Inflation/Deflation

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 BCA's U.S. Equity Strategy team would like to wish our clients a healthy, happy and prosperous New Year. Portfolio Strategy The growth vs. value style bias is due for a bounce, but beyond the near run, the outlook has become more balanced. Stick with a small vs. large cap bias for the time being, but get ready to book profits if domestic wage inflation continues to accelerate. Buy into the health care facilities sell-off. Value is surfacing as profit margin pressures subside. Recent Changes S&P 1500 Health Care Facilities - Boost to overweight today. Downgrade Alert Growth vs. Value - Downgrade alert. Table 1Sector Performance Returns (%) Contrarian Alert: Reflation Is Reversing Contrarian Alert: Reflation Is Reversing Feature Stocks look poised to maintain their momentum-fueled march higher into yearend, seemingly impervious to potential profit backlash from tightening monetary conditions, a more hawkish Fed and/or overheating sentiment. Sellers are holding back in anticipation of lower tax rates next year. In fact, our Composite Sentiment Gauge has surged to extremely bullish levels (Chart 1). This gauge comprises surveys of traders, individuals and investment professional sentiment. Overtly bullish readings have been a reliable contrary indication of building tactical risks, although not foolproof. The broad market has returned nearly 80%, excluding dividends, since the beginning of 2012, and over 5% since election night in November. Lately, earnings expectations have increased their contribution to the market's return, but the vast majority of the gains over the last five years can be explained by multiple expansion. Soaring median industry price/sales ratios are consistent with lopsidedly optimistic sentiment (Chart 1). Now that the Fed has signaled its intention to steadily raise interest rates in 2017, a critical question is whether profits can take over the reins from liquidity as the main market driver, at least partially validating the valuation increase? On this front, our confidence level is low. Profit margins are steadily narrowing. Our profit margin proxy is not signaling any imminent relief (Chart 2). With labor costs rising, faster sales are needed to halt the squeeze. But U.S. dollar appreciation is a significant headwind to top-line performance, given that 45% of sales come from abroad. As hedges fall off, the impact on 2017 revenue will become increasingly meaningful. Corporate debt levels are disturbingly high, in absolute terms and as a share of GDP (Chart 2, bottom panel). If borrowing costs continue to climb, then it will be hard for companies to turn expansionist, potentially offsetting any benefit from a reduced tax rate. Against this backdrop, it is difficult to envision a robust rebound in corporate profits. Our confidence level would be higher if monetary conditions were still reflationary. Instead, our Reflation Gauge (RG), a combination of oil prices, Treasury yields and the U.S. dollar, has plummeted at its fastest rate ever (Chart 3)! The speed and ferociousness of the plunge underscores the economic need for a massive and imminent fiscal offset. Chart 1Sentiment Is Overheating Sentiment Is Overheating Sentiment Is Overheating Chart 2Stiff Headwinds For The Corporate Sector Stiff Headwinds For The Corporate Sector Stiff Headwinds For The Corporate Sector Chart 3Reflation Is Dead Reflation Is Dead Reflation Is Dead The RG leads both equity sentiment and the U.S. Economic Surprise Index (ESI, Chart 3). If economic activity begins to disappoint in the coming months, i.e. before any meaningful fiscal stimulus arrives, there is a window of risk for the equity market because valuations will narrow as optimism fades, especially in those sectors that have gone vertical since the U.S. election. Keep in mind, last week we showed that typical Fed tightening cycles augur well for non-cyclical sector relative performance on a 12 and 24 month horizon. Surprisingly, financials and utilities have also managed to at least keep pace with the broad market, with cyclical sectors lagging behind overall market returns. The bottom line is that a number of objective indicators are signaling that the post-election rally will hit turbulence, perhaps in the first quarter of the New Year. Investors would be well served from a cyclical perspective to take advantage of value creation in defensive sectors while reaping any windfalls received in deep cyclical sectors. Will Growth Vs. Value Recover? The sudden surge in the financials and industrials sector has caused a sharp correction in the growth vs. value (G/V) share price ratio. The scope of the move has been both powerful and unnerving, catching many off guard, including us. Is this the start of a value renaissance after nearly eight years of growth stock dominance? History shows that sustained rotations into the value complex require validation from strengthening global economic growth. We have shown in previous research that G/V share price momentum is negatively correlated with the growth in durable goods orders, house prices and profits, i.e. when these variables accelerate, growth underperforms value. By virtue of the improvement in our global PMI composite (Chart 4), it would be easy to conclude that value stocks are coming back in vogue. Financials, energy and industrials account for over 50% of the value composite. These sectors only comprise roughly 15% of the growth benchmark. In addition, the technology sector weighs in at one third of the growth index, while representing only 8% of the value cohort. In addition, consumer discretionary and health care also represent about the same weight as technology in the growth composite, but only contribute about half that in the value index. It is no wonder that rising bond yields and hopes for a fiscal stimulus bonanza have triggered such a violent G/V reaction. While we are sympathetic to this view, extrapolating the last six weeks to continue over the next six months is dangerous. Much of the Treasury yield advance has been driven by inflation expectations. Global real yields are up, but not by as much as share prices have discounted (Chart 5). That is not surprising, as the soaring U.S. dollar is a deflationary force, and heralds a sharp rebound in the G/V ratio (Chart 5, top panel). Chart 4A Vicious Correction... A Vicious Correction... A Vicious Correction... Chart 5... That May Soon Reverse ... That May Soon Reverse ... That May Soon Reverse U.S. currency strength will make it difficult for developing economies to service large foreign debt obligations and could drain domestic liquidity if they are forced to sell foreign exchange reserves to defend their currencies. It is notable that EM capital spending is virtually nil in real terms, and their share prices are underperforming the global benchmark by a wide margin (Chart 5). Our Global Economic Diffusion Index has crested (Chart 5, shown inverted), perhaps picking up emerging market sluggishness. Unless the U.S. dollar begins to weaken, it is premature to forecast robust economic growth in the coming quarters, thereby raising some skepticism about the durability of the value stock rebound. The objective message from our Cyclical Macro Indicators for the growth vs. value style is slowly shifting from bullish to neutral, and the pricing power advantage no longer exists (Chart 6). However, the latter is an unwinding of the rate of change shock in the commodity complex rather than renewed demand-driven pricing power gains in the deep cyclical space. From a longer-term perspective, growth stocks should stay well supported by the increase in long-term earnings growth expectations (Chart 7). When the latter are rising, growth stocks tend to enjoy multiple expansion relative to value shares. Moreover, if equity volatility perks up on uncertainty over the path and pace of future fiscal policy and a more hawkish Fed, then growth stocks should receive another source of natural support. The VIX and G/V indices tend to correlate positively over time (Chart 7). Chart 6Mixed Signals Mixed Signals Mixed Signals Chart 7Structural Supports Structural Supports Structural Supports In sum, choosing value over growth is not a slam dunk, nor is forecasting a recovery to new highs in the G/V ratio given the large sector weightings discrepancies. Rather, a reflex rally in the G/V ratio is probable as post-election financials/industrials sector enthusiasm wanes, with a lateral move thereafter. Bottom Line: We will likely recommend moving to a neutral style bias over the coming weeks/months from our current growth vs. value stance, but expect to do so from a position of strength. A Revival In Small Business Animal Spirits? A broad-based and powerful rotation into small caps has occurred, as all the major small cap sectors have surged relative to their large cap counterparts (Chart 8), flattering our current stance. Small caps fit nicely into one of our overriding longer-term themes, namely favoring domestic over global industries. Small companies are typically domestically-geared regardless of geography, underscoring that if anti-globalization trends pick up steam, this theme could gain traction around the world. The potential for U.S. corporate tax cuts has provided another source of domestic company enthusiasm, because multinationals already have low effective tax rates. However, these developments are not assured, details remain scant, and chasing small cap relative performance on that basis alone could be a mistake from a tactical perspective. We have noted that we would recommend profit taking if evidence of a reversal in the small vs. large cap profit outlook materialized. Recent labor market and pricing power data are slightly worrying. The NFIB survey of the small business sector showed that planned labor compensation is still diverging markedly from the overall employment cost index (Chart 9, second panel). While reported price changes have also nudged higher, the discrepancy in labor cost gauges may be signaling that the massive profit margin gap between small and large companies will not be quick to close (Chart 9, bottom panel). Still, the overall NFIB survey was strong, and suggests that animal spirits in the small business sector may finally be reawakening (Chart 10, second panel). The latter may reflect an easing in worries about government red tape, excessive bureaucracy and health care costs. Chart 8Broad-based Small Cap Outperformance Broad-based Small Cap Outperformance Broad-based Small Cap Outperformance Chart 9Yellow Flag For Margins Yellow Flag For Margins Yellow Flag For Margins Chart 10Overbought, But Not Overvalued Overbought, But Not Overvalued Overbought, But Not Overvalued These sentiment shifts may allow extremely overbought technical conditions for the relative share price ratio to persist for a while longer (Chart 10, middle panel), particularly if the Trump honeymoon phase for the overall market lasts until early in the New Year. Importantly, there is no meaningful valuation roadblock at the moment (Chart 10). From a longer-term perspective, however, it is notable that the share price ratio is trading well above one standard deviation from its mean. Such a stretched technical level warns against getting too comfortable with small caps. In fact, the share price ratio is tracing out a pattern similar to the early-1980s (Chart 11), when it enjoyed a brief run to new highs in 1983 on the back of similar aspirations of meaningful fiscal thrust and as the U.S. dollar sprang higher. However, that surge was short-lived and in hindsight, was a blow-off top that marked the beginning of a massive underperformance phase. Chart 11The Big Picture The Big Picture The Big Picture Bottom Line: Stick with a small/large cap bias for now, but get ready to take profits if the relative profit margin outlook does not soon improve. Buy Into Health Care Facilities Weakness Rapid sub-surface market gyrations are creating attractive value in a number of areas, particularly in the defensive health care sector. In particular, we downshifted our view on the S&P health care facilities index at mid-year, because consumer spending on health care was decelerating, which favored moving into equities that paid for medical services (managed care) vs. those that provided them. While that trend remains intact, health care facilities stocks appear to be discounting an extreme scenario. The current concern is that the Affordable Care Act (ACA) will be repealed, leaving hospitals to foot the bill for uninsured patients. While such a scenario would potentially reverse the decline in the provision for doubtful accounts (PDA, Chart 12), a major profit margin support, the ACA is more likely to be reworked than repealed especially in the absence of a replacement plan. Importantly, there are other offsets. PDA follows the unemployment rate, which is signaling that the former will decline further. Hospital cost inflation is beginning to recede, led by drug costs (Chart 12). Physician services costs and inflation in other medical supplies is also subsiding. Health care facilities have also reduced capital spending in a bid to protect profit margins. Construction data show that hospitals have eased back on the throttle significantly (Chart 13). A shift to a profit margin preservation mentality is confirmed by the sharp reduction in headcount growth and decline in total wage inflation (Chart 13). Labor cost control provides another positive profit margin support, over and above the fillip from the reacceleration in hospital pricing power (Chart 13). Consumers are allocating an increasing portion of their spending to hospitals, which provides confidence that pricing power gains will stick. It would take massive earnings downgrades to validate the pessimism embedded in current valuations (Chart 14). Technical conditions argue that the sell-off is overshooting. The share price ratio has made new lows, but cyclical momentum is diverging positively. Given that this group is traditionally a strong U.S. dollar winner (Chart 14, top panel), there is scope for a playable relative performance rally in the coming six months. Chart 12Hospital Costs Are Easing... Hospital Costs Are Easing... Hospital Costs Are Easing... Chart 13... While Sales Improve ... While Sales Improve ... While Sales Improve Chart 14Dirt Cheap Dirt Cheap Dirt Cheap Bottom Line: Augment the S&P 1500 health care facilities index (BLBG: S15HCFA - HCA, UHS, WOOF, HLS, LPNT, SEM, SCAI, THC, ENSG, USPH, KND, CYH, QHC) to overweight. Current Recommendations Current Trades Size And Style Views Favor small over large caps. Favor growth over value (downgrade alert).

Theme 1 - Returning U.S. Animal Spirits: I Want To Break Free Animal spirits are making a comeback in the U.S. The catalyst for this development is the hope that a Trump administration will alleviate the regulatory burden that has been a source of worry for corporate America (Chart I-1). Feeding this impression has been Trump's anti-regulation rhetoric. His deal-maker, take-no-prisoners persona, along with a cabinet packed with businessmen and corporate scions further solidifies this perception. However, Trump's electoral victory was only the match igniting the fuel. The conditions for a resurgence of animal spirits were already in place. Animal spirits are only a Keynesian metaphor for confidence. From late 2014 to 2016, a 16% contraction in profits weighed on business confidence. However, pre-tax profits have bottomed and are set to continue their acceleration (Chart I-2). Chart I-1Hurdle To Animal Spirits bca.fes_sr_2016_12_16_s1_c1 bca.fes_sr_2016_12_16_s1_c1 Chart I-2A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing A Drag On CAPEX Vanishing Since profits have bottomed, business capex intentions have picked up steam. As Chart I-3 illustrates, this development not only tends to presage a rise in business investments, it also is a leading indicator of economic activity at large. This rise in capex intentions is not only a reflection of an ebbing contraction in profits. It also indicates that many companies are starting to worry about hitting their capacity constraints if final demand firms up. After having added to their real capital stocks at the slowest pace in decades, U.S. firms are now facing rising sales, a situation that creates a bottleneck (Chart I-4). Chart I-3CAPEX Intentions And Growth bca.fes_sr_2016_12_16_s1_c3 bca.fes_sr_2016_12_16_s1_c3 Chart I-4Improving Sales Outlook ##br##Meets Supply Constraint bca.fes_sr_2016_12_16_s1_c4 bca.fes_sr_2016_12_16_s1_c4 Moreover, the labor market is tightening. All the signs are there: at 4.6%, U.S. unemployment is in line with its long-term equilibrium; the number of individuals outside of the labor force is in line with the 1999 to 2007 period, an era where hidden labor-market slack was inexistent; and the difficulty for small businesses to find qualified labor is growing (Chart I-5). As is the case today, companies are not concerned by a lack of demand, but by the quality of labor - a combination pointing to decreasing slack - wage growth tends to accelerate. Coincidentally, this is also an environment in which companies increase their allocation to corporate investments (Chart I-6). A few factors explain why companies are more willing to invest when slack narrows and wages grow. Obviously, rising labor costs incentivize businesses to skew their production function toward capital instead of labor. Additionally, rising wages support household consumption. Capex is a form of derived demand. A stronger household sector leads to more perceived certainty regarding the robustness of the expected final demand faced by corporations. Thus, when the share of wages and salaries in the national income grows, so do investments (Chart I-7). Chart I-5The Labor Market Is Tight The Labor Market Is Tight The Labor Market Is Tight Chart I-6When Demand Is Solid And Labor Is Tight... bca.fes_sr_2016_12_16_s1_c6 bca.fes_sr_2016_12_16_s1_c6 Chart I-7Animal Spirits At Work bca.fes_sr_2016_12_16_s1_c7 bca.fes_sr_2016_12_16_s1_c7 This means that while we had already expected the consumer to be a key engine of growth next year, we expect the corporate sector to join the fray.1 To us, this combination represents the main reason to expect our Combined Capacity Utilization Gauge to move into "no slack" territory, an environment where the Fed can hike rates durably. Bottom Line: U.S. animal spirits are breaking free. Trump is the catalyst, but conditions for improving business confidence and higher capex have been in place for a period of time. Profits have troughed, capex intentions are on the rise, and capacity constraints are being hit. This will give the Fed plenty of ammo to increase rates in 2017 and 2018. Theme 2 - Monetary Divergences: Pretty Tied Up Monetary policy divergences will continue to be one of the running themes for 2017. As we have argued, the Fed is in a better position to increase interest rates. However, the European Central Bank and the Bank of Japan are firmly pressing on the gas pedal. Last week, the ECB unveiled a new leg to its asset purchase program. True, bond buying will decrease from EUR 80 billion to EUR 60 billion starting April 2017, but the program is now open-ended. Also, the ECB can now buy securities with a maturity of 1-year, as well as securities yielding less than the deposit facility rates. This gives the ECB more flexibility to increase its purchases if need be to placate any potential economic shock in the future. Most crucially, the ECB does not regard its 2019 inflation forecast of 1.7% as in line with its target. Draghi has stressed that this requires the ECB to persist in maintaining its monetary accommodation. This makes sense. While the European economy has surprised to the upside, the recent roll-over in core CPI highlights the continued deflationary forces in the euro area (Chart I-8). These deflationary forces are present because the European output gap remains wide at around 4% of potential GDP.2 While the OECD pegs the Eurozone's natural rate of unemployment at 9%, it is probably lower. Despite a 2.3-percentage-point fall in the Eurozone's unemployment to 9.8% since 2013, euro area wages continue to decelerate, in sharp contrast with the U.S. situation (Chart I-9). This portends to excess capacity in the European labor market. It also limits European household income growth, which has lagged the U.S. by 14% since 2003. (Chart I-9, bottom panel). As a result, European consumption should continue lagging the U.S. Chart I-8Europe's Deflation Problem bca.fes_sr_2016_12_16_s1_c8 bca.fes_sr_2016_12_16_s1_c8 Chart I-9Signs Of Slack In Europe Signs Of Slack In Europe Signs Of Slack In Europe Additionally, European domestic demand has been supported by a rise in the credit impulse - the change in credit flows (Chart I-10). Between 2011 and 2014, to meet the EBA stress test and Basel III criteria, European banks raised capital and limited asset growth, boosting their capital ratios from 7.1% to more than 11% today. Once this adjustment was over, European banks normalized credit flows, boosting the credit impulse. This process is behind us. To keep the credit impulse in positive territory, credit flows would have to keep on expanding, implying that the stock of credit would have to grow at an ever-accelerating pace. However, the poor performance of European bank equities suggests that credit growth will slow (Chart I-11). While this may be too pessimistic a forecast, it is now unlikely that credit growth will accelerate. As a result, the credit impulse will roll over, hurting domestic demand and keeping deflationary pressures in place. Chart I-10Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Credit Trends In Europe: Dark Omen Chart I-11Another Dark Omen Another Dark Omen Another Dark Omen This should translate into a very easy monetary policy in Europe for 2017 and most likely 2018. European rates, both at the short- and long-end of the curve will not rise as much as U.S. rates. In Japan, economic slack has dissipated and the labor market is at full employment (Chart I-12). The unemployment rate stands at 3% and the job-openings-to-applicants ratio sits at 1991 levels. What has prevented the Japanese output gap from moving into positive territory has been fiscal belt-tightening. Between 2011 and today, the Japanese cyclically-adjusted deficit has fallen from 7.5% to 4.5% of GDP, inflicting a large drag on growth. Going forward, we expect Japan's GDP to actually move above trend. Based on the IMF's forecast, fiscal austerity is behind us, suggesting that the force that has hampered growth is now being lifted. This is a conservative assessment. Abe has sounded increasingly willing to expand the government's deficit following his July upper-house election victory. Japanese military spending should be a key source of stimulus. In 2004, Japan and China both spent US$50 billion in that arena. Today, Japanese defense spending is unchanged but China's has grown to US$200 billion (Chart I-13). Therefore, Japan is ever more exposed to an increasingly assertive China in the region. Moreover, a potential rapprochement between the U.S. and Russia - a country formally still at war with Japan - also increases the need for a more self-sufficient Japanese defense strategy. Chart I-12Little Slack In Japan bca.fes_sr_2016_12_16_s1_c12 bca.fes_sr_2016_12_16_s1_c12 Chart I-13A Catch Up Is Needed bca.fes_sr_2016_12_16_s1_c13 bca.fes_sr_2016_12_16_s1_c13 Outside of the fiscal realm, there is cause for tempered optimism regarding Japan. Payroll growth remains strong despite full employment, pointing toward potentially higher wages. Also, the Business Activity Index, machinery orders, and the shipments-to-inventory ratio are all firming. Encapsulating these forces, our model forecasts further improvement in industrial production (Chart I-14). While these would point toward a monetary tightening, such is not the case in Japan. The Japanese central bank has committed to let inflation significantly overshoot before removing any accommodation. Hence, as growth improves, inflation expectations can rise, dampening real rates, depressing the yen, and further supporting growth (Chart I-15). This new BoJ policy is a game changer. Chart I-14Some Glimmer Of Hope bca.fes_sr_2016_12_16_s1_c14 