China remains an unbalanced and fragile economy but the authorities have enough policy flexibility to avoid a hard landing, at least over the year or two. The longer-run outlook is more bearish unless the government moves away from its stop-go policy approach and pursues more supply-side reforms. Inflation has bottomed in the U.S., but the upturn will be gradual in 2017 and it will stay subdued in the euro area and Japan. Divergences in monetary policy between the U.S. and other developed economies will continue to build in 2017 as the Fed tightens and other central banks stay on hold. Unlike a year ago, the Fed's rate expectations look reasonable. Bond yields in the U.S. may fall in the near run after their recent sharp rise, but the cyclical trend is up against a backdrop of monetary tightening, fiscal stimulus and rising inflation. Yields in the euro area will be held down by ongoing QE, while the 10-year yield will stay capped at zero in Japan. The secular bull market in bonds is over although yields could retest their recent lows in the next downturn. The search for yield will remain an important investment theme, but rich valuations dictate only a neutral weighting in investment-grade corporate bonds and a modest underweight in high-yielders. The U.S. equity market is modestly overvalued but the conditions are ripe for an overshoot in 2017 given optimism about a boost to profits from the new administration's policies. Earnings expectations are far too high and ignore the likelihood that rising labor costs will squeeze margins. Nevertheless, that need not preclude equity prices moving higher. There is a good chance of a sell-off in early 2017 and that would be a buying opportunity. Valuations are better in Japan and several European markets than in the U.S. and relative monetary conditions also favor these markets. We expect the U.S. to underperform in 2017. We expect emerging markets to underperform developed markets. The oil price should average around $55 a barrel over the next one or two years, with some risk to the upside. Although shale production should increase, the cutbacks in oil industry capital spending and planned production cuts by OPEC and some other producers will ensure that inventories will have to be drawn down in the second half of 2017. Non-oil commodity prices will stay in a trading range after healthy gains in 2016, but the long-run outlook is still bearish. The dollar bull market should stay intact over the coming year with the trade-weighted index rising by around 5%. Relative policy stances and economic trends should all stay supportive of the dollar. The outlook for the yen is especially gloomy. A stabilization in resource prices will keep commodity prices in a range. We remain bearish on EM currencies. The biggest geopolitical risks relate to U.S.-China relations, especially given president-elect Trump's inclination to engage in China-bashing. Meanwhile, the defeat of ISIS could create a power vacuum in the Middle East that could draw Turkey into a disastrous conflict with the Kurds and Iran/Russia. The coming year is important for elections in Europe but we do not expect any serious threat to the EU or single currency to emerge. Let us take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors December 20, 2016

Highlights Theme 1: Secular Stagnation Vs. Trumponomics. A larger deficit will cause Treasury yields to rise in 2017 and, for at least a while, it will appear as though secular stagnation has been conquered. Theme 2: A Cyclical Sweet Spot. Better growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen early in the year and transition to a bear-flattening only when long-dated TIPS breakevens reach the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish. The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty. Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle. Recovery in the energy sector will cause the uptrend in the default rate to reverse in 2017, but poor corporate health and tightening monetary policy will lead to a resumption of the uptrend in 2018 and beyond. Theme 6: The Muni Credit Cycle Starts To Turn. The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Theme 7: A Rare Opportunity In Leveraged Loans. The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Feature In this Special Report, the last U.S. Bond Strategy report of the year, we present seven major investment themes that will drive U.S. fixed income market performance in 2017. Our regular publication schedule will resume on January 10 with the publication of our Portfolio Allocation Summary for January 2017. Theme 1: Secular Stagnation Vs. Trumponomics With 2016 almost in the books, it is clear that Treasury returns will likely be close to zero for the year. The total return from the Bloomberg Barclays U.S. Aggregate index will be only marginally better, in the neighborhood of 1% to 2% (see the Appendix at the end of this report for a detailed summary of U.S. fixed income returns in 2016). But these disappointing returns don't tell the whole story. Up until November 8, the Bloomberg Barclays Treasury and Aggregate indexes had returned 4% and 5% year-to-date, respectively (Chart 1). It was only then that the surprise election of Donald Trump caused investors to question many of the assumptions that had driven yields lower during the past several years. As of today, there is not much daylight between the market's expected path of the federal funds rate and the FOMC's own projections (Chart 2). This means that for below-benchmark duration positions to perform well going forward it is no longer sufficient to call for a convergence between the market's rate expectations and the Fed's dots, as we had been doing since July.1 For Treasury yields to rise going forward we must exit the regime of secular stagnation - one that has been characterized by serial downward revisions to the Fed's interest rate forecasts - and enter a new regime where improving global growth and Trumponomics lead to a series of faster-than-expected rate hikes and upward revisions to the Fed's dots. Chart 1Bond Market Returns In 2016 bca.usbs_sr_2016_12_20_c1 bca.usbs_sr_2016_12_20_c1 Chart 2Market Almost In Line With Fed bca.usbs_sr_2016_12_20_c2 bca.usbs_sr_2016_12_20_c2 What Is Secular Stagnation? For the purposes of the bond market we define secular stagnation based on the observation that in each cycle since 1980 it has required lower real interest rates to achieve the Fed's inflation target (Chart 3). The logical conclusion to be drawn is that the equilibrium real interest rate - the one that is consistent with steady inflation - must be in a secular downtrend. A paper published last year by the Bank of England (BoE),2 and discussed in detail by our own Bank Credit Analyst last February,3 identifies the drivers of this long-run decline in the equilibrium real rate and ranks them in order of importance. Chart 3This Is What Secular Stagnation Looks Like bca.usbs_sr_2016_12_20_c3 bca.usbs_sr_2016_12_20_c3 One key finding from the BoE's research is that expectations for lower trend growth account for only 100 bps of the 450 bps decline in global real yields since the mid-1980s. Increases in desired savings and decreases in desired investment for a given level of global growth account for the bulk of the decline (300 bps), while 50 bps of the decline remains unexplained (Table 1). Table 1The Drivers Of Secular Stagnation Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 The most important factors identified in the paper include: Demographics: A lower dependency ratio (the non-working age population relative to the working age population) is associated with an increased desire to save. Inequality: The bulk of income gains during the past 35 years have accrued to the richest tiers of the population, the group that is most inclined to save rather than spend. EM Savings Glut: Since the 1990s many emerging market countries have increased foreign exchange reserves to guard against capital outflows, representing an extra source of demand for safe assets. Falling Capital Goods Prices: The relative price of capital goods has fallen about 30% since the 1980s. This means that less savings are required to undertake the same amount of investment. Less Public Investment: The reluctance of governments to pursue large-scale public investment projects has contributed an additional 20 bps of downside to global real yields. Spread Between Cost of Capital & Risk Free Rate: The expected cost of capital (measured using bank credit spreads, corporate bond spreads and the equity risk premium) has not fallen as much as the risk free rate during the past 30 years. This has made investment less sensitive to changes in the risk-free rate. Is Trumponomics The Solution? Can a Donald Trump presidency actually change any of these long-run factors? It is conceivable that fiscal policies focused on spurring capital investment could enhance the outlook for productivity growth and reverse some of the decline in potential GDP growth expectations. However, lower potential GDP growth expectations have also been driven by slower labor force growth, a trend that fiscal policy is powerless to address. On the plus side, the dependency ratio is likely to bottom in the coming years and the increased infrastructure investment that Trump has promised would certainly put upward pressure on rates. It is also possible that the watering-down of certain regulations might bring the cost of capital more in-line with the risk free rate. However, these potentially positive trends need to be weighed against increasingly isolationist trade and immigration policies that will hamper potential GDP growth, as well as proposed tax cuts that disproportionately target the highest income tiers. The latter will only exacerbate the impact of inequality on real yields. What's The Verdict? With so much uncertainty surrounding fiscal policy it is premature to declare the death of secular stagnation. However, secular stagnation will not be the dominant bond market theme in 2017. Amidst all the uncertainty, one thing that seems likely is that a Trump presidency will result in materially higher deficits next year and consequently more Treasury issuance. Chart 4Big Government Only A##br## Problem For Opposition bca.usbs_sr_2016_12_20_c4 bca.usbs_sr_2016_12_20_c4 With one party now in complete control of the Congress it is certain that government spending will increase next year. As our geopolitical strategists have repeatedly pointed out,4 lawmakers are only opposed to higher spending when they are not in power. Survey results show that this is also true of voters (Chart 4). Further, Moody's has estimated a range of outcomes for the federal deficit in 2017 based on how much of Trump's stated campaign agenda is implemented. These estimates range from 4.1% of GDP at the low end to 6% of GDP at the high end. This compares to 3.8% of GDP that was expected under current law.5 The greater supply of Treasury securities next year will offset some of the increased demand stemming from the excess of desired savings relative to investment. This will cause Treasury yields to move higher in 2017 and, for at least a while, it will appear as though the forces of secular stagnation have been conquered. Bottom Line: While Trumponomics will rule in 2017, the forces of secular stagnation are simply dormant and are likely to flare-up again in 2018 and beyond. Theme 2: A Cyclical Sweet Spot In the first half of 2017 the combination of improving economic growth and accommodative monetary policy will create a "sweet spot" for risk assets. The positive environment for risk assets will only end when Fed policy becomes overly restrictive. We expect that restrictive Fed policy will not be an issue until near the end of 2017. Above-Trend Growth Chart 5Contributions To GDP Growth Contributions To GDP Growth Contributions To GDP Growth Even prior to the election, U.S. economic growth appeared poised to accelerate in 2017. The main reason being that some of the factors that restrained growth in 2016 are shifting from headwinds to tailwinds (Chart 5). Consumer spending should continue to be a solid contributor to growth next year, just as in 2016. Surveys of consumer sentiment suggest we should even expect a modest acceleration (Chart 5, panel 1). Residential investment actually contributed negatively to real GDP in Q2 and Q3 of 2016 even though leading indicators remained firm. This drag is bound to reverse (Chart 5, panel 2). Government spending contributed almost nothing to growth in 2016 but is poised to accelerate next year based on trends in public sector employment. This does not even take into account the potential for more stimulative fiscal policy in 2017 (Chart 5, panel 3). Inventories were a large negative contributor to growth this year. History suggests that large inventory drawdowns tend to mean-revert fairly quickly (Chart 5, panel 4). Net exports exerted less of a drag on growth in 2016 than 2015 due to moderation in the pace of exchange rate appreciation. With the dollar still in a bull market, net exports will not be a significant driver of growth in 2017 (Chart 5, bottom panel). Nonresidential investment was also a large drag on growth in 2016 and should return to being a small positive contributor next year. First, most of the drag was related to lower capital spending from the energy sector (Chart 6). Now that oil prices have rebounded this drag will abate. Second, surveys of new orders have remained supportive (Chart 7, panel 1) and industrial production growth has rebounded off its lows (Chart 7, panel 2). The rebound in industrial production growth is also likely related to the recovery in energy prices. Chart 6Contribution To Nonresidential Fixed Investment Spending Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 7Will Capex Return In 2017? bca.usbs_sr_2016_12_20_c7 bca.usbs_sr_2016_12_20_c7 The end of the drag from energy alone will be enough to make nonresidential investment a positive contributor to growth next year. The wildcard is that the easier regulatory