bca.fes_sr_2016_12_16_s1_c14 Chart I-15The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ The Mechanics Targeted By The BoJ Moreover, this policy becomes supercharged when global bond yields rise, a central view for BCA's U.S. Bond Strategy service in 2017.3 Due to their low beta, JGB yields tend to not rise as much as global yields in a bond selloff. With the BoJ targeting near-zero rates at the long-end of the curve, JGB yields have even less upside. Rising global bond yields result in even-wider-than-before global-Japan rate differentials, which hurts the yen. This will stimulate Japanese growth even further, additionally easing monetary policy. Bottom Line: While the U.S. is on the path toward tighter policy, the ECB and the BoJ, by design, are loosening their policy. In Europe, the economy continues to suffer from underlying deflationary forces, forcing the ECB to stand pat for now. In Japan, the BoJ has elected to let inflation overshoot significantly even as the economy strengthens. This is putting downward pressure on Japanese real rates, a de facto further easing of monetary policy. Theme 3 - China And EM Slow-Down: Livin' On A Prayer After a year of respite, in 2017, emerging markets and China will once again be a source of deflationary shocks for the global economy. EM as a whole remains in a structurally precarious position. Since 2008, EM economies have accumulated too much debt and built too much capacity (Chart I-16). Most worrying has been the pace of debt accumulation. In the past five years, debt-to-GDP has risen by 51 percentage points to 146% of GDP. The debt has been backed up with new investments, but such a quick pace of asset accumulation raises the prospects of capital misallocation. When a large economic block like EM spends more than 25% of its GDP for 13 years on investment, the likelihood that many poor investments have been made is high. EM economies show all the hallmarks that capital has been miss-allocated, threatening future debt-servicing capacity. Labor productivity growth has collapsed from 3.5% to 1.5%, despite rising capital-to-labor ratios, while return on equity has collapsed despite surging leverage ratios, a sure sign of falling return on capital (Chart I-17). Chart I-16EM Structural Handicaps EM Structural Handicaps EM Structural Handicaps Chart I-17Symptoms Of A Malaise bca.fes_sr_2016_12_16_s1_c17 bca.fes_sr_2016_12_16_s1_c17 With this backdrop in mind, what happened in 2016 is key to understanding potential 2017 developments. Excess debt and excess capacity are deflationary anchors that raise the vulnerability of EM to shocks, both positive and negative. In 2016, the shock was positive. In the second half of 2015 and early 2016, China engaged in large scale fiscal stimulus (Chart I-18). Government spending grew and US$1.2 trillion of public-private infrastructure projects were rolled out in a mere six months. This lifted Chinese imports from their funk, used up some of the EM's excess capacity, dampened EM deflationary forces, and raised EM return on capital for a period. Additionally, faced with volatile markets, Western central banks eased monetary policy. The ECB and BoJ cut rates, and the Fed backed away from its hawkish rhetoric. The resultant falls in DM real rates and the dollar boosted commodity prices, further dampening EM deflationary forces and boosting EM profitability. Capital flows into EM ensued, easing financial conditions there and brightening the economic outlook (Chart I-19). Chart I-18China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad China Fiscal Backdrop: From Good To Bad Chart I-19EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating EM Financial Conditions Are Deteriorating This process is moving into reverse, the positive shock is morphing into a negative one. The structural handicaps plaguing EM have only marginally improved. Precisely because the Chinese industrial sector has regained composure, the already-fading Chinese stimulus will fully move into reverse (Chart I-20). With credit appetite remaining low and interbank rates already rising as the PBoC slows liquidity injections, the Chinese economy should soon rollover. Moreover, the dollar and global real rates are on the rise. Paradoxically, the return of U.S. animal spirits could endanger the EM recovery. As Chart I-21 shows, an upturn in DM leading economic indicators presages a fall EM LEIs. This simply reflects relative liquidity and financials conditions. Chart I-20China: As Good As It Gets China: As Good As It Gets China: As Good As It Gets Chart I-21DM Hurting EM DM Hurting EM DM Hurting EM Strong advanced economies, especially the U.S., lifts DM real rates and the dollar. This process sucks liquidity away from EM and tightens their financial conditions exogenously (Chart I-22). This hurts EM risk assets, currencies, and their economies. Moreover, since trade with the U.S. and other DM economies only account for 15% and 13% of EM exports, respectively, a fall in EM currencies does little to boost growth there. The fall in EM growth to be seen in 2017 will lay bare their structural weaknesses. As a result, EM assets are likely to suffer considerable downside. EM economies will limit the rise in global inflation by exerting downward pressures on globally traded goods prices as well as many commodities. Moreover, with Europe and Japan more exposed to EM growth than the U.S. (Chart I-23), EM weaknesses would further contribute to monetary divergences between the Fed and the ECB/BoJ. Chart I-22Rising DM Rates Equal Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Rising DM Rates Equals Falling EM Liquidity Chart I-23U.S. Is The Least Sensitive To EM Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Bottom Line: 2016 was a great year for EM plays as Chinese fiscal stimulus and easier-than-anticipated DM policy contributed to large inflows of liquidity into EM assets, supporting EM economies in the process. However, as Chinese fiscal stimulus moves into reverse and as DM rates and the dollar are set to continue rising, liquidity and financial conditions in EM will once again deteriorate. Theme 4 - Oil Vs. Metals: Good Times Bad Times From the previous three themes, a logical conclusion would be to aggressively short commodities. After all, a strong dollar, rising rates, and weak EM are a poisonous cocktail for natural resources. However, the picture is more nuanced. In the early 1980s, from 1999 to 2001, and in 2005, commodity prices did rise along with the dollar (Chart I-24). In the early 1980s, the rally in commodities was concentrated outside of the energy complex. The U.S. economy was rebounding from the 1980s double-dip recession, and Japan was in the middle of its economic miracle. Their vigorous growth resulted in a large positive demand shock, boosting Japan's and the U.S.'s share of global copper consumption from 34% to 37%. This undermined any harmful effect on metal prices from a rising dollar. In both the 1999-to-2001 and 2005 episodes, the share of U.S. and Japanese commodity consumption had already fallen. Most crucially, in both episodes, the rise in overall commodity price indexes only reflected strong energy prices. Outside of this complex, natural resource prices were lackluster (Chart I-25). Chart I-24Commodities And ##br##The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Commodities And The Dollar Can Rise Together Chart I-25When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally When A Commodity Rally Is An Oil Rally In these two instances, oil prices were able to escape the gravitational pull of a strong dollar because of supply disruptions. In 1999, following an agreement to reduce oil production by OPEC and non-OPEC states, output fell by around 4 million barrels per day, causing the market to re-equilibrate itself. In 2005, as EM growth was already creating a supportive demand backdrop, a devastating hurricane season in the Gulf of Mexico curtailed global production by around 1 million bbl/day. Today, the situation is a hybrid of 1999 and 2005. While EM economies are in a much weaker position than in 2005, the U.S. economy is gathering strength. Hence, close to 50% of global oil consumption - U.S. and DM oil demand - will stay firm (Chart I-26). But, most vitally, the supply picture once again dominates. Not only did OPEC agree to a deal to curtail production by 1.2 million bbl/day, but Russia agreed to share the burden, cutting its own output by 300 thousand bbl/day. Shortly after this agreement was reached, Saudi Arabia threw in an olive branch by pledging to further cut its production if necessary to reduce global oil inventories. This means that the oil market will firmly be in deficit in 2017 (Chart I-26, bottom panel). Our Commodity & Energy Service, which forecasted the OPEC move, believes WTI oil prices could occasionally peak toward US$65 /bbl in 2017.4 The picture for metals is more complex. The output of iron and copper continues to grow. On the demand side of the ledger, the U.S. only contributes 4% and 8% of global demand for each metal, respectively. Thus even if Trump were able to implement a large infrastructure program in 2017 - a big if for next year - the effect on global demand would be low. Instead, what matters for metal demand is the outlook for EM in general and China in particular (Chart I-27). On this front, our negative take on China and EM is a big hurdle for metals to overcome. Chart I-26Supportive Oil Back Drop Supportive Oil Back Drop Supportive Oil Back Drop Chart I-27Metals Are About China, Not The U.S. Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Yet, all is not dark. Metal and oil prices have historically been co-integrated. In fact, during the previous episodes where oil strengthened as the dollar rallied, metals have more or less been flat. This pattern is likely to repeat itself, especially if as we expect, EM experience a growth slowdown and not an outright recession. Altogether, expectations of strong oil prices and flat metal prices suggest that any EM slowdown should be more discriminating than in 2015 and early 2016. Countries like Russia and Colombia should fare better than Brazil or Peru. This reality is also true for DM economies. Canada and Norway are likely to outperform Australia. Bottom Line: Despite a bullish view on the dollar and a negative EM outlook, overall commodity indices are likely to rise in 2017. This move will mostly reflect a rally in oil - the benchmark heavyweight - a market where supply is being voluntarily constrained. The performance of metals is likely to be much more tepid, with prices mostly moving sideways next year. Theme 5 - Dirigisme: Sympathy For The Devil In 2017, a new word will need to enter the lexicon of investors: dirigisme. This was the economic policy of France after the Second World War. Dirigisme does not disavow the key support systems of capitalism: the rule of law, private property, the sacrosanct nature of contracts, or representative governments. Instead, dirigisme is a system of free enterprise where, to a certain degree, the state directs the economy, setting broad guidelines for what is admissible from the corporate sector. Donald Trump fully fits this mold. He wants business to be conducted a certain way and will try his hardest to ensure this will be the case. What will be the path chosen by Trump? Globalization and laissez-faire capitalism have been great friends of corporate profit margins and the richest echelons of U.S. society (Chart I-28). While it has also greatly benefited the EM middle class, the biggest losers under this regime have been the middle class in advanced economies (Chart I-29). As long as U.S. consumers had access to easy credit, the pain of stagnating incomes was easily alleviated. Without easy credit the pain of globalization became more evident. Chart I-28The (Really) Rich Got Richer Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Chart I-29Globalization: No Friend To DM Middle Class Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Trump has courted the disaffected middle class. While he is likely to cut regulation, he will also put in place potentially erratic policies that may destabilize markets. The key will be for investors to appreciate his ultimate goal: to boost, even if only temporarily, the income of the American middle class. As such, his bullying of Carrier - the U.S. air-conditioner manufacturer that wanted to shift production to Mexico - is only the opening salvo. Tax policy is likely to move in this direction. A proposed tax reform that would cut tax for exporters or companies moving production back to the U.S. towards 0 - that's zero - and punish importers is already in the pipeline. The implications of such policies on U.S. employment are unclear. While U.S. businesses may repatriate production, they may do so while minimizing the labor component of their operations and maximizing the capital component in their production function. In any case, more production at home will support the domestic economy for a time period. However, the global impact is clearer. These policies are likely to be deflationary for the global economy outside the United States. A switch away from production outside of U.S. jurisdiction will raise non-U.S. output gaps. This should weigh on global wages and globally traded goods prices. Additionally, this deflationary impact will cause global monetary policy to remain easy relative to the U.S., particularly hurting the currencies of nations most exposed to global trade. Compounding this effect, nations that currently export heavily to the U.S. - which will lose competitiveness due to tax policy shifts and/or potential tariffs - are likely to let their currencies fall to regain their lost competitiveness. The currencies of Asian nations, countries that have benefited the most from globalization, are likely to get hit the hardest (Chart I-30). Chart I-30Former Winners Become Losers Under Trump's Dirigisme Outlook: 2017's Greatest Hits Outlook: 2017's Greatest Hits Moreover, along with a shift toward dirigisme, the U.S.'s geopolitical stance could harden further, a troubling prospect in an increasingly multipolar world. Tensions in East Asia are likely to become a recurrent theme over the next few years. Ultimately, the rise of dirigisme means two things: First, the influence of politics over markets and economic developments will continue to grow. Economics is moving closer to its ancestor: political-economy. Second, while Trump's dirigisme can be understood as a vehicle to implement his populist, pro-middle class policies, they will add an extra dose of uncertainty to the global economy. Volatility is likely to be on a structural upswing. Interestingly, the risk of rising dirigisme is more pronounced in the U.S. and the U.K. than in continental Europe. Not only are economic outcomes more evenly distributed among the general population in the euro area, recent elections in Spain or Austria have seen centrist parties beat the populists. While Italy still represents a risk on this front, the likelihood of a victory by the right-wing Thatcherite reformist Francois Fillon for the French presidential election in May is very high.Germany will remain controlled by a grand coalition after its own 2017 elections.5 Bottom Line: The U.S. economy is moving toward a more state-led model as Trump aims to redress the plight of the U.S. middle class. These policies are likely to prove deflationary for the global economy outside of the U.S. and could support the U.S. dollar over the next 12-18 months. On a longer-term basis, the legacy of this development will be to lift economic and financial market volatility. Theme 6 - Inflation: It's A Long Way To The Top Our final theme for the upcoming year is that the inflationary outcome of a Trump presidency will take time to emerge and inflation is unlikely to become a big risk in 2017. Much ink has been spilled predicting that Trump's promises to inject fiscal stimulus exactly when the economy hits full employment will be a harbinger of elevated inflation. After all, this is exactly the kind of policies put in place in the late 1960s. Back then, due to the Great Society program and the deepening U.S. involvement in the Vietnam War, President Johnson increased fiscal stimulus when the output gap was in positive territory. Inflation ensued. This parallel is misleading. True, in the long-term, Trump's fiscal stimulus and dirigisme bent could have stagflationary consequences. However, it could take a few years before the dreaded stagflation emerges. To begin with, the structure of the labor market has changed. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart I-31). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. Likewise, cost-of-living-adjustment clauses have vanished from U.S. labor contracts. Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Additionally, today, capacity utilization - a series that remains well correlated with secular inflation trend - remains much lower than in the 1960s and 1970s (Chart I-32). This means that one of the key ingredients to generate a sharp tick up in inflation is still missing. Chart I-31Labor: From Giant To Midget Labor: From Giant To Midget Labor: From Giant To Midget Chart I-32Capacity Utilization: Not Johnson Nor Nixon bca.fes_sr_2016_12_16_s1_c32 bca.fes_sr_2016_12_16_s1_c32 Chart I-33Today's Slack Is Not Where It Once Was bca.fes_sr_2016_12_16_s1_c33 bca.fes_sr_2016_12_16_s1_c33 Also, when looking at the output gap, the 1960s and 1970s once again paint a markedly different picture versus the present. Today, we are only in the process of closing the output and unemployment gaps. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966. Unemployment had been below its equilibrium rate since 1963, and by 1968 it was 2.5% below NAIRU (Chart I-33). Together the aforementioned factors suggest that inflation should remain quite benign in 2017. We probably still have a significant amount of time before raising the stagflationary alarm bells. Finally, the Fed currently seems relatively unwilling to stay behind the curve for a prolonged period and let inflation significantly overshoot its target. Wednesday, the Fed surprised markets by forecasting three rate hikes in 2017, resulting in a much more hawkish communique than was anticipated. Therefore, the FOMC's tolerance for a "high pressure" economy now seems much more limited than was assumed by markets not long ago. This further limits the inflationary potential of Trump's stimulus. Instead, it highlights the dollar-bullish nature of the current economic environment. Bottom Line: Trump fiscal stimulus at full employment evokes the inflationary policies of the late 1960s and early 1970s. However, back then it took years of economic overutilization before inflation reared its ugly head. Additionally, the structure of the labor market was much friendlier to inflation back then than it is today. Thus, while Trump's policy may raise inflation in the long term, it will take a prolonged period of time before such effects become evident. Instead, in 2017, inflation should remain well contained, especially as the Fed seems unwilling to remain significantly behind the curve. Investment Implications USD The U.S. dollar is in the midst of a powerful bull market. While the USD is already 10% overvalued, the greenback has historically hit its cyclical zenith when it traded with more than a 20% premium to its long-term fair value. This time should be no exception. Beyond our positive view on households, resurging animal spirits are beginning to support the economy. This combination is likely to prompt the Fed to move toward a more aggressive stance than was expected a few months ago (Chart I-34). With monetary divergences fully alive and backed up by economic fundamentals, interest-rate spreads between the U.S. and the rest of the G10 will only grow wider. Factors like a move toward dirigisme and an absence of blow-out inflation will only feed these trends. Chart I-34Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Market's Fed Pricing: More Upside Tactically, the dollar is overbought, but clearly momentum has taken over. There is so much uncertainty floating in terms of economic and policy outcomes that evaluating the fair-value path for interest rates and the dollar is an even trickier exercise than normal for investors. This lack of clarity tends to be a fertile ground for momentum trading. Investors are likely to continue to chase the Fed. This process could last until market pricing for 2017 has overshot the Fed's own prognostications. Chart I-35EUR/USD: Technical Picture EUR/USD: Technical Picture EUR/USD: Technical Picture EUR At this point in time, the euro suffers from two flaws. First, as the anti-dollar, shorting the euro is a liquid way to chase the dollar's strength. Second, monetary divergences are currently in full swing between the ECB and the Fed: the U.S. central bank just increased interest rates and upgraded its rate forecast for 2017; meanwhile, the ECB just eased policy by increasing the total size of its asset purchase program. Investors are in the process of pricing these two trends and EUR/USD has broken down as a result (Chart I-35). The recent breakdown could bring EUR/USD to parity before finding a temporary floor. That being said, a EUR/USD ultimate bottom could still trade substantially below these levels. The U.S. economy is slowly escaping secular stagnation while Europe remains mired in its embrace. The euro is likely to end up playing the role of the growth redistributor between the two. JPY The Bank of Japan has received the gift it wanted. Global bond yields and oil prices are rising. This process is supercharging the potency of its new set of policies. Higher oil prices contribute to lifting inflation expectations, and rising global rates are widening interest-rate differentials between the world and Japan. With the BoJ standing as a guarantor of low Japanese yields, real-rate differentials are surging in favor of USD/JPY. USD/JPY has broken above its 100-week moving average, historically a confirming signal that the bull market has more leg. Additionally, as Chart I-36 shows, USD/JPY is a function of global GDP growth. By virtue of its size, accelerating economic activity in the U.S. will lift average global growth, further hurting the yen. Tactically, USD/JPY is massively overbought but may still move toward 120 before taking a significant pause in its ascent. We were stopped out of our short USD/JPY position. Before re-opening this position, we would want to see a roll-over in momentum as currently, the trend is too strong to stand against. GBP While political developments remain the key immediate driver of the pound, GBP is weathering the dollar's strength better than most other currencies. This is a testament to its incredible cheapness (Chart I-37), suggesting that many negatives have been priced into sterling. Chart I-36USD/JPY: A Play On Global Growth bca.fes_sr_2016_12_16_s1_c36 bca.fes_sr_2016_12_16_s1_c36 Chart I-37Basement-Bargain Pound bca.fes_sr_2016_12_16_s1_c37 bca.fes_sr_2016_12_16_s1_c37 For the first half of 2017, the pound will be victim to the beginning of the Brexit negotiations between the EU and the U.K. The EU has an incentive to play hardball, which could weigh on the pound. In aggregate, while the short-term outlook for the pound remains clouded in much uncertainty, the pounds valuations make it an attractive long-term buy against both the USD and EUR. Chart I-38CAD: More Rates Than Oil bca.fes_sr_2016_12_16_s1_c38 bca.fes_sr_2016_12_16_s1_c38 CAD The Bank of Canada will find it very difficult to increase rates in 2017 or to communicate a rate hike for 2018. The Canadian economy remains mired with excess capacity, massive private-sector debt loads, and a disappointing export performance. This suggests that rate differentials between the U.S. and Canada will continue to point toward a higher USD/CAD (Chart I-38). On the more positive front, our upbeat view on the oil market will dampen some of the negatives affecting the Canadian dollar. Most specifically, with our less positive view on metals, shorting AUD/CAD is still a clean way to express theme 4. AUD & NZD While recent Australian employment numbers have been positive, the tight link between the Australian economy and Asia as well as metals will continue to represent hurdles for the AUD. In fact, the AUD is very affected by theme 3, theme 4, and theme 5. If a move towards dirigisme is a problem for Asia and Asian currencies, the historical link between the latter and the AUD represents a great cyclical risk for the Aussie (Chart I-39). Tactically, the outlook is also murky. A pullback in the USD would be a marginal positive for the AUD. However, if the USD does correct, we have to remember what would be the context: it would be because the recent tightening in U.S. financial conditions is hurting growth prospects, which is not a great outlook for the AUD. Thus, we prefer shorting the AUD on its crosses. We are already short AUD/CAD and tried to go long EUR/AUD. We may revisit this trade in coming weeks. Finally, we have a negative bias against AUD/NZD, reflecting New Zealand's absence of exposure to metals - the commodity group most exposed to EM liquidity conditions, as well as the outperformance of the kiwi economy relative to Australia (Chart I-40). However, on a tactical basis, AUD/NZD is beginning to form a reverse head-and-shoulder pattern supported by rising momentum. Buying this cross as a short-term, uncorrelated bet could be interesting. Chart I-39Dirigisme Is A Problem For The Aussie bca.fes_sr_2016_12_16_s1_c39 bca.fes_sr_2016_12_16_s1_c39 Chart I-40New Zealand Is Perkier Than Australia bca.fes_sr_2016_12_16_s1_c40 bca.fes_sr_2016_12_16_s1_c40 NOK & SEK The NOK is potentially the most attractive European currency right now. It is supported by solid valuations, a current account surplus of 5% of GDP and a net international investment position of nearly 200% of GDP. Moreover, Norwegian core inflation stands at 3.3%, which limits any dovish bias from the Norges Bank. Additionally, NOK is exposed to oil prices, making it a play on theme 4. We like to express our positive stance on the NOK by buying it against the EUR or the SEK. The SEK is more complex. It too is cheap and underpinned by a positive current account surplus. Moreover, the inflation weaknesses that have kept the Riksbank on a super dovish bias mostly reflected lower energy prices, a passing phenomenon. However, being a small open economy heavily geared to the global manufacturing cycle, Sweden is very exposed to a pullback from globalization, limiting the attractiveness of the krona. Moreover, the krona is extremely sensitive to the USD. CHF The SNB is keeping its unofficial floor under EUR/CHF in place. Therefore, USD/CHF will continue to be a direct mirror image of EUR/USD. On a longer-term basis, Switzerland net international investment position of 120% of GDP and its current-account surplus of 11% of GDP will continue to lift its fair value (Chart I-41). Hence, once the SNB breaks the floor and lets CHF float - an event we expect to materialize once Swiss inflation and wages move back toward 1% - the CHF could appreciate violently, especially against the euro. Chart I-41The Swiss Balance Of Payment Position Will Support CHF bca.fes_sr_2016_12_16_s1_c41 bca.fes_sr_2016_12_16_s1_c41 Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 For a more detailed discussion of the consumer and the dollar, please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, available at fes.bcaresearch.com. 2 Marek Jarocinski, and Michele Lenza, "How Large Is The Output Gap In The Euro Area," ECB Research Bulletin 2016, July 1, 2016. 