backdrop under President Trump could unleash the animal spirits of the corporate sector and lead to even larger gains. While this outcome is obviously highly uncertain, there is some evidence that business optimism has already increased. The NFIB small business optimism index shot higher in November (Chart 7, bottom panel) and what's more, the NFIB's Chief Economist Bill Dunkelberg noted that "the November index was basically unchanged from October's reading up to the point of the election and then rose dramatically after the results of the election were known." Accommodative Monetary Policy Even with an improving growth outlook we expect the Fed will be slow to react with a faster pace of rate hikes, opting instead to nurture the recovery in inflation and inflation expectations until they are more firmly anchored around its target. With core PCE inflation still running at 1.7% - below the Fed's 2% target - and the 5-year/5-year TIPS breakeven inflation rate currently at 1.86% - well below the level of 2.4% to 2.5% consistent with the Fed's inflation target - there is no rush for the Fed to send a message that it will move aggressively to snuff out incipient inflationary pressures (Chart 8). Instead, the Fed will continue to send the message that there is no need to be aggressive given the downside risks, and will continue to be sensitive to any negative market response to more restrictive monetary policy. In other words, the "Fed put" is still in place. If risk assets start to sell off due to perceptions of overly restrictive monetary policy, the Fed will be quick to adopt a more dovish posture. The Fed will react in this manner at least until long-dated TIPS breakevens are firmly anchored in the range of 2.4% to 2.5%. It is only at that point that the Fed will be less concerned about negative market reactions to Fed tightening and more concerned with battling inflation. Further, it will take at least until the second half of next year for long-dated TIPS breakevens to return to target. This is because they will be held back by the slow uptrend in actual core inflation. The sensitivity of long-dated TIPS breakevens to core inflation has increased since the financial crisis (Chart 9). We posit that this is due to the zero-lower-bound on the fed funds rate. Prior to the financial crisis, with the fed funds rate well above zero, in the event of a deflationary shock investors would reasonably expect the Fed to offset that shock by easing policy. As such, the deflationary shock had a limited impact on long-dated breakevens. But when the fed funds rate is constrained at the zero-bound, there is reason to question whether the Fed can respond to a deflationary shock as in the past. Given the proximity of the fed funds rate to zero, realized inflation will be a much stronger determinant of long-dated breakevens in the current cycle. Chart 8Inflation Still Needs To Rise bca.usbs_sr_2016_12_20_c8 bca.usbs_sr_2016_12_20_c8 Chart 9Recovery In Breakevens Will Moderate bca.usbs_sr_2016_12_20_c9 bca.usbs_sr_2016_12_20_c9 Inflation Will Move Higher, But Only Slowly Inflation will continue to march higher in 2017, driven by a tight labor market and upward pressure on wage growth. With the unemployment rate already at 4.6% even modest employment gains can lead to exponential increases in wage growth (Chart 10). However, the pass-through from wage growth to overall price inflation is likely to be muted. Shelter, the largest component of core CPI, is mostly determined by rental vacancies which appear to be stabilizing just as market rents are rolling over. Our model suggests that shelter will not drive inflation higher in 2017 (Chart 11, panel 1). Core goods inflation (25% of core CPI) will also remain very low. This component of inflation is most tightly correlated with the trade-weighted dollar (Chart 11, panel 2), and so will stay depressed as long as the bull market in the dollar remains intact. Chart 10Wage Growth & Unemployment Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 11Core Inflation By Component bca.usbs_sr_2016_12_20_c11 bca.usbs_sr_2016_12_20_c11 Historically, wage growth is most tightly correlated with service sector inflation excluding shelter and medical care (Chart 11, bottom panel). This component, which accounts for 25% of core CPI, is where we expect the marginal change in inflation will come from. We expect that the current uptrend in core inflation will remain intact next year, but core PCE will not converge with the Fed's 2% target until late-2017. Investment Implications The combination of better economic growth and accommodative Fed policy is a fertile environment for risk assets, and we expect spread product will perform well in the first half of next year. At the moment, however, we advocate only a neutral allocation to investment grade corporate bonds and an underweight allocation to high-yield based on poor valuation (see Theme 5). Given the positive economic back-drop we will be quick to increase exposure if spreads widen in the near term. Long-dated TIPS breakevens will also continue to widen until they reach the 2.4% to 2.5% range that is consistent with the Fed's inflation target. As such, we remain overweight TIPS relative to nominal Treasury yields, even though the uptrend in breakevens is likely to moderate in the months ahead. We will likely downgrade TIPS in 2017, once long-dated breakevens reach our target in the second half of the year. The cyclical sweet spot of better growth and an easy Fed also means that the Treasury curve is likely to bear-steepen in the New Year. Historically, excluding periods when the Fed is cutting rates, the 2/10 Treasury curve tends to steepen when TIPS breakevens rise and flatten when they fall (Chart 12). Further, after last week's Fed meeting the 5-year bullet now looks very cheap on the curve (Chart 13). Chart 12Wider Breakevens Correlated With A Steeper Yield Curve Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 13The 5-year Bullet Is Cheap On The Curve bca.usbs_sr_2016_12_20_c13 bca.usbs_sr_2016_12_20_c13 We expect Treasury curve steepening to persist next year until TIPS breakevens normalize near our target. At that point the bear-steepening curve environment will shift to a bear-flattening one. Investors should buy the 5-year bullet and sell a duration-matched 2/10 barbell to profit from curve steepening in the first half of next year and to take advantage of the cheapness of the 5-year bullet. Bottom Line: The combination of better economic growth and an accommodative Fed will create a sweet spot for risk assets in the first half of 2017. The Treasury curve will bear-steepen and TIPS breakevens will continue to rise. Curve bear-steepening will transition to bear-flattening once long-dated TIPS breakevens level-off in the 2.4% to 2.5% range. Theme 3: Global Risks Shift From Bond-Bullish To Bond-Bearish Alongside secular stagnation, the most important theme driving U.S. bond markets during the past several years has been the divergence in growth between the U.S. and the rest