3 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com. 4 Please see Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy", dated December 8, 2016, available at ces.bcaresearch.com. 5 For a more detailed discussion of dirigisme, multipolarity, and rising tensions in East Asia, please see Geopolitical Strategy Outlook, "We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. Currencies U.S. Dollar Chart II-1 bca.fes_sr_2016_12_16_s2_c1 bca.fes_sr_2016_12_16_s2_c1 Chart II-2 bca.fes_sr_2016_12_16_s2_c2 bca.fes_sr_2016_12_16_s2_c2 The Fed hiked rates to 0.75% as expected. The dollar began to rally soon after the updated dot-plot suggested a faster pace of tightening than previously expected. Data from Thursday morning displayed a strengthening labor market, with expectations consistently beaten: Initial Jobless Claims came in at 254 thousand, beating expectations of 255 thousand. Continuing Jobless Claims were recorded at 2.018 million, outperforming by 7 thousand. Additionally, the NY Empire State Manufacturing Index also outperformed expectations of 4, coming in at 9. These figures provided an additional lift to the dollar with the DXY nearing the 103 mark. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 The Euro Chart II-3 bca.fes_sr_2016_12_16_s2_c3 bca.fes_sr_2016_12_16_s2_c3 Chart II-4 bca.fes_sr_2016_12_16_s2_c4 bca.fes_sr_2016_12_16_s2_c4 The Euro Area's data releases seem to be a mixed bag. Industrial production failed to meet expectations, and even contracted 0.1% on a monthly basis. The Markit Composite PMI remained steady at 53.9, and was in line with expectations, while the Services PMI fell and underperformed expectations, whereas the Manufacturing PMI rose and beat expectations. The increase in the dollar has also forced down Euro, where it has broken the crucial support level of around 1.055, and traded as low as 1.04. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 The Yen Chart II-5 bca.fes_sr_2016_12_16_s2_c5 bca.fes_sr_2016_12_16_s2_c5 Chart II-6 JPY Technicals 2 JPY Technicals 2 Despite the recent collapse in the Yen, Japan continues to be plagued by strong deflationary pressures. The BoJ will have no choice but to continue to implement radical monetary measures and thus the yen will continue to fall as some of the data lacks vigor: The decline in machinery orders accelerated to 5.6% YoY, underperforming expectations. Japanese industrial production is also contracting, at a pace of 1.4%. Particularly, most measures in the Tankan Survey (for both manufacturers and non-manufacturers) also underperformed expectations. Report Links: Party Likes It’s 1999 - November 25, 2016 One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 British Pound Chart II-7 bca.fes_sr_2016_12_16_s2_c7 bca.fes_sr_2016_12_16_s2_c7 Chart II-8 bca.fes_sr_2016_12_16_s2_c8 bca.fes_sr_2016_12_16_s2_c8 Both the BoE and the market continue to be very bearish on the U.K. economy, causing the pound to be very cheap. However, the cable has remained resilient amid the recent dollar surge, in part because U.K. data, as we have mentioned many times, keeps outperforming expectations. The recent set of data confirms this view: Retail sales ex-fuel grew by 6.6% YoY, beating expectations of 6.1% YoY growth. Average earnings (both including and excluding bonus) also outperformed. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9 bca.fes_sr_2016_12_16_s2_c9 bca.fes_sr_2016_12_16_s2_c9 Chart II-10 bca.fes_sr_2016_12_16_s2_c10 bca.fes_sr_2016_12_16_s2_c10 Australian new motor vehicle sales are still quite weak: They are contracting 0.6% on a monthly basis, albeit at a slower pace from October's 2.4%; On an annual basis, they are now contracting 1.1%. Labor market data was also released, with unemployment increasing to 5.7%. However, the change in employment was better than expected, with 39,100 new total jobs being added to the economy. The Consumer Inflation Expectation measure for December also highlighted an upbeat outlook on inflation, reading at 3.4%, up from 3.2%. Report Links: One Trade To Rule Them All - November 18, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 New Zealand Dollar Chart II-11 bca.fes_sr_2016_12_16_s2_c11 bca.fes_sr_2016_12_16_s2_c11 Chart II-12 bca.fes_sr_2016_12_16_s2_c12 bca.fes_sr_2016_12_16_s2_c12 The recent dollar rally has been very damaging for the kiwi, as it has fallen by 3% since the Fed policy decision. Recent data has also been negative: Manufacturing Sales slowed down to 2.1% in Q3 from 2.2% in Q2 (this number was also revised down from 2.8%). Additionally Business PMI slowed down slightly from 55.1 to 54.4. The NZD has also shown weakness in spite of the surge in dairy price, which now stand at their highest point since June 2014. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13 bca.fes_sr_2016_12_16_s2_c13 bca.fes_sr_2016_12_16_s2_c13 Chart II-14 bca.fes_sr_2016_12_16_s2_c14 bca.fes_sr_2016_12_16_s2_c14 The outlook for Canada's economy remains murky. Although the Financial Stability Report concluded that Canada's financial system remains mostly unchanged from six months ago, the BoC highlighted three key vulnerabilities that remain in the financial system: household debt, for which the debt-to-disposable income is approaching 170%; imbalances in the housing market, where the prices have reached just under 6 times average household income - their highest recorded level; and fragile fixed-income market liquidity. Therefore, underlying weaknesses are apparent and data is reflective of a weak economy. Pressure from a rising dollar will continue to place additional pressure on the CAD going forward. Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Swiss Franc Chart II-15 bca.fes_sr_2016_12_16_s2_c15 bca.fes_sr_2016_12_16_s2_c15 Chart II-16 bca.fes_sr_2016_12_16_s2_c16 bca.fes_sr_2016_12_16_s2_c16 The SNB decided to stay put and leave rates unchanged at -0.75%. In addition, the SNB slightly decreased its forecast for inflation for the coming years. However the central bank remains optimistic on the Swiss economy, as improved sentiment in other advanced economies should help the Swiss export sector. Additionally, the labor market remains solid, with only 3.3% of unemployment. Although the franc should continue to mirror the Euro, all these factors will eventually put upward pressure on this currency. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17 bca.fes_sr_2016_12_16_s2_c17 bca.fes_sr_2016_12_16_s2_c17 Chart II-18 bca.fes_sr_2016_12_16_s2_c18 bca.fes_sr_2016_12_16_s2_c18 The Norges Bank decided to stay put and leave rates at 0.5%. In their Executive Board Assessment the Norges Bank project that rates will remain around their current level in the coming years. They also project that inflation should slowdown given a somewhat slower expected path for growth. However, worries about household debt persist: House prices rose by 11.6% YoY in November, while household debt grew by 6.3%. Additionally household credit is rising faster than household income. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19 bca.fes_sr_2016_12_16_s2_c19 bca.fes_sr_2016_12_16_s2_c19 Chart II-20 bca.fes_sr_2016_12_16_s2_c20 bca.fes_sr_2016_12_16_s2_c20 The Swedish economy has picked up a bit, as annual inflation figures came out at 1.4%, closer to the Riksbank's target. The labor market also displayed resilience as the unemployment rate dropped by 0.2% to 6.2%. Despite the upbeat data, the SEK failed to perform. With the dollar trading at new highs, USD/SEK also reached a new 13-year high, trading above 9.4 for a moment. Additionally, the SEK is trading poorly on its crosses as well, down against most of the G10 currencies. Report Links: One Trade To Rule Them All - November 18, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The FOMC statement was somewhat more hawkish than expected. The Fed is on course to raise rates two to three times next year. Trump's policy views are squarely bearish for bonds, but more mixed for stocks. Investors are focusing too much on the positive aspects of Trump's agenda, while ignoring the glaringly negative ones. The 35-year bond bull market is over. Deep-seated political and economic forces will conspire to lift inflation over the coming years. For now, rising wages and prices are welcome news given that inflation remains below target in most economies. However, with productivity and labor force growth still weak around the world - and likely to stay that way - reflation will eventually morph into stagflation. Feature A Fork In The Road Charlie Wilson, the former CEO of General Motors, once famously declared that "what is good for GM is good for the country." There is little doubt that policies that boost economic growth can benefit both Wall Street and Main Street alike. On occasion, however, what is good for one may not be good for the other. Consider Donald Trump's campaign promise to curb illegal immigration and crack down on firms that move production abroad. Reduced immigration means fewer potential customers, and hence weaker sales growth. Fewer immigrant workers and less outsourcing also means higher wages for native-born workers. Bad news for Wall Street, but arguably good news for Main Street. Chart 1Diminished Labor Market Slack Boosting Wages bca.gis_wr_2016_12_16_c1 bca.gis_wr_2016_12_16_c1 The distinction between Wall Street and Main Street is critical for thinking about how various policies affect bonds and stocks. Bond prices tend to be more influenced by what happens to the broader economy (the key concern for Main Street), whereas equity prices tend to be more influenced by what happens to corporate earnings (the key concern for Wall Street). Corporate earnings have recovered much more briskly over the past eight years than the overall economy. Thus, it is no surprise that stock prices have surged while bond yields have tumbled. Things may be changing, however. A tighter U.S. labor market is pushing up wages, and this is starting to weigh on corporate profit margins (Chart 1). Meanwhile, bond yields are finally rebounding after hitting record low levels earlier this year. A Somewhat Hawkish Hike This week's FOMC statement reinforced the upward trajectory in yields. Both the median and modal "dot" in the Summary of Economic Projections shifted from two to three hikes next year. While Chair Yellen mentioned that a few participants "did incorporate some assumption about the change in fiscal policy," we suspect that many did not, reflecting the lack of clarity about the timing, composition, and magnitude of any fiscal package. As these details are fleshed out, it is probable that both growth and inflation assumptions will be revised up, helping to keep the Fed's tightening bias in place. The key question is whether U.S. growth will be strong enough next year to allow the Fed to keep raising rates. Our view is that it will. As we argued in October in "Better U.S. Economic Data Will Cause The Dollar To Strengthen,"1 a recovery in business capex, a turn in the inventory cycle, a pick-up in spending at the state and local government level, and continued solid consumption growth driven by rising real wages will all support demand in 2017. Indeed, it is likely that the Fed will find itself a bit behind the curve, allowing inflation to drift higher. The Structural Case For Higher Inflation The cyclical acceleration in U.S. and global inflation that we will see over the next few years will be buttressed by structural trends. As we first spelled out in this year's Q3 Strategy Outlook entitled "The End Of The 35-Year Bond Bull Market,"2 a number of political and economic forces will conspire to lift inflation and nominal bond yields over time. Let us start with the politics. Here, three inflationary forces stand out: The retreat from globalization; The rejection of fiscal austerity; The continued will and growing ability of central banks to push up inflation. Globalization Under Attack Globalization is an inherently deflationary force. In a globalized world, if a country experiences an idiosyncratic shock which raises domestic demand, this can be met with more imports rather than higher prices. In addition, the entry of millions of workers from once labor-rich, but capital-poor economies such as China, has depressed the wages of less-skilled workers in developed economies.3 Poorer workers tend to spend a greater share of their incomes than richer workers (Chart 2). To the extent that globalization has exacerbated income inequality, it has also reduced aggregate demand. It is too early to know to what extent Donald Trump will try to roll back globalization. So far, his cabinet appointments - perhaps with the exception of immigration hawk Jeff Sessions - are little different from what a run-of-the-mill Republican like Jeb Bush would have made. Yet, as we noted last week, it will be difficult for Trump to backtrack from his protectionist views because his white working-class base will abandon him if he does.4 As Chart 3 shows, the share of Republican voters who support free trade has plummeted from over half to only one-third. For better or for worse, the Republican Party has become a populist party. Davos Man beware. Chart 2The Rich Save, The Poor Not So Much bca.gis_wr_2016_12_16_c2 bca.gis_wr_2016_12_16_c2 Chart 3Republican Voters Are Rejecting Free Trade Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks In any case, even if populist pressures do not cause global trade to collapse over the coming years, the period of "hyperglobalization," as Arvind Subramanian has called it, is over. As we discussed three weeks ago,5 many of the things that facilitated globalization over the past 30 years were one-off developments: China cannot join the WTO more than once; tariffs in most developed countries cannot fall much more because they are already close to zero; there is nothing on the horizon that will match the breakthrough productivity gains in global shipping that stemmed from containerization; the global supply chain is already highly efficient, etc. Thus, at the margin, globalization will be less of a deflationary force than it once was. Back To Bread And Circuses After a brief burst of fiscal stimulus following the financial crisis, governments moved quickly to tighten their belts. Now, however, the pendulum is starting to swing back towards easier fiscal policy, as nervous politicians look for ways to thwart the populist backlash (Chart 4). The U.K. is a good example of this emerging trend. Prior to the Brexit vote, the Conservative government had planned to tighten fiscal policy by a further 3.3% of GDP over the remainder of this decade. This goal has been thrown out the window, with Theresa May now even hinting about the prospect of some fiscal stimulus. Elsewhere in Europe, governments continue to flout their fiscal targets. Not only has the European Commission turned a blind eye to this development, but a recent report by the Commission actually suggested that a "desirable fiscal orientation" would entail larger budget deficits next year than what member states are currently targeting (Chart 5). Chart 4The End Of Austerity Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Chart 5The European Commission Recommends Greater Fiscal Expansion Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks In Japan, Prime Minister Abe has scrapped plans to raise the sales tax next year. The supplementary budget announced in August will boost annual spending by 0.5% of GDP over the next three years. Our geopolitical team thinks that further spending measures will be introduced, especially on defense. For his part, Donald Trump has pledged massive fiscal stimulus consisting of increased infrastructure and defense expenditures, along with a whopping $6.2 trillion in tax cuts over the next 10 years even before accounting for additional interest costs. Investors shouldn't rejoice too much, however. Effective tax rates for S&P 500 companies are already well below statutory levels on account of the numerous loopholes in the tax code (Chart 6). Small businesses rather than large corporations will disproportionately benefit from Trump's tax measures. Chart 6The U.S. Effective Corporate Tax Rate Is Already Quite Low bca.gis_wr_2016_12_16_c6 bca.gis_wr_2016_12_16_c6 Moreover, it is doubtful that the maximum fiscal thrust from Trump's policies will be reached before 2018. By that time, the economy is likely to have reached full employment. As such, much of the stimulus is likely to show up in the form of higher wages rather than increased real corporate sales. More Monetary Ammo The global financial crisis set off the biggest deflation scare the world has seen since the Great Depression. Eight years later, central banks are still struggling to raise inflation. The conventional wisdom is that central banks are "out of bullets." This view, however, is much too pessimistic. Even if one excludes the use of such radical measures as helicopter money, it is still the case that traditional monetary policy becomes more effective as spare capacity is reduced. Consider the case of forward guidance. If an economy has a large output gap, a central bank's promise to keep interest rates at zero, 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, another adverse economic shock, etc. In contrast, if the output gap is already quite small, as is the case in the U.S. today, a promise to let the economy run hot is more likely to be taken seriously. Chart 7 shows that the level of the U.S. core PCE deflator, the Fed's preferred inflation gauge, is nearly 4% lower than it would have been if inflation had remained at its 2% target since 2008. Given that the Fed has a symmetric target - meaning that inflation overshoots should be just as common as undershoots - aiming for an inflation rate above 2% over the next few years makes some sense. If inflation does move up to the 2.5%-to-3% range, the Fed might be reluctant to bring it back down since this would require slower growth and higher unemployment. In fact, a case could be made that the Fed and other central banks should simply raise their inflation targets. Both private and public debt levels are still quite elevated all over the world (Chart 8). Higher inflation would be one way to reduce the real value of those liabilities. Chart 7Inflation Has Undershot the Fed's Target Inflation Has Undershot the Fed's Target Inflation Has Undershot the Fed's Target Chart 8Elevated Debt Levels Elevated Debt Levels Elevated Debt Levels The difficulty in pushing nominal short-term rates much below zero is another reason to aim for a higher inflation rate. Back in 1999 when the FOMC first broached the idea of introducing a 2% inflation target, the Fed's simulations suggested that the zero lower bound would only be reached once every 20 years, and even on these rare occurrences, interest rates would be pinned to zero for only four quarters (Table 1). In reality, the U.S. economy has spent more than half of the time since then either at the zero bound or close to it. While we do not expect any central bank to raise their inflation targets anytime soon, long-term investors should nevertheless prepare for this possibility. Table 1The Fed Underestimated The Probability Of Rates Being Stuck At Zero Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Slow Potential Growth: Deflationary At First, Inflationary Later On The narrowing of output gaps around the world has given central banks more traction over monetary policy. However, there has been a dark side to this development - and one that also leans in the direction of higher inflation. As Chart 9 shows, spare capacity has declined in every major economy not because demand has been strong, but because supply has been weak. Chart 9AWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_12_16_c9a bca.gis_wr_2016_12_16_c9a Chart 9BWeak Supply Growth Has Narrowed Output Gaps bca.gis_wr_2016_12_16_c9b bca.gis_wr_2016_12_16_c9b The decline in potential GDP growth reflects both slower productivity and labor force growth. As we have discussed in past reports, while cyclical factors have weighed on potential growth, structural factors also loom large.6 The former include falling birth rates, flat-lining labor participation, plateauing educational attainment, and a shift in technological innovation away from business productivity and towards consumer-centric applications such as social media. Chart 10A Decline In Productivity Growth Is Deflationary In The Short Run, But Inflationary In The Long Run Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Critically, slower potential GDP growth tends to be deflationary at the outset but becomes inflationary later on. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households react to the prospect of slower 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 10). 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 when 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 11). 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 11An Aging Population Eventually Pushes Up Interest Rates Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Japan provides a good example of how this transition might occur. Chart 12 shows that the household savings rate has fallen from over 14% in the early 1990s to only 2% today. Meanwhile, the ratio of job openings-to-applicants has reached a 25-year high. Amazingly, the tightening in the labor market has occurred despite anemic GDP growth and a huge surge in female employment. Prime-age female labor participation has already risen above U.S. levels (Chart 13). As participation rates stabilize, labor force growth in Japan will decline from a cyclical high of around 0.8% at present to -0.2%. That may be enough to precipitate a sharp labor shortage, leading to higher wages and an end to deflation. Chart 12Japan: Declining Household Savings ##br## Rate And A Tightening Labor Market Japan: Declining Household Savings Rate And A Tightening Labor Market Japan: Declining Household Savings Rate And A Tightening Labor Market Chart 13Japan: Female Labor Force ##br## Participation Now Exceeds The U.S. bca.gis_wr_2016_12_16_c13 bca.gis_wr_2016_12_16_c13 What will the Bank of Japan do when this fateful day arrives? The answer is probably nothing. The BoJ would welcome a virtuous circle in which rising inflation pushes down real rates, leading to a weaker yen, a stronger stock market, and even higher inflation expectations. Such a virtuous circle almost emerged in 2012 had the Japanese government not short-circuited it by tightening fiscal policy by 3% of GDP. It won't make the same mistake again. Investment Conclusions Global assets have swung wildly in the weeks following the U.S. presidential election. The selloff in bonds and the rally in the dollar make perfect sense to us - indeed, we predicted as much in our September report entitled "Three Controversial Calls: Trump Wins, And The Dollar Rallies."7 In contrast, the surge in U.S. equities seems overdone. Yes, certain elements of Trump's political agenda such as deregulation and lower corporate tax rates are good news for stocks. But other aspects such as trade protectionism and tighter immigration controls are not. Others still, such as increased government spending, are good in theory but carry sizeable side-effects, the chief of which is that the stimulus may arrive at a time when the economy no longer needs it. Some commentators have argued that the good aspects of Trump's agenda will be implemented before the bad ones, giving investors a reason to focus on the positive. We are not so sure. If Trump gives the Republican establishment everything it wants on taxes and regulations, he will lose all his remaining leverage over trade and immigration. Rather than waiting to be stabbed in the back by Paul Ryan, strategically, Trump is likely to insist that Congress implement his populist platform before he hands it the keys to the economy. Even if one ignores the political intrigue, it is still the case that global stocks have tended to suffer following major spikes in bond yields such as the one we have just experienced (Table 2). We suspect that this time will not be any different. As such, investors would be wise to adopt a more defensive tactical posture over the next few months. Table 2Stocks Tend To Suffer When Bond Yields Spike Main Street Bonds, Wall Street Stocks Main Street Bonds, Wall Street Stocks Chart 14Global Growth Is Accelerating Global Growth Is Accelerating Global Growth Is Accelerating Things look better over a one-to-two year cyclical horizon. Outside of the U.S., much of the global economy continues to suffer from excess spare capacity. Recent data suggesting that global growth is accelerating is welcome news in that regard (Chart 14). Not only will stronger growth boost corporate earnings, but with the ECB, BoJ, and many other central banks firmly on hold, any increase in inflation expectations will translate into lower real rates, providing an additional fillip to spending. We continue to prefer European and Japanese stocks over their U.S. counterparts, on a currency-hedged basis. Emerging markets are a tougher call. The real trade-weighted dollar probably has another 5% or so of upside from current levels. Historically, a stronger greenback has been bad news for EM equities. On a more positive note, faster global growth should give some support to commodity prices. BCA's commodity strategists remain quite bullish on crude and natural gas, a view that has been further reinforced by both Saudi Arabia and Russia's announcements to restrict oil supply beginning in January. Still, on balance, we recommend a slightly underweight position in EM equities. Looking beyond the next two years, the outlook for global risk assets is likely to darken again. We are skeptical that Trump's much lauded supply-side policies will boost productivity to any great degree. Against a backdrop of rising budget deficits and brewing populist sentiment around the world, reflation may begin to give way to stagflation. In such an environment, bond yields could rise substantially from current levels, taking stocks down with them. Enjoy it while it lasts. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 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. 2 Please see Global Investment Strategy, "Strategy Outlook Third Quarter 2016: End Of The 35-Year Bond Bull Market," dated July 8, 2016, available at gis.bcaresearch.com. 3 David H. Autor, David Dorn, and Gordon H. Hanson, "Trade Adjustment: Worker-Level Evidence," The Quarterly Journal of Economics (2014). 4 Please see Global Investment Strategy Weekly Report, "Trump And Trade," dated December 9, 2016, available at gis.bcaresearch.com. 5 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization," dated November 25, 2016, available at gis.bcaresearch.com. 6 Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 25, 2016, and Global Investment Strategy Special Report, "Slower Potential Growth: Causes And Consequences," dated May 29, 2015, available at gis.bcaresearch.com. 7 Please see Global Investment Strategy Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Recommendation Allocation Quarterly - December 2016 Quarterly - December 2016 Highlights Growth was picking up before the election of President Trump. His election merely accelerates the rotation from monetary to fiscal policy. This is likely to cause yields to rise, the Fed to tighten and the dollar to strengthen further. That will be negative for bonds, commodities and emerging market assets, and equivocal for equities. Short term, markets have overshot and a correction is likely. But the 12-month picture (higher growth and inflation) suggests risk assets such as equities will outperform. Our recommendations mostly have cyclical tilts. We are overweight credit versus government bonds, underweight duration and, in equity sectors, overweight energy, industrials and IT (and healthcare for structural reasons). Among alts, we prefer real estate and private equity over hedge funds and structured products. We limit beta through overweights (in common currency terms) on U.S. equities versus Europe and emerging markets. We also have a (currency-hedged) overweight on Japanese stocks. Feature Overview A Shift To Reflation The next 12 months are likely to see stronger economic growth, particularly in the U.S., and higher inflation. That will probably lead to higher long-term interest rates, the Fed hiking two or three times in 2017, and further dollar strength. The consequences should be bad for bonds, but mixed for equities - which would benefit from a better earnings outlook, but might see multiples fall because of a higher discount rate. The election of Donald Trump merely accelerates the rotation from monetary policy to fiscal policy that had been emerging globally since the summer. Trump's fiscal plans are still somewhat vague,1 but the OECD estimates they will add 0.4 percentage points to U.S. GDP growth in 2017 and 0.8 points in 2018, and 0.1 and 0.3 points to global growth. Growth was already accelerating before the U.S. presidential election. Global leading indicators have picked up noticeably (Chart 1), and the Q3 U.S. earnings season surprised significantly on the upside, with EPS growth of 3% (versus a pre-results expectation of -2%) - the first YoY growth in 18 months (Chart 2). Chart 1Global Growth Picking Up bca.gaa_qpo_2016_12_15_c1 bca.gaa_qpo_2016_12_15_c1 Chart 2U.S. Earnings Growing Again bca.gaa_qpo_2016_12_15_c2 bca.gaa_qpo_2016_12_15_c2 The problem with the shift to fiscal, then, is that it comes at a time when slack in U.S. economy has already largely disappeared. The Congressional Budget Office estimates the output gap is now only -1.5%, which means it is likely to turn positive in 2017 (Chart 3). Unemployment, at 4.6%, is below NAIRU2 (Chart 4). Historically, the output gap turning positive has sown the seeds of the next recession a couple of years later, as the Fed tightens policy to choke off inflation. Chart 3Output Gap Will Close In 2017 bca.gaa_qpo_2016_12_15_c3 bca.gaa_qpo_2016_12_15_c3 Chart 4Will This Trigger Inflation Pressures? bca.gaa_qpo_2016_12_15_c4 bca.gaa_qpo_2016_12_15_c4 As the Fed signaled at its meeting on December 14, it is likely to raise rates two or three times more in 2017. But we don't see it getting any more hawkish than that. Janet Yellen has made it clear that she will not preempt Trump's fiscal stimulus but rather wait to see it passed by Congress. The market is probably about right in pricing in an 80% probability of two rate hikes in 2017, and a 50% probability of three. With the Atlanta Fed Wage Growth Tracker rising 3.9% YoY and commodity prices (especially energy) starting to add to headline inflation, the Fed clearly wants to head off inflation before it sets in. We do not agree with the argument that the Fed will deliberately allow a "high-pressure economy." The result is likely to be higher long-term rates. The 10-year U.S. yield has already moved a long way (up 100 BP since July), and our model suggests fair value currently is around 2.3% (Chart 5). Short term, then, a correction is quite possible (and would be accompanied by moves in other assets that have overshot since November 9). But stronger global growth and an appreciating dollar over the next 12 months could easily push fair value up to 3% or beyond. The relationship between nominal GDP growth (which is likely to be 4.5-5% in 2017, compared to 2.7% in 1H 2016) and long-term rates implies a rise to a similar level (Chart 6). Accordingly, we recommend investors to be underweight duration and prefer TIPs over nominal bonds. Chart 5U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value U.S. 10-Year At Fair Value Chart 6Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Rise In Nominal GDP Could Push It Up To 3% Global equities, on a risk-adjusted basis, performed roughly in line with sovereign bonds in 2016 - producing a total return of 9.2%, compared to 3.3% for bonds (though global high yield did even better, up 15.1%). If our analysis above is correct, the return on global sovereign bonds over the next 12 months is likely to be close to zero. Chart 7Will Investors Reverse The Move##br## from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? Will Investors Reverse The Move from Equities To Bonds? The outlook for equities is not unclouded. Higher rates could dampen growth (note, for example, that 30-year fixed-rate mortgages in the U.S. have risen over the past two months from 3.4% to 4.2%, close to the 10-year average of 4.6%). The U.S. earnings recovery will be capped by the stronger dollar.3 And a series of Fed hikes may lower the PE multiple, already quite elevated by historical standards. Erratic behavior by President Trump and the more market-unfriendly of his policies could raise the risk premium. But we think it likely that equities will produce a decent positive return in this environment. Portfolio rebalancing should help. Since the Global Financial Crisis investors have steadily shifted allocations from equities into bonds (Chart 7). They are likely to reverse that over the coming quarters if bond yields continue to trend up. Accordingly, we moved overweight equities versus bonds in our last Monthly Portfolio Update.4 Our recommended portfolio has mostly pro-cyclical tilts: we are overweight credit versus government bonds, overweight most cyclical equity sectors, and have a preference for risk alternative assets such as real estate and private equity. But our portfolio approach is to pick the best spots for taking risk in order to make a required return. We, therefore, balance this pro-cyclicality by some lower beta stances: we prefer investment grade debt over high yield, and U.S. and Japanese equities over Europe and emerging markets. Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com What Our Clients Are Asking What Will Trump Do? Trump made several speeches in September with details of his tax plan. He promised to (1) simplify personal income tax, cutting seven brackets to three, with 12%, 25% and 33% tax rates; (2) cut the headline corporate tax rate to 15% (from 35%); and (3) levy a 10% tax on the $3 trillion of corporate retained earnings held offshore. He was less specific on infrastructure spending, but Wilbur Ross, the incoming Commerce Secretary, mentioned $550 billion, principally financed through public-private partnerships. The Tax Policy Center estimates the total cost of the tax plan at $6 trillion (with three-quarters from the business tax cut). But it is not clear how much will be offset by reduced deductions. Incoming Treasury Secretary Steven Mnuchin, for example, said that upper class taxpayers will get no absolute tax cut. TPC estimates the tax plan alone will increase federal debt to GDP by 25 percentage points over the next 10 years (Chart 8). The OECD, assuming stimulus of 0.75% of GDP in 2017 and 1.75% in 2018, estimates that this will raise U.S. GDP growth by 0.4 percentage points next year and by 0.8 points in 2018, with positive knock-on effects on the rest of the world (Chart 9). While there are questions on the timing (and how far Trump will go with trade and immigration measures), BCA's geopolitical strategists sees few constraints on getting these plans passed.5 Republications in Congress like tax cuts (and will compromise on the public spending element) and it is wrong to assume that Republican administrations reduce the fiscal deficit - historically the opposite is true (Chart 10). Chart 8Massive Increase In Debt Quarterly - December 2016 Quarterly - December 2016 Chart 9GDP Impact Of U.S. Fiscal Stimulus Quarterly - December 2016 Quarterly - December 2016 Chart 10A Lot of Stimulus, And Extra Debt bca.gaa_qpo_2016_12_15_c10 bca.gaa_qpo_2016_12_15_c10 Implications for markets? Short term positive for growth and inflation; longer-term a worry because of crowding out from the increased government debt. How Will The Strong USD Impact Global Earnings? We have a strong U.S. dollar view and also favor U.S. equities over the euro area and emerging markets. Some clients question our logic because conceptually a strong USD should benefit earnings growth in the non-U.S. markets, and therefore non-U.S. equities should outperform. Chart 11USD Impact On Global Earnings bca.gaa_qpo_2016_12_15_c11 bca.gaa_qpo_2016_12_15_c11 Currency is just one of the factors that we consider when we make country allocation decisions, and our weights are expressed in USD terms unhedged. We will hedge a currency only when we have very high conviction, such as our current Japan overweight with a yen hedge, which is based on our belief that the BOJ will pursue more unconventional policies to stimulate the economy. This is undoubtedly yen bearish but positive for Japanese stocks. As shown in Chart 11, a stronger USD has tended to weaken U.S. earnings growth (panel 1). However, what matters to country allocation is relative earnings growth. Panels 3 and 5 show that in local currency terms, earnings growth in emerging markets and the euro area did not always outpace that in the U.S. when their currencies depreciated against the USD. In fact, when their currencies appreciated, earnings growth in USD terms tended to outpace that in the U.S. (panels 2 and 4), suggesting that the translation impact plays a very important role. This is consistent with what we have found for relative equity market returns (see Global Equity section on page 13). Currency affects revenues and costs in different proportions. If both revenues and costs are in same currency, then only net profit is affected by the currency. But, since many companies manage their forex exposure, at the aggregate level the currency impact will always be "weaker than it should be". What Is The Outlook For Brexit And The Pound? The U.K. shocked the world on 24 June 2016 with its vote to leave the European Union. However, the process and terms of exit are yet to be finalized pending the Supreme Court's decision on the role of parliament in invoking Article 50 of the Lisbon Treaty. Depending on this decision, there is a spectrum of possible outcomes for the U.K./EU relationship. At the two ends of the spectrum are: 1) a hard Brexit - complete separation from the EU, in which case the pound will plunge further; 2) a soft Brexit - with a few features of the current relationship retained, in which case the pound will rally. Chart 12What's Up Brexit? What's Up Brexit? What's Up Brexit? The fall in the nominal effective exchange rate to a 200-year low (Chart 12) is a clear indication of the potential serious long-term damage. With the nation's dependence on foreign direct investment (FDI) to finance its large current account deficit (close to 6% of GDP), more populist policies and increased regulation will hurt corporate profitability, making local assets less profitable to foreigners. The pound is currently caught up in a vicious circle of more depreciation, leading to higher inflation expectations and depressed real rates, which adds further selling pressure. This is the likely path of the pound in the case of a hard Brexit. For U.K. equities, under a hard Brexit that adds downward pressure to the pound, investors should favor firms with global revenues (FTSE 100) and underweight firms exposed more to domestic business and a potential recession (FTSE 250). The opposite holds true in the case of a soft Brexit. Investors should also underweight U.K. REITs because of cyclical and structural factors that will affect commercial real estate. In the case of a hard Brexit, structural long-term impacts to the British economy include: 1) a decline in the financial sector - the EU will introduce regulations that will force euro-denominated transactions out of London; 2) a slowdown in FDI - the U.K. will cease to be a platform for global companies to access the EU, triggering a long-term decline in foreign inflows; 3) weaker growth - with EU immigration into the U.K. expected to fall by 90,000 to 150,000 per year, estimates.6 point to a 3.4% to 5.4% drop in per capita GDP by the year 2030. What Industry Group Tilts Do You Recommend? In October 2015, we advocated that, because long-term returns for major asset classes would fall short of ingrained expectations, investors should increase alpha by diving down into the Industry Group level.7 How have these trades fared, and which would we still recommend? Long Household And Personal Products / Short Energy. We closed the trade for a profit of 12.2% in Q12016. This has proven to be quite timely as oil prices, and Energy stocks along with it, have rallied substantially since. Long Insurance / Short Banks. The early gains from this trade reversed in Q2 as long yields have risen rapidly, leading to yield curve steepening. However, our cyclical view is still intact. Relative performance is still holding its relationship with the yield curve (Chart 13). Historically, Fed tightening has almost always led to bear flattening. We expect the same in this cycle, which should lead to Insurance outperformance. Long Health Care Equipment / Short Materials. This trade generated early returns but has since underperformed as Materials bounced back sharply. Nevertheless, we remain bearish on commodities and EM-related plays, viewing this rise in Materials stocks as more of a technical bounce from oversold valuations (Chart 14). Commodities remain in a secular bear market. On health care, we maintain our structural bullish outlook given aging demographics, increased spending on health care and attractive valuations. Short Retail / Global Broad. We initiated trade in January after the Fed initiated liftoff. Consumer Discretionary stocks collapsed after, and this trade has provided a gain of 2.01%. We maintain this view as the recent hike and 2017 hikes will continue to dampen Retail performance (Chart 15). Additionally, Retail has only declined slightly while other Consumer Discretionary stocks have falling drastically, suggesting downside potential from convergence. Chart 13Flatter Yield Curve Is Bullish bca.gaa_qpo_2016_12_15_c13 bca.gaa_qpo_2016_12_15_c13 Chart 14An Oversold Bounce bca.gaa_qpo_2016_12_15_c14 bca.gaa_qpo_2016_12_15_c14 Chart 15Policy Tightening = Underperformance bca.gaa_qpo_2016_12_15_c15 bca.gaa_qpo_2016_12_15_c15 Global Economy Overview: The macro picture looks fairly healthy, with growth picking up in developed economies and China, though not in most emerging markets. The weak patch from late 2015 through the first half of 2016, with global industrial and profits recessions, appears to be over. The biggest threat to growth now is excessive dollar strength, which would slow U.S. exports and harm emerging markets. U.S.: U.S. growth was surprising on the upside (Chart 16) even before the election. Q2 real GDP growth came in at 3.2% and the Fed's Nowcasting models indicate 2.6-2.7% in Q4. After rogue weak ISMs in August, the manufacturing indicator has recovered to 53.2 and the non-manufacturing ISM to 57.2. However, growth continues to be driven mainly by consumption, with capex as yet showing few signs of recovery. A key question is whether a Trump stimulus will be enough to reignite "animal spirits" and push corporates to invest more. Euro Area: Eurozone growth has also been surprisingly robust. PMIs for manufacturing and services in November came in at 53.7 and 53.8 respectively; the manufacturing PMI has been accelerating all year. This is consistent with the ECB's forecasts for GDP growth of 1.7% for both this year and next. However, risk in the banking system could derail this growth. Credit growth, highly correlated with economic activity, has picked up to 1.8% YOY but could slow if banks turn cautious. Japan: Production data has reacted somewhat to Chinese stimulus, with IP growth positive (Chart 17) for the past three months and the Leading Economic Index inching higher since April. But the strength of the yen until recently and disappointing inflation performance (core CPI -0.4% YOY) have depressed exports and consumer sentiment. The effectiveness of the BoJ's 0% yield cap on 10-year government bonds, which has weakened the yen by 14% in two months, should trigger a mild acceleration of growth in coming quarters. Chart 16U.S. Economy Surprising ##br##On The Upside bca.gaa_qpo_2016_12_15_c16 bca.gaa_qpo_2016_12_15_c16 Chart 17Growth Picks Up In##br## Most DMs And China bca.gaa_qpo_2016_12_15_c17 bca.gaa_qpo_2016_12_15_c17 Emerging Markets: China has continued to see positive effects from its reflation of early 2016, with the manufacturing PMI close to a two-year high. The effects of the stimulus will last a few more months, but the authorities have reined back now and the currency is appreciating against its trade basket. The picture is less bright in other emerging markets, as central banks struggle with weak growth and depreciating currencies. Credit growth is slowing almost everywhere (most notably Turkey and Brazil) which threatens a further slowdown in growth in 2017. Interest rates: Inflation expectations have risen sharply in the U.S. following the election, but less so in the eurozone and Japan. They may rise further - pushing U.S. bond yields close to 3% - if the Trump administration implements a fiscal stimulus anywhere close to that hinted at. This could, in turn, push the Fed to raise rates at least twice more in 2017. The ECB has announced a reduction in its asset purchases starting in April 2017, too, but the Bank of Japan will allow inflation to overshoot before tightening. Chart 18Earnings Bottoming But##br## Valuation Stretched bca.gaa_qpo_2016_12_15_c18 bca.gaa_qpo_2016_12_15_c18 Global Equities Cautiously Optimistic: Global markets have embraced the "hoped for" pro-growth and inflationary policies from the new U.S. administration since Trump's win on November 8. In the latest GAA Monthly Update published on November 30,8 we raised our recommendation for global equities relative to bonds to overweight from neutral on a 6-12 month investment horizon. However, the call was driven more by underweighting bonds than by overweighting equities, given the elevated equity valuations and declining profit margins.