of the world. We have repeatedly pointed out that these global growth divergences have led to upward pressure on the dollar, and that a strong dollar necessarily limits the amount of monetary tightening that can be achieved through higher interest rates. The strong dollar thus serves as a cap on long-dated Treasury yields. This theme will remain very much intact for most of 2017, but will probably be less potent than in prior years. Our Global LEI diffusion index - a measure of global growth divergences - has moved firmly into positive territory. This makes it unlikely that we will see another dollar appreciation of the scale witnessed in 2014/15 (Chart 14). The fact that the U.S. is still leading the way in terms of growth means the bull market in the dollar will stay in place, but the appreciation will be less potent going forward. Still, from the perspective of Treasury yields, it will be important to monitor the trade-off between accelerating global growth on the one hand and a stronger dollar on the other. One tool we have devised to help guide us in this respect is our 2-factor Global PMI model (Chart 15). This is a model of the 10-year Treasury yield based on global PMI and bullish sentiment toward the U.S. dollar. A stronger global PMI puts upward pressure on the 10-year Treasury yield while, for a given level of global growth, an increase in bullish sentiment toward the dollar pressures the 10-year yield lower. Chart 14Global Growth Divergences ##br##Less Pronounced bca.usbs_sr_2016_12_20_c14 bca.usbs_sr_2016_12_20_c14 Chart 152-Factor Global ##br##PMI Model bca.usbs_sr_2016_12_20_c15 bca.usbs_sr_2016_12_20_c15 At present, this model tells us that fair value for the 10-year Treasury yield is 2.26%, well below current levels. This is one reason we tactically shifted to a benchmark duration stance on December 6 even though we expect yields to rise next year. Going forward we will continue to use this model to assess whether increasing global growth or a stronger dollar is dominating in terms of the impact on Treasury yields. Chart 16A Bond Bearish Surprise? bca.usbs_sr_2016_12_20_c16 bca.usbs_sr_2016_12_20_c16 Through the mechanism described above, the rest of the world will continue to be a bond-bullish force with respect to U.S. Treasury yields for most of 2017. However, near the end of 2017 it is possible that either the Eurozone or Japan could start to exert upward pressure on U.S. Treasury yields. This could occur if it seems likely that either economic bloc is poised to reach its inflation target and the market starts to discount an end to their extremely accommodative monetary policies. We have highlighted the risks of such events in prior reports, in the context of our Tantrum Theory of Global Bond Yields.6 The unemployment rate in the Eurozone is declining rapidly, but has historically needed to break below 9% before core inflation starts to rise (Chart 16, panels 1 & 2). If the current pace of above-trend growth in Europe is sustained throughout 2017 then higher inflation and the end of the European Central Bank's (ECB) asset purchases could become a risk to global bond markets late next year. However, even minor setbacks in growth would be enough to push this risk out to 2018. In Japan, although inflation is still well below the Bank of Japan's (BoJ) target, yen weakness suggests it should begin to rise (Chart 16, bottom panel). While the BoJ has promised to wait until inflation is above target before abandoning its yield curve peg, it is possible that near the end of next year, if inflation is much higher, the market will start to discount the eventual end of the BoJ's policy and cause global bonds to sell off. For now we would characterize these bond-bearish surprises from the BoJ and/or ECB as tail risks for the global bond market that could flare in late 2017. Bottom Line: The trade-off between accelerating global growth and a stronger dollar will dictate the pace of next year's rise in Treasury yields. Be on the lookout for bond-bearish surprises from the ECB and BoJ in late 2017. Theme 4: Lingering Policy Uncertainty With fiscal policy having the potential to drastically alter the economic landscape and yet with so much still unknown about what will occur, lingering policy uncertainty will undoubtedly be a major theme for fixed income markets in 2017. Historically, the Global Economic Policy Uncertainty index created by Baker, Bloom and Davis7 has been a reliable gauge of these risks and has also tracked asset prices surprisingly well (Chart 17). Recently, the uncertainty index has spiked and asset prices have not responded in kind. This is likely a signal that the spike in uncertainty will quickly reverse, but it could be a signal that asset prices are overly complacent. At the very least the spike in uncertainty highlights the fact that bond markets have been very quick to discount the potentially positive impacts of a Trump presidency, but are at risk if these policies are not delivered. This lack of a "policy risk premium" in fixed income markets is driven home by the reading from our 3-factor Global PMI model (Chart 18). This model adds the Global Economic Policy Uncertainty index to the 2-factor Global PMI model mentioned in the previous section, increasing the explanatory power of the model in the process. At present, the 3-factor model gives a fair value reading of 1.82% for the 10-year Treasury yield. Chart 17Economic Policy Uncertainty & Bond Markets Economic Policy Uncertainty & Bond Markets Economic Policy Uncertainty & Bond Markets Chart 183-Factor Global PMI Model bca.usbs_sr_2016_12_20_c18 bca.usbs_sr_2016_12_20_c18 While the most recent spike in policy uncertainty may reverse before asset prices respond, the volatile nature of the incoming administration means that more frequent spikes of the uncertainty index are likely in 2017. At some point asset prices will probably react. There is another political risk in 2017 that carries extra importance for bond markets. In 2017 President Trump will appoint two new Fed Governors. Also, there is a good chance that Janet Yellen and Stanley Fischer will not be re-appointed as Chair and Vice-Chair respectively when their terms expire in early 2018. Given the pedigrees of Trump's economic advisors, we would expect the newly appointed Governors in 2017 to have hawkish policy leanings. While this will not significantly alter Fed decision making in 2017, since the core members of the Committee will still be in place, there is a risk that the market will anticipate that one of the newly appointed Governors will be Janet Yellen's eventual replacement. If that Governor is hawkish, then there is a risk that the market will start to discount a much more hawkish Fed reaction function as early as next year. This could potentially speed up the transition from a bear-steepening curve environment to a bear-flattening environment, putting spread product at risk earlier than we currently anticipate. The MBS market would also be at risk in this scenario, since any incoming hawkish