(Chart 18) The hoped-for U.S. pro-growth policies would, if well implemented, be positive for earnings growth, but the "perceived" earnings boost has not yet shown up in analysts' earnings revisions (panel 3). In fact, only three sectors (Financials, Technology and Energy) currently have positive earnings revisions, because analysts had already been raising forward earnings estimates since early 2016. According to I/B/E/S data as of November 2016, about 80% of sectors are forecast to have positive 12-month forward earnings growth, while only about 20% have positive 12-month trailing earnings growth (panel 3). Within global equities, we continue to favor developed markets over emerging market on the grounds that most EMs are at an early stage of a multi-year deleveraging.9 We also favor the U.S. over the euro area (see more details on the next page). The Japan overweight (currency hedged) is an overwrite of our quant model: we believe that the BoJ will pursue increasingly unconventional monetary policy measures over the coming 12 months. The quant model (in USD and unhedged) has suggested a large underweight in Japan but has gradually reduced the underweight over the past two months. Our global sector positioning is more pro-cyclical than our more defensively-oriented country allocations. In line with our asset class call, we upgrade Financials to neutral and downgrade Utilities to underweight, and continue to overweight Energy, Technology, Industrials, and Healthcare while underweighting Telecom, Consumer Discretionary and Consumer Staples. Country Allocation: Still Favor U.S. Over Euro Area GAA's portfolio approach is to take risk where it is likely to be best rewarded. Having taken risk at the asset class level (overweight equities vs. bonds), at the global equity sector level with a pro-cyclical tilt, and at the bond class level with credit and inflation tilts, we believe it's appropriate to maintain our more defensive equity tilt at the country level by being market weight in euro area equities on an unhedged USD basis while maintaining a large overweight in the U.S. Chart 19Uninspiring profit Outlook bca.gaa_qpo_2016_12_15_c19 bca.gaa_qpo_2016_12_15_c19 It's true that the euro area PMI has been improving. Relative to the U.S., however, the euro area's cyclical improvement, driven by policy support, has lost momentum. It's hard to envision what would reverse this declining growth momentum, suggesting European earnings growth will remain at a disadvantage to the U.S. (Chart 19, panel 1) It's also true that the underperformance of eurozone equities versus the U.S. has reached an historical extreme in both local and common currency terms, and that euro equities are trading at significant discount to the U.S. But Europe has always traded at a discount, and the current discount is only slightly lower than its historical average. Our work has shown that valuation works well only when it is at extremes, which is not the case currently. Conceptually, a weak euro should boost euro area equity performance at least in local currency terms, yet empirical evidence does not strongly support such a claim: the severe underperformance since 2007 has been accompanied by a 43% drop in the euro versus the USD (Chart 19 panel 2). In fact, in USD terms, the euro area tended to outperform the U.S. when the euro was strong (panel 3), suggesting that currency translation plays a more dominant role in relative performance. Our currency house view is that the euro will depreciate further against the USD, given divergences in monetary and fiscal policy between the two regions. As such, we recommend clients to continue to favor U.S. equities versus the euro area, but not be underweight Europe given that it is technically extremely oversold. Sector Allocation: Upgrade Financials To Neutral Our sector quant model shifted global Financials to overweight in December from underweight, largely driven by the momentum factor. We agree with the direction of the quant model as the interest rate environment has changed (Chart 20, panel 1) and valuation remains very attractive (panels 2), but we are willing to upgrade the sector only to market weight due to our concern on banks in the euro area and emerging markets. Within the neutral stance in the sector, we still prefer U.S. and Japanese Financials to eurozone and emerging market ones. Despite the poor performance of the Financials sector relative to the global benchmark, U.S. and Japanese financials have consistently outperformed eurozone financials, driven by better relative earnings without any valuation expansion (panel 3). U.S. banks have largely repaired their balance sheets since the Great Recession, and the "promised" deregulation by the new U.S. administration will probably help U.S. banks. In the euro area, however, banks, especially in Italy, are still plagued with bad loans (panel 4). We will watch banking stress in the region very closely for signs of contagion (panel 5) The upgrade of financials is mainly financed by downgrading the bond proxy Utilities to underweight from neutral, in line with our asset class view underweighting fixed income. Chart 20Global Financials: Regional Divergence bca.gaa_qpo_2016_12_15_c20 bca.gaa_qpo_2016_12_15_c20 Chart 21Global Equities: No Style Bet bca.gaa_qpo_2016_12_15_c21 bca.gaa_qpo_2016_12_15_c21 Smart Beta Update: No Style Bet In a Special Report on Smart Beta published on July 8 2016,10 we showed that it is very hard to time style shifts and that an equal-weighted composite of the five most enduring factors (size, value, quality, minimum volatility and momentum) outperforms the broad market consistently on a risk-adjusted basis. Year-to-date, the composite has performed in line with the broad market, but over the past three months there have been sharp reversals in the performance of the different factors, with Min Vol, Quality and Momentum sharply underperforming Value and Size (Chart 21 panel 1). We showed that historically the Value/Growth tilt has been coincident with the Cyclical/Defensive sector tilt (panel 3). Panel 2 also demonstrates that the Min Vol strategy's relative performance can also be well explained by the Defensives/Cyclicals sector tilt. Sector composition matters. Compared to Growth, Value is now overweight Financials by 25.6%, Utilities by 13.2%, Energy by 8.3% and Materials by 2.5%, while underweight Tech by 23%, Healthcare by 12.7%, and Consumer Discretionary by 10%. REITs is in pure Growth, while Utilities and Telecom are in pure Value, and Energy has very little representation in Growth. In our global sector allocation, we favor Tech, REITs, Energy, and Healthcare, while underweight Utilities, Consumer Discretionary and Telecoms, and neutral on Financials and Materials. As such, maintaining a neutral stance on Value vs. Growth is consistent with our sector positioning. Government Bonds Maintain slight underweight duration. After 35 years, the secular bull market in government bonds is over. Even with Treasury yields skyrocketing since the Trump victory, the path of least resistance for yields is upward (Chart 22). Yields should grind higher slowly as inflation rises and growth indicators continue to improve. Bullish sentiment has dropped considerably, but there is further downside potential. Additionally, fiscal stimulus from Japan and further rate hikes from the Fed will provide considerable tailwinds. Overweight TIPS vs. Treasuries. Despite still being below the Fed's target, with headline and core CPI readings of 1.6% and 2.2% respectively, U.S. inflation has clearly bottomed for the cycle (Chart 23). This continued rise is a result of cost-push inflation driven by faster wage growth. Trump's increased spending and protectionist trade policies are both inflationary. As real GDP growth should remain around 2% annualized and the labor market continues to tighten, this effect will only intensify. Valuations have become less attractive but very gradual Fed hikes will not be enough to derail the upward momentum in consumer prices. Overweight JGBs. The BoJ has ramped up its commitment to exceeding 2% inflation by expanding its monetary base and locking in 10-year sovereign yields at zero percent. Additionally, the end of the structural decline in interest rates suggests global bonds will perform poorly going forward. During global bond bear markets, low-beta Japanese government debt has typically outperformed (Chart 24). This will likely hold true again as global growth improves and Japanese authorities increase fiscal stimulus while maintaining their cap on bond yields. Chart 22Maintain Slight Underweight Duration bca.gaa_qpo_2016_12_15_c22 bca.gaa_qpo_2016_12_15_c22 Chart 23Inflation Uptrend Intact bca.gaa_qpo_2016_12_15_c23 bca.gaa_qpo_2016_12_15_c23 Chart 24Overweight JGBs bca.gaa_qpo_2016_12_15_c24 bca.gaa_qpo_2016_12_15_c24 Corporate Bonds The BCA Corporate Health Monitor remains deeply in "Deteriorating Health" territory, indicating weakness within corporate balance sheets (Chart 25). Over the last quarter, the rate of deterioration actually slowed, with all six ratios improving slightly. Nevertheless, the trend toward weaker corporate health has been firmly established over the past eleven quarters. This is consistent with the very late stages of past credit cycles. Maintain overweight to Investment Grade debt. In the absence of a recession, spread product will usually outperform. U.S. growth should accelerate in 2017, with consumer confidence being resilient, fiscal spending expected to increase, and the drag from inventories unwinding. Monetary conditions are still accommodative and the potential sell-off from the rate hike should be milder than it was in December 2015 (Chart 26). Additionally, credit has historically outperformed in the early stages of the Fed tightening cycle. However, there are two key risks to our view. The end of the structural decline in interest rates presents a substantial headwind to investment grade performance. Since 1973, median and average returns were slightly negative during months where long-term yields rose. During the blow-off in yields in the late 1970s, corporate debt performed very poorly. However, yields had reached very high levels. Secondly, valuations are unattractive, with OAS spreads at their lowest in about one and a half years (Chart 27). Chart 25Balance Sheets Deteriorating Balance Sheets Deteriorating Balance Sheets Deteriorating Chart 26Still Accommodative bca.gaa_qpo_2016_12_15_c26 bca.gaa_qpo_2016_12_15_c26 Chart 27Expensive Valuations bca.gaa_qpo_2016_12_15_c27 bca.gaa_qpo_2016_12_15_c27 Commodities Secular Perspective: Bearish We reiterate our negative long-term outlook on the commodity complex on the back of a structural downward shift in global demand led primarily by China's transition to a services-driven economy. With this slack in demand, global excess capacity has sent deflationary impulses across the globe, limiting upside in commodity prices.11 Chart 28OPEC To The Rescue bca.gaa_qpo_2016_12_15_c28 bca.gaa_qpo_2016_12_15_c28 Cyclical Perspective: Neutral A divergent outlook for energy and base metals gives us a neutral view for aggregate commodities over the cyclical horizon (Chart 28). Last month's OPEC deal supports our long-standing argument of increasing cuts in oil supply, which will support energy prices. However, metal markets suffer from excess supply. A stronger U.S. dollar will continue to be a major headwind over the coming months. Energy: OPEC's agreement to cut production by 1.2 mb/d has spurred a rally in the crude oil price, as prospects for tighter market conditions next year become the base case. However, with the likelihood that the dollar will strengthen further in coming months, oil will need more favorable fundamentals to rise substantially in price from here. Base Metals: The U.S. dollar has much greater explanatory power12 than Chinese demand in price formation for base metals. The recent rally in base metals is overdone with metals prices decoupling from the dollar; we expect a correction in the near-term driven by further dollar strength. Metal markets remain oversupplied as seen by rising iron ore and copper inventories. We remain bearish on industrial and base metals. Precious Metals: Gold, after decoupling from forward inflation expectations in H1 2016 - rising while inflation expectations were weak - has converged back in line with the long-term inflation gauge. Our expectation of higher inflation, coupled with rising geopolitical uncertainties, remain the two key positives for the gold price. However, our forecast of U.S. dollar appreciation will limit upside potential for the precious metal. Currencies Key Themes: USD: Much of the post-Trump rally in the dollar can be explained by the sharp rally in U.S. bond yields (Chart 29). We expect more upside in U.S. real rates relative to non-U.S. rates, driven by the U.S.'s narrower output gap and the stronger position of its household sector. As labor market slack continues to lessen and wage pressures rise, the Fed will be careful not to fall behind the curve; this will add upward pressure to the dollar. Chart 29Dollar Continues It's Dominance bca.gaa_qpo_2016_12_15_c29 bca.gaa_qpo_2016_12_15_c29 Euro: Since the euro area continues to have a wider output gap than the U.S., the euro will face additional downward pressure on the back of diverging monetary policy. As the slack diminishes, the ECB will respond appropriately - we believe the euro has less downside versus the dollar than does the yen. Yen: Although the Japanese economy is nearing fully employment, the Abe administration continues to talk about additional stimulus. As inflation expectations struggle to find a firm footing despite the stimulus, the BOJ is explicitly aiming to stay behind the curve. Additionally, with the BOJ pegging the 10-year government bond yield at 0% for the foreseeable future, we expect further downward pressure on the currency. EM: We expect more tumult for this group as rising real rates have been negative for EM assets in this cycle. EM spreads have widened in response to rising DM yields which has led to more restrictive local financial conditions. The recovery in commodity prices has been unable to provide any relief to EM currencies - a clear sign of continued weak fundamentals (rising debt, excess capacity and low productivity). Commodity currencies will face more downside driven by their tight correlation with EM equities (0.82) and with EM spreads. Alternatives Overweight private equity / underweight hedge funds. Global growth is fairly stable and has the potential to surprise on the upside. In the absence of a recession, private equity typically outperforms as the illiquidity premium should provide a considerable boost to returns. Hedge funds, on the other hand, have displayed a negative correlation with global growth. Historically, they have outperformed private equity only during recessions or periods of high credit market stress (Chart 30). Overweight direct real estate / underweight commodity futures. Commercial real estate (CRE) assets are in a "goldilocks" scenario: Growth is sufficient to generate sustainable tenant demand without triggering a new supply cycle. Favor Industrials for its income potential and Retail given resilient consumer spending. Overweight trophy markets, as demand remains robust given multiple macro risks. Commodities have bounced, but remain in a secular bear market caused by a supply glut and exacerbated by a market-share war (Chart 31). Overweight farmland & timberland / underweight structured products. The trajectory of Fed policy, the run-up in equity prices and the weak earnings backdrop have increased the importance of volatility reduction. Favor farmland & timberland. Substantial portfolio diversification benefits, resulting from low correlations with traditional assets, coupled with a positive skew, make these assets highly attractive. As the most bond-like alternative, structured products tend to outperform during recessions, which is not our base case (Chart 32). Chart 30PE: Tied To Real Growth bca.gaa_qpo_2016_12_15_c30 bca.gaa_qpo_2016_12_15_c30 Chart 31Commodities: A Secular Bear Market bca.gaa_qpo_2016_12_15_c31 bca.gaa_qpo_2016_12_15_c31 Chart 32Structured Products Outperform In Recessions bca.gaa_qpo_2016_12_15_c32 bca.gaa_qpo_2016_12_15_c32 Risks To Our View Our main scenario is for stronger growth, higher inflation and an appreciating dollar in 2017, leading to equities outperforming bonds. Where could this go wrong? Growth stagnates. U.S. growth could fail to pick up as expected: the stronger dollar will hurt profits, which might lead to companies cutting back on hiring; higher interest rates could affect the housing market and consumer discretionary spending; companies may fail to increase capex, given their low capacity utilization ratio (Chart 33). In Europe, systemic banking problems could push down credit growth which is closely correlated to economic growth. Emerging markets might see credit events caused by the stronger dollar and weaker commodities prices. Political risks. An unconventional new U.S. President raises uncertainty. How much will Trump emphasize his more market-unfriendly policies, such as tougher immigration control, tariffs on Chinese and Mexican imports, and interference in companies' decisions on where to build plants? His more confrontational foreign policy stance risks geopolitical blow-ups. Elections in France, the Netherland and Germany in 2017 could produce populist government. The Policy Uncertainty Index currently is high and this historically has been bad for equities (Chart 34). Chart 33Maybe Companies Won't Increase Capex bca.gaa_qpo_2016_12_15_c33 bca.gaa_qpo_2016_12_15_c33 Chart 34Policy Uncertainty Is High bca.gaa_qpo_2016_12_15_c34 bca.gaa_qpo_2016_12_15_c34 Synchronized global growth. If the growth acceleration were not limited to the U.S. but were to spread, this might mean that the dollar would depreciate, particularly as it is already above fair value (Chart 35). In this environment, given their inverse correlation with the dollar (Chart 36), commodity prices and EM assets might rise, invalidating our underweight positions. Chart 35Dollar Already Above##br## Fair Value Dollar Already Above Fair Value Dollar Already Above Fair Value Chart 36How Would EM And Commodities Move##br## If USD Weakens? bca.gaa_qpo_2016_12_15_c36 bca.gaa_qpo_2016_12_15_c36 1 We discuss them in the "What Our Clients Are Asking," section of this Quarterly Portfolio Outlook. 2 Non-accelerating inflation rate of unemployment - the level of unemployment below which inflation tends to rise. 3 Please see "How Will The Strong USD Impact Global Earnings," in the What Our Clients Are Asking section of this Quarterly Portfolio Outlook. 4 Please see Global Asset Allocation, "Monthly Portfolio Update: The Meaning of Trump," dated November 30, 2016, available at gaa.bcaresearch.com. 5 Please see Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency", dated November 30, 2016, available at gps.bcaresearch.com. 6 According to National Institute of Economic Research.com. 7 Please see Global Asset Allocation Strategy Special Report, "Asset Allocation In A Low-Return World, Part IV: Industry Groups," dated October 25, 2015, available at gaa.bcaresearch.com. 8 Please see Global Asset Allocation,"Monthly Portfolio Update," dated November 30, 2016 available at gaa.bcaresearch.com 9 Please see Global Asset Allocation Special Report,"Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com 10 Please see Global Asset Allocation Strategy Special Report, "Is Smart Beta A Useful Tool In Global Asset Allocation?," dated July 8, 2016, available at gaa.bcaresearch.com. 11,12 Please see Global Asset Allocation Special Report, "Refreshing Our Long-Term Themes," dated December 5, 2016 available at gaa.bcaresearch.com Recommended Asset Allocation

Highlights Dear Client, This week's BCA's Commodity & Energy Strategy features our 2017 Outlook for the Gold market. We will address the other precious metals markets early in the New Year. We model gold as a currency. While fundamental data - supply, demand and inventories - are important, they do not drive gold prices. Gold has been our window on market expectations for Fed policy, given it is highly sensitive to the central bank's preferred inflation gauge - the Personal Consumption Expenditure (PCE) core index (ex food and energy prices) - and the evolution of key variables driven by Fed actions: the broad trade-weighted dollar (USD, in our usage), and 5- and 10-year real rates. Gold prices also are highly sensitive to broad macroeconomic variables - e.g., U.S. real wages and EM income growth. In addition to behaving like a currency, gold has continuing appeal to investors as a safe haven, particularly in turbulent markets and especially outside a deflationary context. Our research confirms gold provides an excellent portfolio hedge against inflation - particularly vs. core PCE inflation. Before getting to our gold outlook, a housekeeping note: We are closing our long Dec/17 WTI futures vs. short Dec/18 WTI futures basis Tuesday's mark-to-market value of $0.89/bbl for an indicated profit 493.3% (vs. the $0.15/bbl level at which we opened the position). We put the position on as the market was correcting from its earlier rally, just before the Saudi oil minister made his "whatever it takes" remarks in Vienna on Saturday. We also are closing our long 2017Q1 natural gas position as of Tuesday's mark-to-market close for an indicated profit of 16.3%. We remain bullish the backwardation trade and will look for opportunities to re-set the position on sell-offs in the front of the curve. We also remain bullish U.S. natural gas near-term, we expect U.S. production growth to resume next year. We trust you will find this week's report useful going into the New Year. Kindest regards, Robert P. Ryan, Managing Editor Feature Precious Metals: What Is Gold Pricing To? After falling some 16% from its recent high of $1,374/oz, gold appears to have found support just above $1,150/oz as the year winds down. Part of this sell-off no doubt was induced by investors liquidating ETFs and futures ahead of yesterday's FOMC meeting, where the Fed, as expected, raised its overnight rate 25 basis points (Chart 1). Even before the Fed's rate hike yesterday, which markets were pricing in with near 100% certainty (Chart 1, bottom panel), monetary conditions had been tightening going into the FOMC meeting; The broad trade-weighted USD was up some 7% since the bottoming for the year in May, while the St. Louis Fed's 5-year 5-year forward inflation expectation rate was up almost 70 basis points (at 2.09%) since bottoming in June. The other part of gold's price evolution reflects uncertainty surrounding U.S. fiscal and monetary policy, particularly as markets grope for insight on the fiscal policies that will be pursued by the incoming Trump administration. In addition to their direct implications for U.S. economic growth, these policy decisions will profoundly influence EM growth, which is the critical variable for commodity prices generally. Unsurprisingly, the combination of increasing financial stress brought about by contracting monetary conditions, and policy uncertainty emanating from the U.S. has lifted gold volatility (Chart 2). Chart 1Gold Corrects bca.ces_wr_2016_12_15_c1 bca.ces_wr_2016_12_15_c1 Chart 2Increasing Financial Stress ##br##Pulls Gold Volatility Higher Increasing Financial Stress Pulls Gold Volatility Higher Increasing Financial Stress Pulls Gold Volatility Higher The tightening of financial conditions likely will, over the short-term, induce a slowing in