Fed Governor would be very likely to favor an unwind of the Fed's balance sheet at a much quicker pace than is currently anticipated. We already recommend an underweight allocation to MBS due to low spread levels and a continued recovery in the housing market that will keep net issuance trending higher. A change of leadership at the Fed represents an additional tail risk. Although we think it is premature to say for certain that Chair Yellen and Vice-Chair Fischer won't be re-appointed in 2018, the key risk for next year is that the market anticipates that they will be replaced. Bottom Line: Frequent spikes in the Global Economic Policy Uncertainty index are likely next year, probably warranting a policy risk premium in asset prices. The composition of the FOMC is another tail risk that bears monitoring. Theme 5: A Pause In The Default Cycle The uptrend in the trailing 12-month speculative grade default rate will reverse in 2017, falling from its current 5.6% back closer to 4%. But this will only be a temporary reprieve and the uptrend will resume in 2018 and beyond. Increases in job cut announcements, contractions in corporate profits and tightening C&I lending standards all tend to coincide with a rising default rate (Chart 19). All three of these factors signaled rising defaults last year, but have since rolled over. We have often drawn a comparison between the current default cycle and the default cycles of the mid-1980s and mid-1990s, and this comparison is still apt. Chart 19The Current Default Cycle Is A Hybrid Of the Mid-1980s and Late-1990s bca.usbs_sr_2016_12_20_c19 bca.usbs_sr_2016_12_20_c19 Distress in the energy sector caused a contraction in corporate profits and rising defaults in 1986. But then a sharp easing of Fed policy and a recovery in oil prices caused the uptrend in defaults to reverse. Corporate profit contraction, increasing job cut announcements and tighter lending standards also caused the default rate to trend higher in 1998. This time, however, Fed policy remained restrictive (Chart 19, bottom panel) and banks had no incentive to ease lending standards amidst a back-drop of rising corporate leverage. The default rate continued to trend higher in the late 1990s, and did not peak until the next recession. While the energy price shock and subsequent recovery make the current cycle similar to the 1980s episode, the fact that the Fed is more inclined to hike than cut rates brings to mind the late 1990s. This leads us to believe that the recovery in energy prices will cause the default rate to fall next year. This, along with better economic growth and a relatively accommodative Fed, will keep downward pressure on credit spreads throughout most of 2017. However at some point, likely after TIPS breakevens have recovered to pre-crisis levels, the Fed's tone will turn decidedly more hawkish. This will lead to renewed tightening in lending standards, a resumption of the uptrend in defaults and wider corporate spreads. Despite our optimism about the macro outlook for 2017 we cannot forget that corporate balance sheet health continues to deteriorate (Chart 20). Our Corporate Health Monitor has been in 'deteriorating health' territory since 2013, and although corporate spreads have tightened since February they have yet to regain their 2014 lows. Additionally, net leverage for the nonfinancial corporate sector - defined as outstanding debt less cash on hand as a percent of EBITDA - is still trending higher (Chart 20, bottom panel). The only other period since 1973 when corporate spreads narrowed as net leverage increased was following the oil price crash and default spike of 1986. In that period spreads remained under downward pressure for approximately two years but never regained their prior lows. Spreads also benefitted from Fed rate cuts and a weakening dollar during that timeframe. In our view, the best way to play the corporate bond market in the current cycle is to maintain a cautious long-term bias but to look for attractive opportunities to initiate overweight positions. At the moment, we are actively looking to upgrade our allocation to corporate bonds but need a more attractive entry point first. At 405 bps, the average spread on the Bloomberg Barclays High-Yield index is only 65 bps above the average level observed in the 2004 to 2006 period when our Corporate Health Monitor was deep in 'improving health' territory. Not surprisingly, the spread appears even lower after adjusting for expected default losses (Chart 21). Chart 20Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage Corporate Balance Sheets Continue To Add Leverage Chart 21Corporate Bond Valuation Corporate Bond Valuation Corporate Bond Valuation The default-adjusted high-yield spread is our preferred valuation measure for high-yield and investment grade corporate bonds alike. As is shown in Charts 22 and 23, the current default-adjusted spread of 162 bps is consistent with negative excess returns for both investment grade and high-yield bonds, on average, over a 12-month investment horizon. Chart 2212-Month Excess High-Yield Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart 2312-Month Excess Investment Grade Returns Vs.##br## Ex-Ante Default-Adjusted Spread (2002 - Present) Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 However, this average negative excess return is heavily influenced by a few periods when excess returns were deeply negative. A more detailed examination, shown in Tables 2 & 3, reveals that when the default-adjusted spread is between 150 bps and 200 bps, 12-month excess returns for high-yield have been positive 65% of the time. Investment grade excess returns have been positive only 35% of the time with spreads at current levels, but have been positive 55% of the time when the default-adjusted spread is between 100 bps and 150 bps. Table 212-Month High-Yield Excess Returns & Ex-Ante Default-Adjusted Spread Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Table 312-Month Investment Grade Excess Returns & Ex-Ante Default-Adjusted Spread Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Given our optimistic assessment of the macro back-drop, we conclude that excess returns for both investment grade and high-yield corporate bonds are likely to be positive, but very low, during the next 12 months. But we will continue to look for opportunities to upgrade our allocation to spread product from more attractive levels. Bottom Line: The improving macro back-drop means that the default rate will move lower in 2017. However, the poor state of corporate balance sheets means that the default rate will likely resume its uptrend in 2018, once Fed policy turns decidedly more hawkish. Theme 6: The Muni Credit Cycle Starts To Turn Back in October, we published a Special Report 8 wherein we observed that Municipal / Treasury (M/T) yield ratios tend to fluctuate in long-run cycles determined by ratings downgrades and net borrowing at the state & local government level. That is, there exists a municipal bond credit cycle much in the same