economic growth at the margin going into 2017Q1, which will, all else equal, cause the USD to weaken, according to our colleagues at BCA's Foreign Exchange Strategy service.1 In addition, it likely will cause U.S. interest rates to retreat, consistent with our House view. Short-term, both of these effects should be bullish gold, which is why we're recommending investors go tactically long if prices retrace to $1,150/oz (see below). Forming A Strategic View On Gold Becomes More Difficult The proximate cause of the heightened risk in financial markets that is showing up in gold volatility is the uncertainty surrounding U.S. monetary and fiscal policy next year in the U.S., and an increasingly fragmented commercial and political backdrop globally. Forming a longer term view on gold is difficult, given the huge amount of incomplete economic information available to markets, much of which will only become clear over the next quarter or two. There are, of course, a host of geopolitical risks - i.e., the types of risk investors typically use gold to hedge against - but we will leave those assessments to our colleagues at BCA's Geopolitical Strategy service.2 The incoming U.S. presidential administration has promised greater fiscal stimulus, which is bullish for growth, and, at the same time, has signaled its hostility to the Fed. On the back of higher growth expectations - overlaid against a labor market in the U.S. that is close to full employment - inflation expectations are rising. This is coloring interest-rate expectations - particularly the path for real rates - and contributing to the strengthening of the USD. Among risk factors, these three - higher inflation, a stronger USD and rising real rates - rank at the top of most investors' hierarchies, regardless of how they allocate. Realistically, it will take time for the incoming Trump administration to draft the legislation that deploys fiscal stimulus - at least six months. It will then take even more time to see this legislation have effect. Given this reality, we agree with the assessment of our colleagues on the FX and bond desks that key U.S. monetary variables - chiefly the USD and real rates - have moved too far too fast, and likely will correct. The increased inflation expectations we've seen in the forward markets, however, probably are warranted. Going Tactically Long, Expecting Higher Inflation Chart 3Fiscal Stimulus Will Lift Real Wages,##br## Then Core PCE bca.ces_wr_2016_12_15_c3 bca.ces_wr_2016_12_15_c3 Given this expectation, we believe the correction in gold was warranted. We will get tactically long spot gold at tonight's close, with a stop loss of 5%. This will position us for what we believe will be a strategic opportunity to be long gold once U.S. fiscal policy comes into focus. With the U.S. at or close to full employment, we expect the fiscal stimulus introduced next year - tax cuts, deregulation, increased defense spending, and more money for infrastructure - to provide a significant boost to the economy beginning in 2017H2. This will, we believe, result in stronger wage growth, which will lead to higher inflation. All else equal, this will lift core PCE (Chart 3): Our modeling indicates a 1% increase in real U.S. nonfarm wages translates into a 0.62% increase in core PCE.3 As good as this sounds, we have to account for the Fed's likely response. Presently, we expect two rate hikes next year. Depending on how strong growth comes in, we might even get a third hike in the Fed funds rate next year, as Fed Chair Yellen suggested at her press conference yesterday. If, as we expect, the USD corrects over the short term, this would imply another rally in the dollar next year, as markets once again price in a tighter U.S. monetary policy against a backdrop of global monetary accommodation. The big unknown is how far out ahead of the expected inflation increase the Fed will get vis-à-vis its interest-rate policy. If Janet Yellen and her colleagues decide to allow the economy to run hot, and keep monetary policy "behind the curve" - i.e., slowly raise real rates while the economy is expanding and inflation is increasing - that will be bullish for gold. If, on the other hand, the Fed wants to get out "ahead of the curve" - i.e., raise rates in anticipation of higher inflation before it actually materializes - that would be bearish. We believe the Fed will err on the side of allowing the economy to run hot and will keep monetary policy "behind the curve" next year, and most likely in 2018. So, in addition to core PCE picking up, we would expect the USD to rise, but not by as much as it would if the Fed were more aggressive in its policy stance. Most important for commodity markets, we believe real rates will not surge ahead with the Fed continuing to maintain a relatively accommodative policy. This is a bullish backdrop for gold. But it's not enough to compel us to get long strategically. Why We Won't Go All-In On Gold Chart 4A Relatively Accommodative ##br##Fed Will Be Bullish For Gold bca.ces_wr_2016_12_15_c4 bca.ces_wr_2016_12_15_c4 We believe the Fed will err on the side of continued relative accommodation for two reasons: The U.S. central bank will be restrained by the continued massive accommodation of other systemically important central banks - i.e., it cannot unilaterally tighten policy too aggressively in a world where accommodation reigns: It would send the USD through the roof and kill off whatever expansion the U.S. could muster under the Trump administration's fiscal policy. The Fed's core PCE inflation target is symmetric, with an indicated target level of 2% p.a. change. For the past 20 years, the average p.a. change in core PCE has been 1.7%. The Fed can allow inflation to overshoot for years before the symmetry of its target is violated: Among other things, this would allow the Fed to further distance itself from the zero lower bound on interest rates, which appears to be a goal of many of the central bankers. Our modeling suggests that if the Fed remains behind the curve as inflation is increasing gold prices could appreciate substantially after the expected U.S. fiscal stimulus kicks in. A 1% increase in core PCE translates into an increase in gold prices exceeding 4%. A 1% decrease in real rates implies a 6% increase in gold prices. And a 1% decrease in the USD translates to close to a 3% increase in gold prices (Chart 4).4 We're comfortable with a short-term gold position, but we are not ready to go all-in on gold as a strategic allocation at present because we do not know what to expect from the incoming Trump administration in terms of fiscal policy initiatives. Nor do we know whether the president-elect will assume office openly hostile to the sitting Fed Chair, Dr. Yellen. Trump has indicated dissatisfaction with her leadership of the Fed, and has indicated he will not reappoint her when her term is up, given the accommodation the Fed pursued while she was in charge. If the relationship becomes acrimonious while she continues to run the Fed, the independence of the Fed may come under question, and the coherence of policy might be placed in doubt. An openly hostile relationship between the U.S. chief executive and the head of the country's independent central bank will make it difficult to form macro expectations, particularly around gold prices. Perhaps such uncertainty would improve gold's appeal as a safe-haven, which would keep the metal bid in the event of such an outcome. Of course, the next logical question would be, who would Trump appoint to replace Yellen? If his beef with the central bank was that policy was too accommodative, does that mean he's likely to appoint a more hawkish Chair when Yellen's term is up? If so, this would be decidedly bearish gold and commodities in general. Hence the inability to take a clear position strategically. EM Growth Will React To U.S. Policy, And Affect Gold What happens in Washington doesn't stay in Washington. Fed policy is extremely important for EM growth, which has been picking up recently (Chart 5). The global driver of increasing commodity demand - and U.S. core PCE - has been EM income growth (Chart 6), which we proxy using non-OECD oil consumption and world base metals demand, given 50% of base metals demand comes from China.5 Chart 5EM Growth At Risk ##br##If Fed Gets Aggressive bca.ces_wr_2016_12_15_c5 bca.ces_wr_2016_12_15_c5 Chart 6EM Oil and Base Metals Demand##br## Highly Correlated With U.S. Core PCE bca.ces_wr_2016_12_15_c6 bca.ces_wr_2016_12_15_c6 Too aggressive a policy stance by the Fed - e.g., getting too far out "ahead of the curve" - would suffocate EM income growth by encouraging capital flight and increasing the burden of USD-denominated debt in those countries. Bottom Line: We are recommending a tactically long gold position, given our expectation the USD and interest rates will correct after moving too far too fast in anticipation of stronger U.S. economic growth following the election of Donald Trump as the 45th president of the United States. Although we do expect significant stimulus from the incoming administration's to-be-announced fiscal policies will stoke inflation going forward - especially with the U.S. economy at or close to full employment - we are uncomfortable going strategically long gold until we gain greater clarity on these policies. In addition, we await a clear signal on the sort of relationship the executive office will have with the Fed. Robert P. Ryan, Senior Vice President rryan@bcaresearch.com 1 Please see BCA Research's Foreign Exchange Strategy "Cyclical And Tactical Divergences," dated December 9, 2016, available at fes.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Strategic Outlook "Strategy Outlook 2017: We Are All Geopolitical Strategists Now," dated December 14, 2016, available at gps.bcaresearch.com. 3 Real nonfarm hourly compensation follows the same long-term trend as core PCE - i.e., these variables are cointegrated. The adjusted-R2 for the cointegrating regression is 0.99. 4 This is a long-term estimate (2000 to present). The adjusted-R2 for the cointegrating regression using these inputs is 0.95. Of course, if the Fed gets out "ahead of the curve" these effects will work in the opposite direction: Increasing real rates, falling core PCE and a stronger USD will militate against any price appreciation. 5 We have noted in previous research that oil and base metals demand frequently are used to approximate EM income growth, given the income elasticity of demand for these commodities approaches 1.0. The OECD notes, "Non-OECD countries are found to have a higher income elasticity of oil demand than OECD countries. On average across countries, a one per cent rise in real GDP pushes up oil demand by half a per cent in OECD countries over the medium to long run, whereas the figure is closer to unity for most non-OECD countries." Please see "The Price of Oil - Will It Start Rising Again?" OECD Economics Department Working Paper No. 1031, p. 6 (2013). The evolution of these real EM demand variables shares a common trend with U.S. money supply (M2), real rates in the U.S., and the trade-weighted USD. In addition, these real variables also are highly correlated with EM exchange rates, as is to be expected. Please see issue of BCA Research's Commodity & Energy Strategy "Memo TO Fed: EM Oil, Metals Demand Key To U.S. Inflation," dated August 4, 2016, available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Closed Trades

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. 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 establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 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 voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the 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. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors 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. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: 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 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always 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 denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. 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 United States to preserve its security. Far from it - China has no greater security threat than the United States. 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. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights This week we elaborate on the issues that we believe will be critical to investors going into 2017: Feature 1. Is China beginning to export inflation? Not yet. As long as the RMB depreciates faster than the rate of domestic inflation, China will be exporting deflation to the rest of the world. 2. Is the selloff in so-called search-for-yield beneficiaries over? Most likely not. There is still meaningful upside in global bond yields as well as downside in prices of bond proxies and search-for-yield beneficiaries. 3. Will China recover or will it have another growth slump in 2017? China's industrial cycle will be topping out in the next couple of months and will relapse thereafter. 4. Will strong U.S./DM growth lift EM economies in 2017? Not really. EM will continue to be driven by its domestic credit cycle and commodities prices. If anything, higher U.S. interest rates and a strong U.S. dollar are bearish for both the EM credit cycle and commodities prices. Overall, we expect EM stocks, currencies, credit markets and domestic bonds to sell off and underperform their U.S./DM peers well into 2017. Is China Beginning To Export Inflation? With various inflation measures in China rising (Chart I-1A and Chart I-1B), the key question is whether China will soon export inflation rather than deflation to the rest of the world. Chart I-1AInflation In RMB Terms, ##br##Deflation In USD Terms bca.ems_wr_2016_12_14_s1_c1a bca.ems_wr_2016_12_14_s1_c1a Chart I-1BInflation In RMB Terms, ##br##Deflation In USD Terms bca.ems_wr_2016_12_14_s1_c1b bca.ems_wr_2016_12_14_s1_c1b Investors often confuse domestic inflation in China with China exporting inflation beyond its borders. The missing link is the exchange rate. Because of the yuan's depreciation, China is still exporting deflation, even though its domestic inflation rate is rising. Specifically: Chinese core consumer price inflation, consumer services inflation and ex-factory producer price inflation are all negative in U.S. dollar terms even though they are accelerating in local currency terms (Chart I-1A and Chart I-1B). Importantly, Chinese export prices and U.S. import prices from China are deflating in U.S. dollar terms but rising in RMB terms (Chart I-2). A rise in input costs in China has, so far, not translated into higher U.S. dollar prices of mainland goods shipped overseas. The reason is that the RMB's depreciation has allowed export companies to reduce U.S. dollar prices while receiving more RMBs per a unit. In China, labor compensation and unit labor costs are rising much faster in RMB terms than in U.S. dollar terms due to the currency's depreciation (Chart I-3). Chart I-2Chinese Export Prices ##br##Are Not Rising In USD Terms Chinese Export Prices Are Not Rising In USD Terms Chinese Export Prices Are Not Rising In USD Terms Chart I-3Chinese Unit Labor Costs ##br##Are Rising In RMB But Not In USD bca.ems_wr_2016_12_14_s1_c3 bca.ems_wr_2016_12_14_s1_c3 Income per capita (a proxy for employee compensation) is growing at an annual rate of 8% in nominal RMB terms, 6% in real (inflation-adjusted) terms and 2.5% in U.S. dollar terms (Chart I-4). Hence, the RMB's depreciation over the past year has reduced the pace of labor cost increases to Chinese producers in U.S. dollar terms. This has allowed producers to tolerate lower selling prices in U.S. dollars. Finally, there is thus far no evidence worldwide that tradable manufacturing goods (non-commodities) prices are rising. Specifically, Korean and Taiwanese export prices as well as manufactured export goods prices in Mexico have stabilized but are not yet rising (Chart I-5). Chart I-4Income Growth: ##br##Nominal, Real Terms & In USD bca.ems_wr_2016_12_14_s1_c4 bca.ems_wr_2016_12_14_s1_c4 Chart I-5Global Manufacturing ##br##Goods Prices: No Inflation Yet bca.ems_wr_2016_12_14_s1_c5 bca.ems_wr_2016_12_14_s1_c5 Bottom Line: Even though domestic price inflation has risen, China's export prices are still falling in U.S. dollar terms. The exchange rate is the key: As and if the RMB depreciates much further - and we expect it to depreciate 12% versus the greenback and to reach USD/CNH 7.8 by the end of 2017 - China will still be exporting deflation to the rest of the world. Is The Selloff In Search-For-Yield Beneficiaries Over? The selloff in so-called search-for-yield beneficiaries - trades that have in recent years benefited from a low interest rate environment globally - will likely persist in the first few months of 2017. Back in July,1 we argued that U.S./DM bond yields were set to rise considerably. Currently, we still expect bond yields to climb further. We believe there is still prevailing investor complacency about U.S./global bond yields as well as bond proxies elsewhere. U.S. bond yields in general, and inflation-adjusted (TIPS) yields in particular, are still very depressed and could rise meaningfully (Chart I-6). There is no reason why 5- and 10-year TIPS yields cannot reach their late 2015 levels - a move of about 30-50 basis points from current levels. At the moment, the market is pricing only 52 basis points in Federal Reserve rate hikes in 2017. This is not enough as animal spirits are rising in America at a time when the labor market is tight, and wages and unit labor costs are accelerating. All of this combined warrants meaningfully higher U.S. bond yields. Critically, in recent years a lot of money has flown into funds that invest in bonds and bond proxies. As U.S. bond yields rise, it is natural to expect some outflows from these funds. Odds are that these outflows could occur in January when many investors review their portfolios. Bond proxies such U.S. dividend aristocrat stocks, U.S. REITs, utilities and telecom share prices have barely corrected. EM local currency bond yield spreads over duration-matched U.S. Treasurys have not widened at all (Chart I-7, top panel). This does not make sense, as EM local bonds have benefited substantially from the so-called global search-for-yield of the past several years, and thereby should suffer meaningfully as U.S. bond yields are rising. Besides, EM currencies have weakened, and their outlook is worrisome.2 In fact, the EM local currency bond index has massively underperformed duration-matched U.S. Treasurys in common currency terms, and will likely continue to do so in the next six months (Chart I-7, bottom panel). Asian corporate spreads in general, and Chinese offshore corporate spreads in particular, have not widened yet (Chart I-8, top panel). More importantly, Chinese offshore corporate spreads over sovereigns have continued to narrow, and now stand at only 65 basis points (Chart I-8, bottom panel). In sum, there has so far been little setback in Asia/China credit markets. Chart I-6U.S. TIPS ##br##Yields Are Too Low bca.ems_wr_2016_12_14_s1_c6 bca.ems_wr_2016_12_14_s1_c6 Chart I-7EM Local Currency Bond ##br##Yields To Rise Much Further bca.ems_wr_2016_12_14_s1_c7 bca.ems_wr_2016_12_14_s1_c7 Chart I-8Asian And Chinese ##br##Corporate Spreads Are Too Low Asian And Chinese Corporate Spreads Are Too Low Asian And Chinese Corporate Spreads Are Too Low It would be strange if after years of blind search-for-yield there is no meaningful retrenchment in search-for-yield beneficiaries as U.S. bond yields shoot up. Finally, the S&P 500 is making new highs, indicating U.S. bond yields have not yet become restrictive. Odds are that U.S. bond yields will continue to rise until they hurt economic growth or the S&P 500. In other words, bond yields will likely overshoot before rolling over. Bottom Line: The path of least resistance for U.S. bond yields remains up. Hence, the current selloff in global bonds, bond proxies and search-for-yield beneficiaries will continue. China: Another Growth Slump In 2017? From our investor meetings on both the east and west coasts of the U.S. over the past month, we got a sense that investor sentiment toward China has improved considerably. While many U.S. investors are not upbeat about China's long-term outlook, the majority have seemingly become complacent on mainland growth for 2017. The common viewpoint is that ahead of Communist party leadership changes at the Party Congress next fall, the authorities will ensure that growth conditions remain very firm. As a result, the reasoning goes that China-related plays will do well in 2017. The missing point, however, is that Chinese policymakers have lately been marginally tightening liquidity/credit conditions amid the lingering credit bubble, and are no longer easing policy. On a rate-of-change basis, this policy stance no longer supports growth acceleration. On the contrary, it warrants a top-out in the nation's industrial cycle in early 2017 and probably a slowdown later in 2017. Chart I-9Interbank Liquidity Tightening In China Interbank Liquidity Tightening In China Interbank Liquidity Tightening In China Not only have Chinese corporate bond yields climbed alongside rising global bond yields, but the People's Bank of China (PBoC) has also tightened liquidity in the interbank market for non-bank financial institutions (Chart I-9). This is intended to limit speculative activities among non-bank financial organizations (shadow banking). This policy move is consistent with PBoC Governor Zhou Xiaochuan's statement this past October at the annual World Bank/IMF meetings in Washington, namely: "With the gradual recovery of the global economy, China will control its credit growth."3 As U.S. and European growth is firming up, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced in late October that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Macro Prudential Assessment ratios, starting from the third quarter.4 The clampdown on WMP accounting will reduce banks' capital adequacy ratios, curbing their ability to originate loans. Finally, property market tightening measures implemented of late are expected to lead to a slowdown in sales and renewed contraction in property starts. This will depress Chinese construction and demand for industrial commodities/materials as well as capital goods. Notably, both credit and fiscal impulses in China have already peaked over (Chart I-10). With no major new fiscal spending initiatives and credit growth gradually moderating, the credit and fiscal impulses will likely diminish. Chart I-11 illustrates that the recovery in industrial electricity consumption (a reliable proxy for industrial activity), industrial profits and manufacturing PMI since early this year has been largely due to combined credit and fiscal impulses. As these impulses wane, the industrial cycle will roll over. Chart I-10China: Credit And Fiscal ##br##Impulses Have Petered Out China: Credit And Fiscal Impulses Have Petered Out China: Credit And Fiscal Impulses Have Petered Out Chart I-11China: Industrial Sector ##br##Growth To Peter Out In Early 2017 China: Industrial Sector Growth To Peter Out In Early 2017 China: Industrial Sector Growth To Peter Out In Early 2017 Some clients may wonder why we are placing so much emphasis on the pending rollover of credit and fiscal impulses now, while placing little emphasis on these same indicators in early in 2016 when they were recovering. The rationale is as follows: when there is a credit bubble - as there is in China now - we tend to downplay the importance of policy easing and put more significance on policy tightening. The opposite also holds true: when the credit/banking system is healthy, we tend to downplay the impact of moderate policy tightening and put greater emphasis on policy easing. In a credit bubble, it does not take much tightening to trigger a downtrend/unwind of excesses. Similarly, moderate tightening in a healthy credit system should not be feared. While base metals prices have surged, tracking improvement in China's industrial sector, there is little evidence that the magnitude of this rally is justified by improvement in underlying demand. Chart I-12 demonstrates that