way that there exists a corporate credit cycle. Additionally, we introduced a Municipal Health Monitor - a composite indicator of the health of state & local government finances - to help us assess the stage of the municipal credit cycle and observed that it has tended to follow our Corporate Health Monitor with a lag of approximately two years (Chart 24). Chart 24The Municipal Credit Cycle Lags The Corporate Cycle bca.usbs_sr_2016_12_20_c24 bca.usbs_sr_2016_12_20_c24 This analysis leads us to believe that our Municipal Health Monitor will move into 'deteriorating health' territory at some point during 2017 and that municipal bond downgrades could start to outpace upgrades late next year. As such, we adopt a cautious stance with respect to the municipal bond market, not least of which because of the potentially negative impact on the market from a Donald Trump presidency. Lower tax rates next year will certainly undermine the tax advantage of municipal debt, while the potential for increased infrastructure spending could lead to a sizeable increase in municipal bond supply. Historically, most public investment has been financed at the state & local government level, and while Trump's current infrastructure plan relies entirely on incentives for private sector investment, these details could change before any plan is implemented. By far the largest risk to the municipal bond market would be if the municipal tax exemption is done away with entirely in the context of broader tax reform, but this now appears unlikely. Even in the absence of a federal government initiative we would not rule out increased state & local government investment next year. State & local government finances have made substantial progress since the crisis and many states are now in a position where they may start to loosen the purse strings (Chart 25). This poses an upside risk to muni supply in 2017. Of course, we have already seen large fund outflows in response to Trump's election victory. ICI data show that net outflows from municipal bond funds have totaled $14.86 billion since the end of October, and while M/T yield ratios have risen, they remain near the middle of their post-crisis trading ranges (Chart 26). Chart 25Healthy Enough To Invest bca.usbs_sr_2016_12_20_c25 bca.usbs_sr_2016_12_20_c25 Chart 26Municipal / Treasury Yield Ratios bca.usbs_sr_2016_12_20_c26 bca.usbs_sr_2016_12_20_c26 We will continue to look for opportunities to upgrade municipal bonds when the reading from our tactical Muni model turns more positive (Chart 27). This model- based on policy uncertainty, issuance, fund flows and ratings migration - shows that M/T yield ratios are not yet attractive. This is true even if we assume that last month's spike in policy uncertainty is completely reversed. This model has a strong track record of predicting Muni excess returns since 2010 (Table 4). Chart 27Tactical Muni Model Tactical Muni Model Tactical Muni Model Table 4Municipal Bond Excess Returns* Based On Fair Value Model** Residual: 2010 - 2016 Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Bottom Line: The municipal credit cycle will take a turn for the worse in 2017, and muni downgrades could start to outpace upgrades later in the year. Remain underweight for now, but look for near-term tactical buying opportunities in municipal bonds. Theme 7: A Rare Opportunity In Leveraged Loans Chart 28Leveraged Loans Will Outperform In 2017 Leveraged Loans Will Outperform In 2017 Leveraged Loans Will Outperform In 2017 Our final theme for 2017 relates to the potential for floating rate leveraged loans to outperform fixed rate high-yield bonds. Historically, these periods of outperformance have been few and far between. There have only been two periods since 1991 when loans have outperformed bonds for any length of time (Chart 28). However, we believe that the conditions are in place for loans to outperform fixed-rate junk in 2017. There are two factors that can potentially cause leveraged loans to outperform fixed-rate junk. The first is rising LIBOR, which causes loan coupon payments to reset higher. While there is some concern that LIBOR floors prevent loans from benefitting from higher LIBOR, most loans have LIBOR floors of 75 bps or 100 bps. With 3-month LIBOR already at 99 bps, LIBOR floors will not be a constraint for much longer. The second factor that could cause loans to outperform bonds is an elevated default rate. Since loans are higher-up in the capital structure than bonds, they benefit from higher recovery rates. This matters more in terms of relative performance when the default rate is high. It is highly unusual for elevated defaults and rising LIBOR to coincide. This is because the Fed is typically cutting rates when the default rate is rising. However, next year, much like in the late 1990s, both conditions are likely to be in place. Bottom Line: The rare combination of rising LIBOR and elevated defaults will cause leveraged loans to outperform fixed-rate junk bonds in 2017. Ryan Swift, Vice President U.S. Bond Strategy rswift@bcaresearch.com 1 Please see Global Fixed Income Strategy / U.S. Bond Strategy Weekly Report, "Six Reasons To Tactically Reduce Duration Exposure Now", dated July 19, 2016, available at usbs.bcaresearch.com 2 Lukasz Rachel & Thomas D. Smith, "Secular Drivers of the Global Real Interest Rate (Staff Working Paper No. 571)", Bank of England, December 2015. 3 Please see Bank Credit Analyst Special Report, "Secular Stagnation And The Medium-Term Outlook For Bonds", dated February 25, 2016, available at bca.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com 5 Mark Zandi, Chris Lafakis, Dan White and Adam Ozimek, "The Macroeconomic Consequences of Mr. Trump's Economic Policies", Moody's Analytics, June 2016. 6 Please U.S. Bond Strategy Special Report, "The Tantrum Theory Of Global Bond Yields", dated August 16, 2016, available at usbs.bcaresearch.com 7 For further details on the construction of this index please see www.policyuncertainty.com 8 Please see U.S. Bond Strategy Special Report, "Trading The Municipal Credit Cycle", dated October 18, 2016, available at usbs.bcaresearch.com Appendix: U.S. Bond Market 2016 Risk/Return Summary Chart A-1U.S. Bond Returns In Historical Context U.S. Bond Returns In Historical Context U.S. Bond Returns In Historical Context Chart A-22016 Total Returns Versus Volatility Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-32016 Vol-Adjusted Total Returns Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-42016 Excess Returns Versus Volatility Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-52016 Vol-Adjusted Excess Returns Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-62016 Corporate Sector Excess Returns Versus Duration-Times-Spread Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017 Chart A-7The Performance Of Our Corporate Sector Model In 2016 Seven Fixed Income Themes For 2017 Seven Fixed Income Themes For 2017

Highlights Dear Clients, Please note that this will be our final Weekly Report for the year. We will resume our regular publishing schedule on January 3, 2017. The U.S. Investment Strategy team wishes you a restful holiday season and a prosperous New Year. Chart 1Trump + Yellen Trump + Yellen Trump + Yellen Recent bond market moves are soft echoes of the 1994 bond bear market, when investors suddenly began to price in a much less benign outlook for the Fed. There are mitigating factors that mean the current bond selloff will not be as violent. But the normalization of policy rates is no longer a challenge for the distant future. This process was always going to be fraught with risk, given the unprecedented amount of accommodation (conventional and unconventional) employed after the Great Recession. Even a mild version of 1994 could undermine equity returns. Indeed, the risk is that investors have pulled forward profit growth expectations due to anticipated fiscal stimulus (that may disappoint) at a time when domestic monetary conditions are tightening. Feature It was no surprise that the FOMC raised the Fed funds rate by 25bps at last week's meeting. But investors were caught off-guard by the move higher in the Fed's "dot" forecast. Instead of two more hikes next year, the Fed now expects to raise rates three times. Moreover, the Fed inched up its estimate of the terminal interest rate to 3.0% from 2.875%. These revisions to the path of interest rates did not occur with any material changes to the Fed's economic projections. During the post-meeting press conference, Fed Chair Janet Yellen downplayed the "dot" revisions, by noting that the median projections moved due to changes by only some Fed participants. But despite Yellen's soothing remarks, the financial markets did not interpret the revisions to be minor. The dollar strengthened by nearly 2%, and 10-year bond yields spiked by 20bps (Chart 1). These market moves are soft echoes of the 1994 bond bear market - when investors suddenly began to price in a much less benign outlook for the Fed. Investors will note that in that cycle, the Fed's extended on hold period in 1993 had lulled bond investors into a false sense of complacency; investors were almost completely caught off-guard when tightening began in early February 1994 (Chart 2 and Chart 3). At the end of 1993, the market projected that the 3-month rate, the 10-year and the 30-year yield would be 4.3%, 6.2% and 6.5%, respectively, by the end of 1994. The actual yields at the end of 1994 turned out to be more than 130 basis points higher at 5.6%, 7.8% and 7.85%. From the trough in yields in September 1993 to the peak in November 1994, the Treasury index lost 5%. High-grade spread product, such as Agencies, MBS and investment-grade corporate bonds also suffered losses. The S&P 500 fell by about 9% in early 1994. Economic improvement was the main factor for the re-pricing of the Fed funds rate in 1994 (Chart 4). In the first half of the year, the unemployment rate declined 0.5% (from 6.6% to 6.1%) and monthly average payrolls were above 320,000! As the economy gained self-feeding momentum, the Fed steadily hiked interest rates, causing Treasuries and spread product to buckle. In fact, inflation did not go up but bond yields kept rising and the U.S. economy remained robust. The Mexican financial crisis in late 1994/early 1995, directly stemming from Fed tightening, marked the end of the Treasury bear and Fed restraint. Chart 21993 Complacency, 1994 Panic bca.usis_wr_2016_12_19_c2 bca.usis_wr_2016_12_19_c2 Chart 3Bond Market Is Still Behind bca.usis_wr_2016_12_19_c3 bca.usis_wr_2016_12_19_c3 Chart 41994 Economic Acceleration Fueled The Bond Bear bca.usis_wr_2016_12_19_c4 bca.usis_wr_2016_12_19_c4 All of this bears some resemblance to current conditions, albeit the level of growth today is much lower. Like early 1994, the economy now appears on the cusp of full employment (Chart 5). Most forecasters (including BCA) expect that growth will shift to an above-trend pace for at least a few quarters. And indeed, the debate has already shifted from deflation to the potential for inflation. To be sure, as we wrote last week, it takes a long time to change a prevailing mindset about inflation or deflation and it is unlikely that the Fed will find itself in a position to aggressively tighten against an inflation breakout over the next twelve months. But if GDP growth bucks the pattern of recent years in which first quarter growth disappointed expectations, then bond investors could begin to look for the exits more fervently. What is different this cycle than in 1994? For one thing, the Fed's communication strategy has drastically changed. Since 2012, the Fed has been publishing the "dot plot," a set of FOMC projections for inflation, GDP and the projected policy path. These projections serve as forward guidance about policy intent and in theory, should help smooth out any changes in market participants' expectations about the Fed's policy path and reduce the likelihood of overshoots in expectations. In addition, it seems likely that bonds are now more concentrated in "strong hands." One of the major concerns in 1994 was that retail investors, i.e. the household sector, piled into bonds at precisely the wrong time: throughout the 1980s, bond returns only marginally trailed that of equities and with far less volatility, lulling retail investors into believe bonds couldn't lose them money. Today, according to the BIS,2 around 40% of U.S. Treasuries are owned by the Federal Reserve and the foreign official sector. In addition, the BIS also posits that it is possible that pension funds (the third largest holders of Treasuries) and insurance companies may even benefit from rising rates in the medium term, as a normalized yield environment would allow them to more easily meet promised returns. This composition of ownership, in particular the Fed and foreign official investors - who are non-profit seeking entities, will not be forced to sell into a bear market. Chart 5On The Cusp Of Full Employment bca.usis_wr_2016_12_19_c5 bca.usis_wr_2016_12_19_c5 True, corporate bonds are now more heavily concentrated in the hands of private investors who seek yield and total return. The prospective price volatility of these securities may be much higher than an entire generation of fixed income investors' experience has taught them to expect. Finally, the U.S. dollar traded sideways from 1990-1993, and fell throughout 1994, which is very different from today. Currently, the policy feedback loop limits the degree to which the Fed can ultimately raise interest rates. This loop has been in place since last year: each hawkish move from the Fed has been met by a sharp upward adjustment in the trade-weighted dollar and a selloff in equities and credit spreads. Tighter-than-expected financial conditions have then forced the Fed to lower its outlook for future economic growth and adopt a more dovish policy stance. A more dovish Fed then caused financial conditions to ease and the dollar to fall, and this easing eventually emboldened Fed policymakers to move in a more hawkish