China's imports of base metals have been flat since 2010, with all swings due to inventory cycles. The mainland's iron ore consumption has also been mediocre since late 2014 (Chart I-12, bottom panel). The recent rally in copper and other base metals prices is somewhat, though not entirely, due to financial demand. Chart I-13 reveals that commercial firms (producers) have been selling (shorting) copper while financial investors (non-commercial enterprises) have been buying according to data from Commodity Futures Trading Commission (CFTC). Copper prices are now sitting at their long-term moving average that often marks tops in bear market rallies and bottoms in bull market selloffs (Chart I-13, bottom panel). We expect copper prices to face a major resistance at their current levels, and relapse sooner than later. The U.S. consumes about seven times less copper and other industrial metals compared with China. Therefore, acceleration in U.S. growth and capital spending will be more than offset by a renewed slump in Chinese growth. Several Chinese and China-related financial markets are at a critical juncture (Chart I-14). Their breakdown from current levels will confirm our bias that China's industrial cycle will enter another slump in 2017. Chart I-12China: Net Imports Of Industrial ##br##Metals And Iron Ore Consumption bca.ems_wr_2016_12_14_s1_c12 bca.ems_wr_2016_12_14_s1_c12 Chart I-13Copper Rally Is Driven ##br##By Financial Demand bca.ems_wr_2016_12_14_s1_c13 bca.ems_wr_2016_12_14_s1_c13 Chart I-14China Related Plays ##br##Are At A Critical Juncture bca.ems_wr_2016_12_14_s1_c14 bca.ems_wr_2016_12_14_s1_c14 Bottom Line: China's industrial/capital spending cycle will peter out and will decelerate again in 2017. Will Strong DM Growth Lift EM Economies? Strengthening/robust growth in the U.S. and other developed economies will not be sufficient to lift EM growth. First, in the 1997-98 period, real GDP growth was 4.5% in the U.S. and 3.5% in Europe. In particular, U.S. import volume growth was booming at a double-digit pace (Chart I-15) yet it did not prevent widespread crises throughout the EM during this period. In a nutshell, these 1997-98 crises occurred amid plunging U.S./DM bond yields. Chart I-15The U.S. Growth/Import Boom In 1997-98 Did Not Preclude EM Crises bca.ems_wr_2016_12_14_s1_c15 bca.ems_wr_2016_12_14_s1_c15 Given the economic boom and falling bond yields in the U.S. and Europe did not prevent the 1997-98 EM financial crises, strong U.S./DM growth now is unlikely to help developing countries much. The importance of U.S. and European economies to EM has declined tremendously since the late 1990s, while the importance of China and intra-EM trade has grown. U.S. import volumes have been weak the past 12 months and will likely recover in 2017, yet this will not be enough to prevent an EM growth slump. The EM crises in 1997-98 were due to poor EM fundamentals and the latter are not much better now. Second, EM growth is primarily driven by the domestic credit cycle and commodities prices. We are bearish on both. Chart I-16 shows EM EPS growth and the aggregate EM credit impulse with projections. Assuming credit growth in each individual EM country converges with its nominal GDP growth in the next 12 months, and in China's case in the next 24 months, the 2017 projected EM credit impulse (equity market cap-weighted) will be negative. Historically, the credit impulse has been a good indicator for EPS (Chart I-16).5 Chart I-16EM EPS Growth To Relapse Again In 2017 EM EPS Growth To Relapse Again In 2017 EM EPS Growth To Relapse Again In 2017 In short, EM EPS will improve in the near-term but relapse later in 2017. Share prices are forward looking and their rally early this year is probably already discounting near-term EPS improvement. Thereby, EM share prices are at risk at the moment. Third, real capital spending (inflation-adjusted) in EM ex-China and China is as large as the U.S. and EU (Chart I-17). As the capital spending downturn in China and the rest of EM persists (Chart I-18), this will offset any capex recovery in DM and weigh on commodities, primarily industrial metals, as well as global machinery stocks. Chart I-17Capital Spending By Regions: ##br##EM/China As Large As U.S. And EU bca.ems_wr_2016_12_14_s1_c17 bca.ems_wr_2016_12_14_s1_c17 Chart I-18EM Ex-China Capex ##br##Has Been Contracting bca.ems_wr_2016_12_14_s1_c18 bca.ems_wr_2016_12_14_s1_c18 Bottom Line: EM growth will disappoint and EM listed companies' EPS will continue shrinking in 2017, despite the likely profit improvement in the very near term. 2017: The Beginning Of The End Of The EM Bear? Chart I-19 illustrates that this relative equity bear market in EM versus DM is getting late from a duration standpoint. That said, the magnitude of this bear market has been smaller compared with the previous one. Although we do not expect EM stocks to underperform as much as they did in the previous cycle, we still believe there is sizable downside in the months ahead. In short, EM share prices appear very vulnerable technically (Chart I-20), and will likely relapse in absolute terms and also underperform DM markets. Investors should stay short/underweight EM equities versus DM. Chart I-19The EM Bear Market Is Late But Not Over bca.ems_wr_2016_12_14_s1_c19 bca.ems_wr_2016_12_14_s1_c19 Chart I-20EM Stocks Are Technically Vulnerable EM Stocks Are Technically Vulnerable EM Stocks Are Technically Vulnerable For dedicated EM equity investors, our overweights are Korea, Taiwan, China, India, Thailand, Russia and central Europe. Our underweights are Malaysia, Indonesia, Turkey, Brazil and Peru. EM bank stocks hold the key, and their underperformance versus DM banks has further to run. Maintain the short EM banks / long U.S. banks equity position. EM currencies will depreciate further (odds of new lows are considerable for many of them) and local currency bonds will sell off. In our November 30 Weekly Report,6 we discussed the outlooks for EM local bond markets and exchange rates at great length, and offered asset allocation recommendations across EM local bond markets. EM sovereign and corporate credit spreads will widen versus U.S. corporate spreads. Stay underweight EM credit markets. Within EM sovereign credit, our overweights are Russia, Mexico and Argentina, Hungary, Peru and other defensive credit. In turn, our underweights are South Africa, Turkey, Brazil, Indonesia and Malaysia. As usual, the complete list of our equity, fixed-income and currency recommendations is available at the end of each week's report (please refer to pages 16 and 17). Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 Please refer to the Emerging Markets Strategy Weekly Reports, dated July 13 and July 27, 2016; available at ems.bcaresearch.com. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled " Will The Carnage In EM Local Bonds Persist?," dated November 30, 2016; a link is available on page 18. 3 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 5 For more details, please refer to the Emerging Markets Strategy Special Report, titled "Gauging EM/China Credit Impulses," dated August 31, 2016; a link is available on page 18. 6 Please refer to the Emerging Markets Strategy Weekly Report, titled " Will The Carnage In EM Local Bonds Persist?," dated November 30, 2016; a link is available on page 18. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

President-elect Trump and the specter of his spendthrift policy proposals have generated significant client interest/inquiries on equities and inflation - not asset prices, but of the more traditional kind: consumer price inflation. Chart 1 shows that a little bit of inflation would be positive for the broad equity market, further fueling the high-risk, liquidity-driven blow off phase. However, when inflation has reached 3.7%-4% in the past, the broad equity market has stumbled (Chart 2). Sizeable tax cuts, increased infrastructure and defense spending (i.e. loose fiscal policy), protectionism and a tougher stance on immigration are inherently inflationary policies (and bond price negative) ceteris paribus. Chart 1A Whiff Of Inflation##br## Is Good For Stocks... bca.uses_sr_2016_12_05_c1 bca.uses_sr_2016_12_05_c1 Chart 2...But Too Much ##br##Is Restrictive ...But Too Much Is Restrictive ...But Too Much Is Restrictive However, our working assumption is that in the next 9-12 months, CPI headline inflation will only renormalize, rather than surge. Importantly, the magnitude and timing of the implementation of Trump's policy pledges is unknown. Moreover, the Fed's reaction function is also uncertain, and the resulting economic growth and U.S. dollar impact will be critical in determining whether any lasting inflation acceleration occurs. Table 1 Equity Sector Winners And Losers When Inflation Climbs Equity Sector Winners And Losers When Inflation Climbs For global inflation to take root beyond the short term, Europe and Japan would also have to follow Canada's and America's fiscal largesse to swing the global deflation/inflation pendulum toward sustained inflation. The Fed's Reaction Function Our sense is that a Yellen-led Fed will allow for some inflation overshoot to materialize. This view was originally posited in her 2012 "optimal control"1 speech and more recently reiterated with her mid-October speech emphasizing "temporarily running a "high-pressure economy," with robust aggregate demand and a tight labor market."2 The Fed has credible tools to deal with inflation. If economic growth does not soar, but rather sustains its post-GFC steady 2-2.5% real GDP growth profile as we expect, then taking some inflation risk is a high-probability. The implication is that the Fed will likely not rush to abruptly tighten monetary policy, a view confirmed by the bond market , which is penciling in only 40bps for 2017 (Chart 3). A sustainable breakout in bond yields would require inflation (and to a lesser extent real GDP growth) to significantly surprise to the upside and thus compel the Fed to aggressively raise the fed funds rate. Is that on the horizon? While wage inflation has perked up, unit labor cost inflation has a spotty track record in terms of leading core consumer goods prices. Why? About 20% of the CPI and PCE inflation baskets are produced abroad, underscoring that domestic costs are not a factor in setting prices. There is a tighter correlation between unit labor costs and service sector inflation, but even here there is not a consistent relationship (Chart 4). Consequently, there is minimal pressure on the Fed to get aggressive, suggesting that most of the cyclical back up in long-term yields may have already occurred. Chart 3Fed Will Be Late, As Always bca.uses_sr_2016_12_05_c3 bca.uses_sr_2016_12_05_c3 Chart 4Wage And CPI Inflation Often Diverge Wage And CPI Inflation Often Diverge Wage And CPI Inflation Often Diverge The 1960s Analogy The 1960s period provides an instructive guide for today. Then, an extremely tight labor market and a positive output gap was initially ignored by the Fed, i.e. the economy was allowed to overheat (Chart 5). This ultimately led to the surge of inflation in the 1970s, especially given the then highly unionized labor market (see appendix Chart A1). While there are similarities between the current backdrop and the 1960s, namely an extended business cycle, full employment, narrowing output gap, easy monetary and a path to easing fiscal policies, and rising money multiplier, there are also striking differences. At the current juncture, wage inflation is half of what it was in the mid-1960s. Even unit labor costs heated up to over 8% back then, nearly four times the current level. Chart 5The 1960's... bca.uses_sr_2016_12_05_c5 bca.uses_sr_2016_12_05_c5 Chart 6... And Today bca.uses_sr_2016_12_05_c6 bca.uses_sr_2016_12_05_c6 Full employment has only been recently attained (Chart 6) and in order to pose a long-term inflation worry, it would have to stay near 5% for another three years. True, the output gap is almost closed, and is forecast to turn marginally positive in 2017/2018, but much will depend on the timing of fiscal stimulus. Industrial production has diverged negatively from the output gap of late, suggesting that excess capacity still lingers in some parts of the economy (Chart 7). The upshot is that inflationary pressures may stay contained for some time, especially if the U.S. dollar continues to firm. The global environment remains marked by deficient demand, not scarce resources. Chart 8 shows that the NFIB survey of the small business sector has a good track record in leading core inflation. The survey shows that businesses are still finding it difficult to lift selling prices. That is confirmed by deflation in the retail price deflator. Chart 7Divergent Economic Slack Messages bca.uses_sr_2016_12_05_c7 bca.uses_sr_2016_12_05_c7 Chart 8Pricing Power Trouble bca.uses_sr_2016_12_05_c8 bca.uses_sr_2016_12_05_c8 Finally, while the money multiplier has troughed, it would have to jump to a level of 4.9 to parallel the 1960s (Chart 9). This is a tall order and it would really require the Fed to very aggressively wind down its balance sheet. Chart 9Monitoring The Money Multiplier bca.uses_sr_2016_12_05_c9 bca.uses_sr_2016_12_05_c9 Therefore, a 1960s repeat would be a tail risk, and not our base case forecast. What About The Greenback? Chart 10 shows that inflation decelerates during U.S. dollar bull markets. Our Foreign Exchange Strategy service believes that the currency has more cyclical upside3, given that it has not yet overshot on a valuation basis and interest rate differentials will favor the U.S. for the foreseeable future. Accordingly, it may be difficult for inflation to rise on a sustained basis. Chart 10Appreciating Dollar Is##br## Always Disinflationary Appreciating Dollar Is Always Disinflationary Appreciating Dollar Is Always Disinflationary So What? Accelerating inflation is a modest risk, but not our base case forecast. Nevertheless, for investors that are more worried about the prospect of higher inflation, the purpose of this Special Report is to serve as an equity sector positioning roadmap if inflationary pressures become more acute sooner than we anticipate. Historically, inflation has been synonymous with an aggressive Fed and hard asset outperformance, suggesting that deep cyclical sectors would be primary beneficiaries. Table 1 on Page 2 shows that over the last six major inflationary cycles, energy, materials, real estate and health care have been consistent outperformers. Utilities, tech and telecom have been clear underperformers. The remaining sectors have been a mixed bag. However, this cycle, potential growth is much lower than in the past, underscoring that the hit to overall profits from tighter monetary policy could be pronounced, potentially undermining equity market risk premiums. If inflation rises too quickly and the Fed hits the economic brakes, then it is hard to envision cyclical sectors putting in a strong market performance, especially given their high debt loads and shaky balance sheets, i.e. they are at the epicenter of corporate sector vulnerability if interest rates rise too quickly. Owning shaky balance sheets in a sluggish global economy is a strategy fraught with risk. On the flipside, the recent knee jerk sell off in more defensive sectors represents a reversal of external capital flows, and is not representative of an underlying vulnerability in their earnings prospects. As a result of this shift, valuations now favor more defensive sectors by a wide margin. Ultimately, we expect relative profit trends to dictate relative performance on a cyclical investment horizon, and are not rushing to position our portfolio for accelerating inflation. Anastasios Avgeriou, Vice President Global Alpha Sector Strategy anastasios@bcaresearch.com 1 https://www.federalreserve.gov/newsevents/speech/yellen20120411a.htm 2 https://www.federalreserve.gov/newsevents/speech/yellen20161014a.htm 3 https://fes.bcaresearch.com/articles/view_report/20812 Health Care (Overweight) Health care stocks have consistently outperformed during the six inflationary periods we studied. Over the long haul it has paid to overweight this sector given the structural uptrend in relative share prices. Spending on health care services is non-cyclical and demand for such services is also on a secular rise around the globe: in the developed markets driven largely by the aging population and in the emerging markets by the adoption of health care safety nets (Chart 11). Health care pricing power is expanding at a healthy clip, outshining overall CPI. Importantly, recent geopolitical uncertainty had cast a shadow on the sector's pricing power prospects that suffered from a constant derating. Now that political and pricing power uncertainty is lifting, a rerating looms. Finally, the health care sector's dividend yield allure is the lowest among defensive sectors and remains 44bps below the broad market, somewhat insulating the sector from the inflation driven selloff in the bond market (Chart 12). Chart 11Health Care bca.uses_sr_2016_12_05_c11 bca.uses_sr_2016_12_05_c11 Chart 12Health Care bca.uses_sr_2016_12_05_c12 bca.uses_sr_2016_12_05_c12 Consumer Staples (Overweight) Similar to the health care sector, consumer staples stocks have been stellar outperformers over the past 55 years. The sector's track record during the six inflationary periods we studied is split down the middle. Most consumer staples companies are global conglomerates and their efforts have been focused on building global consumer brands, allowing them to implement a stickier pricing strategy. As a result, overall inflation/deflation pressures are more benign (Chart 13). Relative consumer staples pricing power is expanding and has been in an uptrend for the past five years. As the U.S. dollar has been in a bull market since 2011, short-circuiting the commodity super cycle, consumer staples manufacturers have been beneficiaries of falling commodity input costs. The implication is that profit margins have been expanding due to both rising pricing power and lower input costs (Chart 14). Chart 13Consumer Staples bca.uses_sr_2016_12_05_c13 bca.uses_sr_2016_12_05_c13 Chart 14Consumer Staples bca.uses_sr_2016_12_05_c14 bca.uses_sr_2016_12_05_c14 Telecom Services (Overweight - High Conviction) Relative telecom services performance and inflation appear broadly inversely correlated since the early 1970s, underperforming 60% of the time when core PCE prices accelerate. Importantly, in two of the periods we studied (during the late-70s and the TMT bubble) the drawdowns were massive, skewing the mean results portrayed in Table 1 on page 2. This fixed income proxy sector tends to suffer in times of inflation as competing assets dilute its yield appeal and vice versa (Chart 15). Telecom services pricing power has been declining over time as the government deregulated this once monopolistic industry. As more entrants forayed into the sector boosting competition, pricing power erosion accelerated. While relative sector pricing power has been mostly mired in deflation with a few rare expansionary spurts, there is an offset as the industry has entered a less volatile selling price backdrop: communications equipment costs are also constantly sinking (they represent a major input cost), counterbalancing the industry's profit margin outlook (Chart 16). Chart 15Telecom Services bca.uses_sr_2016_12_05_c15 bca.uses_sr_2016_12_05_c15 Chart 16Telecom Services bca.uses_sr_2016_12_05_c16 bca.uses_sr_2016_12_05_c16 Consumer Discretionary (Overweight) While the overall trend in consumer discretionary stocks has been higher since the mid-1970s, relative performance mostly declines during inflationary times. Consumer spending takes the backseat as a performance driver when interest rates rise on the back of higher inflation. In addition, previous inflationary periods have also coincided with surging energy prices, representing another source of diminishing consumer discretionary purchasing power (Chart 17). Consumer discretionary selling prices are expanding relative to overall wholesale price inflation, but they have been losing some steam of late. Were energy prices to sustain their recent cyclical advance, as BCA's Commodity & Energy Strategy service expects, that would represent a minor headwind to discretionary outlays. True, the tightening in monetary conditions could also be a risk, but we doubt the Yellen-led Fed would slam on the brakes at a time when the greenback is close to 15 year highs. The latter continues to suppress import prices and act as a tailwind to consumer spending and more than offsetting the energy and interest rate headwinds (Chart 18). Chart 17Consumer Discretionary bca.uses_sr_2016_12_05_c17 bca.uses_sr_2016_12_05_c17 Chart 18Consumer Discretionary bca.uses_sr_2016_12_05_c18 bca.uses_sr_2016_12_05_c18 Real Estate (Overweight) REITs have been outperforming the overall market during the five inflationary periods we analyzed, exemplifying their hard asset profile. While the 1976-81 iteration skewed the mean results, REITs still come out with the third best showing among the top eleven sectors even on median return basis (see Table 1 on page 2). Real estate prices tend to appreciate when inflation is accelerating, because landlords have consistently raised rents at least on a par with inflation (Chart 19). REITs pricing power has outpaced overall CPI. Apartment REITs rental inflation has been on a tear since the GFC, and the multi-family construction boom will eventually act as a restraint. The selloff in the bond market represents another risk to REITs relative returns as this index falls under the fixed income proxied equity basket, but the sector is now attractively valued (Chart 20). Chart 19Real Estate bca.uses_sr_2016_12_05_c19 bca.uses_sr_2016_12_05_c19 Chart 20Real Estate Real Estate Real Estate Energy (Neutral) The energy sector comes out on top of the median relative return results in times of inflation, and second best in average terms (Table 1 on page 2). Oil price surges are typically synonymous with other forms of inflation. During the six inflationary periods we analyzed, all but one period were associated with relative share price outperformance. Oil producers in particular benefit from the increase in the underlying commodity almost immediately (assuming little to no hedging), which also serves as an excellent inflation hedge (Chart 21). While relative energy pricing power had stabilized following the tumultuous GFC, Saudi Arabia's decision in late 2014 to refrain from balancing the oil market triggered a plunge in oil prices, similar to the mid-1980s collapse. The OPEC deal reached last week to curtail oil production should rebalance the market more quickly, assuming OPEC cheating will be limited, removing downside price risks. Nevertheless, any oil price acceleration to the $60/bbl level will likely prove self-limiting, as supply will come to the market and producers would rush to lock in prices by hedging forward (Chart 22). Chart 21Energy Energy Energy Chart 22Energy Energy Energy Financials (Neutral) Financials relative returns are neither hot nor cold when inflation rears its ugly head. In fact they sit in the middle of the pack in terms of relative median and mean returns. This lack of consistency reflects different factors that exerted significant influence in some of these inflationary periods. Moreover, Chart 23 shows that relative share prices have been mean reverting since the 1960s, likely blurring the inflation influence. Ultimately, the yield curve, credit growth and credit quality determine the path of least resistance for the relative share price ratio of this early cyclical sector. Financials sector pricing power has jumped by about 400bps over the past 18 months. Given the recent steepening of the yield curve, the odds are high that sector pricing power will remain firm via rising net interest margins. Any easing in the regulatory backdrop could also provide a fillip to margins (Chart 24). Chart 23Financials Financials Financials Chart 24Financials Financials Financials Utilities (Neutral) Utilities relative returns during inflationary bouts are the second worst among the top eleven sectors on an average basis and dead last on a median return basis. In five out of the six inflationary phases we examined, utilities stocks