direction. The loop then repeats. The reason this loop has been in place is because U.S. monetary policy is so far in advance of other central banks. Overall, there are mitigating factors that suggest that the current bond selloff will not be as violent as 1994. But the normalization of policy rates is no longer a challenge for the distant future. As expectations of economic growth improve, a re-pricing of Fed interest rate hike expectations will persist. This process was always going to be fraught with risk, given the unprecedented amount of accommodation (conventional and unconventional) employed after the Great Recession. We expect that bond selloffs over the next year will happen in fits and starts, as the feedback loop from the bond market and dollar to policy decisions repeats. The move in Treasury yields since mid-November has proceeded too quickly relative to the improvement in economic fundamentals and will pause in the near term to prevent financial conditions from exerting an excessive drag on growth. However, we believe short duration positions will make money on a 2-3 year horizon. How Will Equities Cope? Apart from the 1994 episode, there have been three other major Fed tightening cycles since 1985 (Chart 6). In each case, the 10-year Treasury suffered an almost 10% or more annual loss, either following or just before short-term rates began their ascent. Investors underestimated the pace and extent of rate hikes every time and equity prices also faltered, at least temporarily. This was the case even when the Fed telegraphed a modest and steady 25 basis point-per-meeting pace of rate hikes from 2003 to 2006. The point is that even a mild version of 1994 could undermine equity returns. Indeed, the risk is that investors have pulled forward profit growth expectations due to anticipated fiscal stimulus (that may disappoint) at a time when domestic monetary conditions are tightening. Earnings-per-share growth is significantly lower today than in 1993, and the gap between trailing earnings growth and 12-month forward expectations is wide. This suggests that there is a greater risk of earnings disappointment than was the case in the early 1990s. Meanwhile, valuation is poor (Chart 6, bottom panel). Still, we concede that sentiment and technical indicators continue to favor near-term equity gains (Chart 7). Neither our technical nor our intermediate indicator is signalling danger (although both have rolled over). Only our monetary indicator is flashing a warning. The risk is that the longer the uptrend in stocks continues without interruption, the greater the payback will be should economic performance disappoint. Chart 6Fed Re-Entry Is Historically Tough bca.usis_wr_2016_12_19_c6 bca.usis_wr_2016_12_19_c6 Chart 7An Expensive And Risky Rally bca.usis_wr_2016_12_19_c7 bca.usis_wr_2016_12_19_c7 Animal Spirits Revival? In our view, the most notable development for the U.S. economy in recent weeks has been the impressive swing in confidence since the election in November. If sustained, the rise in confidence could propel growth to an above-trend pace as "animal spirits" are unleashed. We take this possibility seriously, since depressed confidence in the outlook was an important force capping the upside in growth earlier in the recovery. Nonetheless, this is not our base case, since we continue to believe that it is perilous to focus solely on the positive aspects of Trump's political agenda, while ignoring the more negative ones. This phenomenon seems to be borne out in the NFIB survey data. Although still low relative to past recoveries, optimism among small business owners improved drastically last month, according to the NFIB survey (Chart 8). The improvement was broad-based, showing gain in sales expectations, expansion plans and hiring intentions. But as the NFIB's chief economist pointed out, this surge in optimism is mainly due to businesses reacting favorably to Trump's platform of tax cuts and less regulation. In any case, the recent improvement in consumer confidence has not noticeably translated to improved consumer spending yet. Nominal retail sales eked out a tiny 0.1% m/m gain in November and the October data were revised lower. As we highlighted in a previous report, massive price discounting continues to be a factor pushing down nominal spending. Indeed, despite the potential for an upturn in inflation on the back of unconfirmed Trump policies, the current pricing environment remains tough. Core CPI rose only 0.2% in November, and the annual growth rate - at 2.1% - is lower than at the start of the year. Our diffusion index is below 50, meaning that more sub-components of the CPI are decelerating than accelerating (Chart 9). Chart 8Optimism Returning bca.usis_wr_2016_12_19_c8 bca.usis_wr_2016_12_19_c8 Chart 9Consumers Are Confident, Will They Spend? bca.usis_wr_2016_12_19_c9 bca.usis_wr_2016_12_19_c9 The overall message is that economic data continue to display a "two steps forward, one step backward" pattern. We expect growth momentum to gradually build and the economy can grow above trend next year. However, even once the output gap closes, it can take a long time for inflation pressures to build and for inflation expectations to move higher. Ultimately, this dynamic means that the Fed will have the scope to proceed slowly. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 This week's report is greatly inspired by our Special Report, "Reincarnation And Bond Vigilantes," February 5, 2013. 2 "A Paradigm Shift In Markets?," Bank For International Settlements (BIS), December 11, 2016 http://www.bis.org/publ/qtrpdf/r_qt1612a.htm Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process. The model's recommended weightings for the major asset classes are unchanged: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The diffusion index of the three components for The Equity Model remained neutral and in line with our benchmark portfolio recommendation for equities. The technical component retained its "buy" signal, with some improvements in the momentum and breadth & trend indicators. The monetary component, though less bullish for equities as it continued to weaken somewhat, is still in favorable territory for equities. However, on the cyclical front, the earnings-driven component continues to warrant caution as real operating earnings are at a significant distance from positive economic expectations. Earnings momentum has also further deteriorated, based on an earnings diffusion index which compares nominal earnings growth relative to four economic and monetary variables such as oil prices (WTI), ISM Inventories, 10-year Treasury yields and 3-month T-bill rates. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. However the "buy signals" of the cyclical and technical components of the bond model have weakened, nearing critical levels which would surrender the preference for Treasuries in the near term. Chart 10Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 11Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.