suffered a setback. The industry's lack of economic leverage and fixed income attributes anchor the relative share price ratio during inflationary times (Chart 25). Our utilities sector pricing power proxy has sprung to life recently moderately outpacing overall inflation. Natural gas prices, the industry's marginal price setter, have experienced a V-shaped recovery since the March trough, as excess inventories have been whittled down, signaling that recent pricing power gains have more upside. Nevertheless, the recent inflation driven jack up in interest rates has dealt a blow to this high dividend yielding defensive sector. Barring a sustained selloff in the bond market at least a technical rebound in relative share prices is looming (Chart 26). Chart 25Utilities Utilities Utilities Chart 26Utilities Utilities Utilities Tech (Underweight) Technology stocks have underperformed every time inflation has accelerated with two exceptions, in the mid-to-late 1960s and mid-to-late 1970s. Creative destruction forces in the tech industry are inherently deflationary. As a result, tech business models have evolved to thrive during disinflationary periods. Moreover, tech stocks have become more mature than typically perceived, having more stable cash flows and paying dividends. The implication is that the negative correlation with inflation will likely remain in place (Chart 27). Tech companies are constantly mired in deflation. While relative pricing power has been in an uptrend since 2011, it has recently relapsed into the deflationary zone. Worrisomely, deflation pressures are likely to intensify as the U.S. dollar appreciates, eating into the sector's earnings growth prospects. Finally, as a reminder, among the top eleven sectors tech stocks have the highest international sales exposure (Chart 28). Chart 27Tech Tech Tech Chart 28Tech Tech Tech Industrials (Underweight - High Conviction) The industrials sector tends to outperform during inflationary periods. In fact, relative share prices have risen 50% of the time since the mid-1960s when inflation was accelerating. The two oil shocks in the 1970s raised the profile of all commodity-related sectors as investors were scrambling to find reliable inflation hedges (Chart 29). Industrials pricing power is sinking steadily, weighed down by the multi-year commodity plunge on the back of China's economic growth deceleration, rising U.S. dollar and increasing supplies. While infrastructure spending is slated to increase at some point in late-2017 or early-2018, we doubt a lot of shovel ready projects will get off the ground quickly enough to satisfy the recent spike in expectations. We are in a wait and see period and remain skeptical that all this fiscal spending enthusiasm will translate into a sustainable earnings driven outperformance phase (Chart 30). Chart 29Industrials Industrials Industrials Chart 30Industrials bca.uses_sr_2016_12_05_c30 bca.uses_sr_2016_12_05_c30 Materials (Underweight) Materials equities have a tight positive correlation with accelerating inflation. Resource-related stocks are the closest representation of hard assets, given their ability to store value among the eleven GICS1 sectors. As inflation takes root and commodity prices rise, materials sales and EPS growth get a boost with relative share prices following right behind (Chart 31). From peak-to-trough relative materials prices collapsed by over 35 percentage points and only recently have managed to stage a modest comeback. Our relative pricing power gauge is flirting with the zero line, but may not move much higher. Deleveraging has not even commenced in the emerging markets, and the soaring U.S. dollar is highly deflationary. It will be extremely difficult for materials prices to advance sustainably if EM financial stress intensifies, given the inevitable backlash onto regional economic growth (Chart 32). Chart 31Materials bca.uses_sr_2016_12_05_c31 bca.uses_sr_2016_12_05_c31 Chart 32Materials bca.uses_sr_2016_12_05_c32 bca.uses_sr_2016_12_05_c32 Appendix Chart A1 bca.uses_sr_2016_12_05_c33 bca.uses_sr_2016_12_05_c33 Chart A2 bca.uses_sr_2016_12_05_c34 bca.uses_sr_2016_12_05_c34 Chart A3 bca.uses_sr_2016_12_05_c35 bca.uses_sr_2016_12_05_c35 Chart A4 bca.uses_sr_2016_12_05_c36 bca.uses_sr_2016_12_05_c36 Chart A5 bca.uses_sr_2016_12_05_c37 bca.uses_sr_2016_12_05_c37 Chart A6 bca.uses_sr_2016_12_05_c38 bca.uses_sr_2016_12_05_c38

Highlights Trump is adding stimulus and potential rigidities to the U.S. economy as the labor market slack vanishes. This evocates the 1970s and stagflation. This risk could resonate among investors as there are enough similarities with the late 1960s / early 1970s. But as well, crucial differences greatly reduce the likelihood of such a scenario. Ultimately, the Fed holds the key. If the Fed stays behind the curve for too long, inflation will emerge. Our bet is that the Fed will not fall behind the curve significantly. On a cyclical basis, the dollar will remain strong and the yen will underperform massively. Feature On November 11 we argued that the first round effect of a Trump victory would be to boost an already improving U.S. economy, giving the Fed more reason to increase interest rates faster than was priced in by markets.1 However, we did conclude our economic assessment of Trump by highlighting the potential for a dangerous outcome: "In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day." What will be the nature of this payback? Goosing up the economy as the U.S. approaches full employment evokes the inflationary policies of the late 1960s and early 1970s. Back then, the Vietnam War caused the Federal government deficit to increase while economic slack was limited. Stagflation ensued. While this parallel is appealing, it is also too simplistic. Trump's policies will be inflationary, but, key structural factors will prevent the fiery inflationary inferno that engulfed the 1970s. Policymakers will need to be careful, however, because while stagflation and the 1970s are only distant risks today, a Pandora's box is being opened. The Similarities The first similarity between the late 1960s / early 1970s is that Trump promises to inject stimulus exactly as the economy hits full employment. When President Johnson increased the U.S.'s involvement in Vietnam, the U.S. output gap was already closed. The result of this fiscal stimulus was to create excess demand. This excess demand not only put upward pressure on wages and prices, but also caused the U.S. current account deficit to balloon. Trump wants to cut taxes by US$6.2 trillion, as expected by the Tax Policy Institute. Before November 8, the labor market had already tightened and wage growth was already accelerating (Chart 1). Stimulating in this context could unleash potent inflationary forces. The second similarity to Vietnam-era stagflation is that Trump's fiscal stimulus will materialize as monetary policy remains easy. By 1969, U.S. real short rates were already hovering near 0%, and were negative for three years between 1974 and 1977 (Chart 2). Today, we are also experiencing deeply negative real rates. However, back then these easy monetary conditions were being felt at the tail end of a multi-decade boom. Today, they reflect the aftermath of a financial crisis that has greatly increased the demand for precautionary savings and depressed the private sector's appetite for credit. Chart 1Tightening Labor Market Tightening Labor Market Tightening Labor Market Chart 2Similarity: Low Real Rates Similarity: Low Real Rates Similarity: Low Real Rates The third parallel comes from the liquidity on bank balance sheets. Today, as was the case in the late 1960s and early 1970s, banks are flush with liquid assets (Chart 3). Thus, banks have the fuel to aggressively lend and create money. Outside of banking crises, the willingness of banks to lend is often closely correlated with the demand for loans.2 Both respond to the same economic shocks, whether positive or negative. After the 1970 recession, the Fed eased aggressively, and business investment rebounded quickly. Today, Trump's fiscal reflation could revive animal spirits in a similar fashion. In both instances, banks have the wherewithal to support growing capex and loan demand. Another troubling resemblance is the illiquid state of household balance sheets. Today, household liquidity represents as small a share of disposable income as it did in 1970 (Chart 4). In fact, compared to total liabilities, household liquidity remains in the lower end of the historical distribution. Why does this matter? Chart 3Similarity: Bank Liquidity Similarity: Bank Liquidity Similarity: Bank Liquidity Chart 4Similarity: Household Illiquidity Similarity: Household Illiquidity Similarity: Household Illiquidity Under this set of circumstances, households will have a higher political tolerance for inflation. Except for the rich, the average household has little to lose from inflation, especially if the rise in prices emanates from an over-stimulated labor market. Inflation does decrease the real value of household liquid assets, but it does the same thing to their much larger debt burdens. The large increase over the past 30 years in U.S. income inequality only reinforces these dynamics (Chart 5). Chart 5Growing Inequalities Trump: No Nixon Redux Trump: No Nixon Redux The last parallel is the potential for a return to pre-Reagan economic rigidities. Trump has talked about imposing tariffs on global exporters in order "to make America great again." He also mentioned limiting immigration in the U.S. Neither of these promises are clear, and like the fiscal stimulus, they could be greatly dialed back compared to the campaign-trail promises. What would be the impact of such a move away from globalization? Our Global Investment Strategy service argues that the growth impact would be limited. Academic models show that since 1990, only 5% of the increase in global GDP growth can be attributed to deeper trade linkages.3 However, the integration of China in the global supply chain and the expansion of the American labor force through immigration has depressed wages for less skilled U.S. workers. Yet, the emergence of new markets outside of the G10 has boosted profits for U.S. multinationals. This has accentuated income inequality. Meanwhile, the marginal propensity to save of rich households is around 60%, while that of the middle class and the poor sits much closer to zero. Thus, the change in the U.S. income distribution has depressed U.S. consumption by 3% since 1980 (Chart 6). This has created a strong deflationary impact on in the economy. Chart 6Unequal Income Depresses Consumption bca.fes_sr_2016_12_02_c6 bca.fes_sr_2016_12_02_c6 Therefore, if Trump does implement a protectionist and anti-immigration agenda, it would likely put upward pressure on prices by causing both a small inward shift in U.S. aggregate supply as well as from the increase in demand resulting from higher middle class wages (and therefore consumption). Bottom Line: Today, like in the late 1960s / early 1970s, five conditions are present to lift inflation: Trump is set to stimulate the economy as it is hitting full employment; Monetary policy is extremely accommodative; Banks have plenty of liquidity to fuel any resurgence in excess demand; household balance sheet make them politically friendly to inflationary dynamics; And by moving away from globalization and immigration, Trump may add further fuel to any inflationary developments The Differences While there are troubling parallels between Trump and the 1970s, key differences could prove to be just as important if not even more so than the similarities. The first difference between now and then is the structure of the labor market. Unionization rates have collapsed from 30% of employees in 1960 to 11% today. The accompanying fall in the weight of wages and salaries in national income demonstrates the decline in the power of labor (Chart 7). Without this power, it is much more difficult for household income to grow as fast as it did in the 1960s and 1970s. In conjunction, cost-of-living-adjustment clauses have vanished from U.S. labor contracts (Chart 8). Hence, the key mechanism that fed the vicious inflationary circle between wages and prices is now extinct. Chart 7Difference: Labor Has Lost Its Power Difference: Labor Has Lost Its Power Difference: Labor Has Lost Its Power Chart 8With No Bargaining Power, Concessions To Labor Ceased... Trump: No Nixon Redux Trump: No Nixon Redux Second, the broad capacity utilization picture could not be more different than in the 1970s. In 1970, the U.S was at the tail end of a decade of strong cyclical spending, which was powered by consumer durable-goods purchases, not by capex and capacity growth (Chart 9). In fact, the stock of fixed assets as a percent of GDP is much higher today than it was back then, pointing to excess capacity in the system, at least relative to the 1970s (Chart 10). Chart 9Difference: Cyclical Spending Difference: Cyclical Spending Difference: Cyclical Spending Chart 10Difference: Capital Stock Difference: Capital Stock Difference: Capital Stock Corroborating this image, capacity utilization remains quite low by historical standards. Interestingly, this series continues to hold good explanatory power for inflation (Chart 11). While a Trump stimulus would cause this measure to perk up, and for deflationary risk to vanish, we are nowhere near levels associated with a major inflation outbreak. Chart 11Difference: Capacity Utilization Difference: Capacity Utilization Difference: Capacity Utilization Even when we look at capacity in the labor market, the picture is once again markedly different. Today, unemployment is only beginning to flirt with its equilibrium after nearly nine years of deep labor market slack. In contrast, by the late 1960s, the unemployment gap had been negative for seven years. It barely moved into positive territory during the 1970 recession and only surged higher after 1974 (Chart 12). This was a very inflationary labor market. Mirroring the U.S., global capacity utilization is depressed and the rest of the world remains a deflationary anchor (Chart 13). In the late 1960s and early 1970s, non-U.S. inflation was just as high as U.S. inflation, as global capacity was tight and global money growth was strong. Today, heavy capex in EM means that despite a sharp slowdown in DM investment after 2000, global capex has remained at 25% or so of global GDP - a very high level compared to history - for 7 out of the last 10 years. Chart 12Difference: Labor Market Difference: Labor Market Difference: Labor Market Chart 13Global Capacity Utilization Is Low Global Capacity Utilization Is Low Global Capacity Utilization Is Low Third, in the 1960s and 1970s, animal spirits were running wild. Despite growing government deficits and rising borrowing costs, the crowding out of the private sector never materialized (Chart 14). This was a testament to the optimistic belief of the era, a belief fed by the resilience of the economy since 1950, as well as by the implicit support created by decades of Keynesian policies. Today, fiscal stimulus and rising consumer spending could resurrect animal spirits. However, this would be a nascent phenomenon, not a multi-decade one, implying a very different set of expectations for investors, consumers, and business than in the late 1960s / early 70s. Fourth, the monetary picture is very different. Today, both the money multiplier and money velocity are extremely depressed, a sign that monetary constipation still defines our age. In the 1960s and 1970s, money velocity and the money multiplier were both elevated or experiencing sharp upturns (Chart 15). This is why low real rates of that era did translate into accelerated economic activity and inflation, unlike the uninspiring effects of low rates or QE programs today. Chart 14Raging Animal Spirits Raging Animal Spirits Raging Animal Spirits Chart 15Difference: Monetary Backdrop Difference: Monetary Backdrop Difference: Monetary Backdrop Finally and most crucially, the rising inflation of the late 1960s only mutated into genuine stagflation after the economy was hit by a massive supply shock: the 1973 oil embargo. In the wake of the Yom Kippur War, OPEC tripled the price of oil - the commodity powering the modern economic machine. Global capacity utilization was already tight, but this shock created a massive inward shift in global aggregate supply, ratcheting aggregate price levels higher while hurting aggregate output (Chart 16). But the true coup de grace only emerged when fiscal and monetary authorities massively eased policy in response to this shock: The U.S. federal deficit skyrocketed from 2.3% of GDP in 1974 to 8% in 1975 and short rates fell from 8.9% in 1974 to 4.9% in 1976. This boosted aggregate demand back to its original level, but with sharply more elevated price levels (Chart 16). Chart 16Mechanics Of A Supply Shock Trump: No Nixon Redux Trump: No Nixon Redux Today, we have seen oil prices collapse by 56% since 2014 in response to a positive supply shock, and global capacity utilization is low. Thus, while fiscal stimulus could push aggregate price levels upward as it lifts aggregate demand, the effect on inflation should prove much more muted than when such policies are implemented in the face of a supply shock. Bottom Line: Important similarities exist between the potential effect of Trump's suggested policies and the economic environment of the late 1960s / early 1970s. However, five structural and cyclical differences suggest that Trump is not bound to recreate stagflation: The de-unionization of the labor force has removed its pricing power, capacity utilization is now infinitely more benign than back then, animal spirits are only recovering today while they were running wild in the late 1960s / early 1970s, the monetary environment backdrop is also much less inflationary, and finally, we are not experiencing the kind of supply shock and mistaken policy response that hit the world in the wake of the 1973 oil embargo. Question Marks Key to the outlook is the Fed itself. Trump's policies will put upward pressure on prices. However, the Fed continues to avoid committing to a tighter policy path beyond this December. The Fed has good reasons to do so: Trump has offered the world no clarity regarding his actual plans while in office. With little labor market slack, any stimulus is inflationary; how inflationary will be a function of the details. So should be the Fed's response. For inflation to truly emerge in the system, the Fed will need to keep policy easy even as Trump's plans become clearer. In the 1970s, a too-easy Fed spurred excess demand that lifted inflation and inflation expectations. Moreover, if the Fed had not cut rates as aggressively as it did in 1974 - a policy that boosted demand but that did nothing to compensate for the shortfall in aggregate supply - the inflationary shock from the oil embargo should have proven much more transitory. The Fed's recent talk of a "high-pressure" economy evokes a repeat of the 1970s mistake. However, there is no guarantee that this error will be repeated. For one, the references to a "high-pressure" economy predated the Trump victory. Second, fiscal stimulus is what the Fed has wanted for a long time. Trump is giving the FOMC the cover they have needed to do what they have tried to do since 2014: increase rates. Finally, inflation expectations are beginning to move upward. This is what the Fed needs to push interest rates higher. Moreover, this is happening as long-term inflation expectations begin decoupling from oil prices (Chart 17). This is important as it suggests that the economy is gaining traction and that markets are starting to anticipate a lift off from the zero lower bound. Thus, while we think a lagging Fed is a risk, it is not currently our base-case scenario. The second question mark is the dollar. One of the key factors that prompted the dis-anchoring of inflation and inflation expectations in the early 1970s was the suspension of the dollar's convertibility to gold in August 1971. This unleashed a period of weakness for the greenback that culminated in a 30% devaluation by 1980 (Chart 18). Moreover, a weak dollar fueled the commodity bull market. Chart 17The Fed Must Enjoy This The Fed Must Enjoy This The Fed Must Enjoy This Chart 18The Dollar Added To Inflation The Dollar Added To Inflation The Dollar Added To Inflation Today, the dollar is strong and expensive, creating a deflationary anchor in the U.S. economy. Our expectations that the Fed will not fall behind the curve once the nature of the Trump stimulus becomes clearer would re-inforce this trend. However, a failure by the Fed to tighten monetary policy appropriately, leaving the U.S. central bank behind the curve, would have a negative impact on the dollar. Not only would it put downward pressure on real rate differentials between the U.S. and the rest of the world, but it would also depress the PPP fair value of the dollar by increasing domestic inflation. Bottom Line: The two key swing factors are the Fed's policy response and the dollar. In the late 1960s / early 1970s, the Fed kept policy too easy. Not only did this greatly fan the underlying inflationary dynamics that were already present in the economy, but it also created a very negative environment for the dollar, prompting the end of the dollar peg in August 1971. This further lifted inflation in the economy. The Endgame And Investment Conclusion Given all these conflicting forces, how will this experiment end? Pure stagflation with late 1970s-style inflation is out of the picture. However, inflation of 4% to 5% is very possible, but it could take time to show up in the data. In the 1960s, it took U.S. inflation until mid-1968 to hit 4%. By that time, the output gap had been positive for around 5 years, hitting 6% of GDP in 1966 (Chart 19). Unemployment had been below its equilibrium rate since 1963, and by 1968 was 2.5% below NAIRU. Chart 19No Slack In The 1960s No Slack In The 1960s No Slack In The 1960s This suggests that unless the Fed falls significantly behind the curve, even 4% inflation may take a long time to emerge this cycle. However, inflationary risks will grow considerably after the next recession. We do not know when this recession will happen, but we know what the result will be: more policy easing. It took until the 1970 recession and the associated policy boost to genuinely dis-anchor inflation expectations in the U.S. Today, an easing in policy and an associated fall in the dollar are likely to be the key criteria to generate real inflation risk in the U.S. As for currency implications, the lack of an inflationary outburst along with a responsible Fed will continue to support the dollar and hurt precious metals. In terms of exchange rates, USD/JPY should perform particularly well. The Japanese economy is near full employment and the Abe administration also is talking about additional stimulus. Yet, while the Fed will not stay behind the curve for long, the BoJ is explicitly aiming at staying behind the curve. This is a recipe for a higher dollar/yen on a 12-18 months basis. The euro is likely to continue to weaken as there remains more slack in the euro area than the U.S. However, this slack is diminishing and the ECB would respond to its disappearance, which implies that EUR/USD has less downside than the yen on a 12-18 months basis. Commodities are unlikely to repeat their amazing performance seen in the 1970s. Thus, commodity currencies should continue to suffer from dollar strength. The pound will be dominated by its own set of dynamics. While the probability of a soft Brexit has been growing ever since the High Court's ruling was issued, the appeal decision still needs to be made. Moreover, headline risk remains very elevated. Thus while valuation argues in favor of GBP, buying GBP today is a high-risk gamble. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 William F. Bassett, Mary Beth Chosak, John C. Driscoll, and Egon Zakrajsek, "Changes In Bank Lending Standards And The Macroeconomy," Journal of Monetary Economics 62 (2014): pp. 23-40. 3 Please see Global Investment Strategy Weekly Report, "The Elusive Gains From Globalization", dated November 25, 2016, available at gis.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades