Money/Credit/Debt

Recommendation Allocation 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 Chart 2U.S. Earnings Growing Again 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 Chart 4Will This Trigger Inflation Pressures? 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 Chart 6Rise 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? 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 Chart 9GDP Impact Of U.S. Fiscal Stimulus Chart 10A Lot of Stimulus, And Extra Debt 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 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? 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 Chart 14An Oversold Bounce Chart 15Policy Tightening = Underperformance 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 Chart 17Growth Picks Up In##br## Most DMs And China 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 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 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 Chart 21Global Equities: No Style Bet 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 Chart 23Inflation Uptrend Intact Chart 24Overweight JGBs 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 Chart 26Still Accommodative Chart 27Expensive Valuations 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 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 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 Chart 31Commodities: A Secular Bear Market Chart 32Structured Products Outperform In Recessions 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 Chart 34Policy Uncertainty Is High 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 Chart 36How Would EM And Commodities Move##br## If USD Weakens? 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 The valuation discount on Italian banks still seems insufficient for the sector's excess NPLs. We expect a better long-term buying opportunity sometime next year. Stay underweight the MIB and IBEX versus the Eurostoxx600. Stay underweight the Eurostoxx600 versus the S&P500. Long Italian BTPs versus French OATs has quickly achieved its profit target. Now prefer long Spanish Bonos versus French OATs. Feature Assessing The Value In Italian Banks Investment reductionism says that the valuation of a bank distils down to three things: The expected size of the bank's assets. In the standard banking model, the dominant asset is the bank's loan book. The expected profitability of the bank's assets. In the standard banking model, the dominant driver of profitability is the net interest margin (the difference between the interest rate received on loans and the interest rate paid on deposits). The expected amount of equity capital required against the bank's assets. The equity capital must absorb the bank's loan losses but it also receives the profits. Increasing the amount of equity capital dilutes the profits over a larger number of shares, and thereby lowers the bank's share price. Chart of the WeekSpain And France have Raised €100bn Of Bank Equity Capital... Italy Has Not Today, the potential reward of owning Italian banks is that they trade at a large valuation discount. Admittedly, growth in assets and profit margins is likely to be anaemic. But Italian banks trade on a price to forward earnings multiple of less than 10. Not only does this seem cheap in absolute terms, it is a 25% discount to other European banks (Chart I-2). Chart I-2Italian Banks Trade At A Significant Discount Chart I-3Italian Bank NPLs Have Increased Sharply But the risk of owning Italian banks is that they still carry €170bn of un-provisioned non-performing loans (NPLs), which is likely to require a large - and dilutive - increase in equity capital. NPLs have increased much more sharply in Italy than in Spain or France (Chart I-3). But the more significant difference is that Italian banks have not yet raised equity capital as a cushion against their rising NPLs. Since 2009, Spanish banks and French banks have both increased their equity capital by more than €100bn. Over this same period, Italian banks have actually shrunk their equity capital (Chart of the Week). Given that Italian bank equity capital stands at €150bn, today's 25% valuation discount is pricing a dilutive increase in equity capital of around €50bn. Will this be a sufficient cushion? Chart I-4How Much Equity Capital Do Italian Banks Require? Our assessment is that it still might be insufficient. Our prudent benchmark is that the Italian banking sector lifts its equity capital to NPL multiple to the lowest coverage that the Spanish banking sector reached in recent years (Chart I-4). That would require Italy to emulate Spain and France and raise closer to €100bn of fresh bank equity capital. Also beware that if an undercapitalized bank cannot raise sufficient equity capital privately in the markets, there is a danger that its investors could suffer heavy losses. This is because the EU rules on state aid for banks changed at the start of 2016. The EU Bank Recovery and Resolution Directive (BRRD) allows a government to step in with a 'precautionary' capital injection only after a first-loss 'bail-in' of the bank's equity and bond holders. Hence, Italian banks are a potential buy if you believe €50bn of extra equity capital will fully alleviate concerns about the large stock of un-provisioned NPLs... and if you believe that the sector's plan to raise equity capital in the market will avoid any major mishap. Given global banks' strong recent bounce, we expect a better long-term buying opportunity sometime next year. Value Doesn't Help Pick Equity Markets Chart I-5Italy's MIB Looks Cheap The headline cheapness of Italian banks inevitably makes Italy's MIB look relatively cheap too (Chart I-5), especially given the Italian stock market's overweighting to banks. Some people suggest sector-adjusting stock market valuations to neutralize the dominating sector skews, thereby creating a truer picture of relative valuation. Adjusted for these sector skews, is a stock market cheap or expensive? This question may be of interest to academics, but it has very little practical relevance for stock market selection. Compared to France's CAC, Italy's MIB and Spain's IBEX are indeed cheaper mainly because of their large overweight to banks. But this cannot change the inescapable fact that this defining large overweight to banks is precisely what drives MIB and IBEX relative performance. Likewise, compared to the S&P500, the Eurostoxx600 is much cheaper mainly because of its overweight to banks combined with its large underweight to technology. But this cannot change the inescapable fact that this defining overweight to banks combined with large underweight to technology is precisely what drives Eurostoxx600 versus S&P500 relative performance. For the sceptics, the charts on page 5 should leave no doubt that everything else is largely irrelevant. The recent outperformance of banks is just a manifestation of the Trump reflation trade, nothing more, nothing less (Chart I-6). Indeed, most of the moves in financial markets over the past month reduce to the same trade in one guise or another. This reflation trade has gone too far too fast, and we would now lean against it. An underweight to banks necessarily means underweighting the MIB and IBEX (Charts I-7 and I-8). Chart I-6The Trump Reflation Trade Has Lifted Banks Chart I-7Banks Drive The MIB Relative Performance Chart I-8Banks Drive The IBEX Relative Performance An underweight to banks and overweight to technology necessarily means underweighting the Eurostoxx600 versus the S&P500 (Charts I-9 and I-10). Chart I-9Banks Versus Technology... Chart I-10...Drive Eurostoxx600 Versus S&P500 Assessing The Value In French, Spanish And Italian Bonds Turning to bonds, the market has deemed that Italian BTPs and Spanish Bonos are more risky investments than French OATs. Therefore BTPs and Bonos require a yield premium over OATs. But what exactly is this yield premium for? In the unlikely event that a large euro area country like Italy or Spain defaulted on its sovereign euro-denominated debt, the monetary union as it stands would be unable to withstand the losses. The euro would likely break up, causing each country to redenominate its bonds into its own new currency, which would then rise or fall against the other new currencies. Today's yield premium on BTPs and Bonos over OATs is simply the expected value of the (annualised) loss that would be suffered in that eventuality. And this expected loss equals the product of two terms: the annual probability of euro break up and the expected depreciation of a new Italian lira (or new Spanish peseta) versus a new French franc after such a break up In turn, the expected depreciation of the lira or peseta versus the franc would broadly equal the respective economy's accumulated competitiveness shortfall versus France. Which leads to a powerful conclusion. Spain has rapidly eroded its competitiveness shortfall versus France, and is on course for full convergence within a couple of years (Chart I-11). If the second term of the above product becomes zero, so too must the product itself. Meaning the yield premium on Bonos over OATS must converge to zero - irrespective of whether the euro survives or not. Chart I-11Spainish Competitiveness Will Soon Reconverge With French Competitiveness Stay long Spanish Bonos versus French OATs. In the case of Italy, a substantial shortfall in competitiveness versus France (and now Spain) does exist, justifying a structural yield premium in BTPs. But recently, this premium widened further because of a larger first term in the above product - a perceived increase in the annual probability of euro break up after the no vote in Italy's referendum on constitutional reform, and Prime Minister Renzi's subsequent resignation. However, as we argued in Italy: Asking The Wrong Question,1 fears of the political repercussions of a no vote were overdone. As the market has come to realise this, the BTP yield premium has quickly retraced most of its recent widening. Our long Italian BTP versus French OATs bond pair trade has achieved its profit target in just 10 days, and we are now closing it (see section below). Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Published on December 1, 2016 and available at eis.bcaresearch.com Fractal Trading Model* This week's recommended trade is to buy gold. Long Gold * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Long Italian Government Bonds / Short French Government Bonds The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br## - Interest Rate Expectations Chart II-6Indicators To Watch ##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br## - Interest Rate Expectations Chart II-8Indicators To Watch ##br## - Interest Rate Expectations

Special Report

Feature At no time in recent history have China's foreign reserves been under such tight scrutiny by global investors as they are now. The country's multi-trillion-dollar official reserve assets, long viewed by both Chinese officials and the global investment community as an unproductive use of resources, have suddenly became a lifeline for China's exchange rate stability. The latest numbers released last week show China's official reserves currently stand at US$3.05 trillion, a massive drawdown from the US$3.99 trillion all-time peak reached in 2014. Over the years, we have been running a series of Special Reports tracking the composition of China's foreign asset holdings.1 This year's update has become all the more relevant. The monthly headline figures on China's official reserves have been eagerly anticipated for clues of domestic capital outflows and the RMB outlook. Meanwhile, as the largest foreign holder of American government paper, changes in China's official reserves are also being scrutinized to assess any impact on U.S. interest rates. Moreover, Chinese outward direct investment (ODI), which had already accelerated strongly in the past few years, has skyrocketed this year - partially driven by expectations of further RMB depreciation. The Chinese authorities have recently tightened scrutiny on large overseas investments by domestic firms, which will likely lead to a notable slowdown in Chinese ODI in the near term.2 This week we take a closer look at the U.S. Treasury International Capital (TIC) system data and various other sources to check the evolution of China's official reserves and foreign assets. There are some important caveats. First, Chinese holdings of U.S. assets reported by the TIC are not entirely held by the People's Bank of China in its official reserves. Some assets, particularly corporate bonds and equities, may be held by Chinese institutional investors. Meanwhile, it is well known that in recent years China has been using offshore custodians in some European countries, the usual suspects being Belgium, Luxembourg and the U.K., which disguises the true situation of the country's official reserve holdings. Finally, China's large conglomerates owned by the central government also hold vast amounts of foreign assets, or "shadow reserves" that could be utilized to support the RMB if needed. Recently these state-owned giants were reportedly required by the government to repatriate some of their foreign cash sitting idle overseas to counter capital outflows. All of this suggests the resources available to the government are larger than the official reserve figures. With these caveats, this week's update reveals some important developments in the past year: Chinese foreign reserves have dropped by around US$400 billion since the end of 2015 to US$3.05 trillion, a level last seen in 2005 when the RMB was de-pegged from the dollar followed by a multi-year ascendance (Chart 1). China still holds the largest amount of foreign reserves in the world, but its global share has dropped to about 40%, down from a peak of over 50% in 2014. TIC data show Chinese holdings of U.S. assets declined by a mere US$100 billion in the past year, leading to a sharp increase in U.S. assets as a share of the country's total foreign reserves (Table 1). This could be attributable to mark-to-market "paper losses" of Chinese holdings in non-dollar denominated foreign assets, due to the broad strength of the greenback. It is also possible that China may have intentionally increased its allocations to U.S. assets due to heightened risks in other countries, particularly in Europe. Chinese holdings of Japanese government bonds also increased significantly this past year. Table 1Chinese Foreign Exchange Reserves Chinese holdings of U.S. Treasurys have dropped by about US$100 billion in recent months, but holdings of some other countries suspected as China's overseas custodians have continued to rise (Chart 2). This could mean that Chinese holdings of U.S. assets could be larger than reflected in the TIC data. Chinese outward direct investments have continued to power ahead. Previously Chinese investments were heavily concentrated in commodities sectors and resource-rich countries. This year the U.S. has turned out to be the clear winner in attracting Chinese capital. Moreover, recent investment deals have been concentrated in consumer related sectors such as tourism, entertainment and technology industries. Chart 1Chinese Foreign Reserves##br## Have Continued To Decline Chart 2U.S. Treasurys: How Much ##br##Does China Really Hold? Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com Qingyun Xu, Senior Analyst qingyun@bcaresearch.com 1 Please see China Investment Strategy Special Report, "Demystifying China's Foreign Assets", dated September 30, 2015, available at cis.bcaresearch.com Please see China Investment Strategy Weekly Report, “How Will China Manage The Impossible Trinity”, dated December 8, 2015, available at cis.bcaresearch.com China's official data shows that the country's total holdings of international assets have stayed flat at around US$6.2 trillion since 2014, including foreign exchange reserves, direct investment, overseas lending and holdings of bonds and equities. Official reserves have declined in recent years, but other holdings have jumped sharply. Reserves assets still account for over half of total foreign assets, but their share has continued to drop. In contrast, outward direct investment and overseas loans have gained significantly both in value terms and as a share of the country's total foreign assets. Chart 3 Chart 4 Despite the sharp decline, international investment positions by Chinese nationals, public and private combined, are still much more heavily concentrated in official reserve assets compared with other major economies. In other major creditor countries, outward direct investments and portfolio investments account for much larger shares than reserve assets. Official reserves in the U.S. are negligible. Chinese official reserves give the PBoC resources to maintain exchange rate stability, but they also lower the expected returns of the country's foreign assets. Encouraging domestic entities to acquire overseas assets directly has been a long-run policy. More recently, however, the authorities have been alarmed by the pace of Chinese nationals' overseas investment and have been taking restrictive measures. Chart 5 Our calculations shows that Chinese total holdings of U.S. assets reached US$1.74 trillion at the end of September 2016, including Treasurys, government agency bonds, corporate bonds, stocks and non-Treasury short-term custody liabilities of U.S. banks to Chinese official institutions, based on the TIC data (Table 1, on page 2). Treasurys still account for the majority of the country's total holdings of U.S. assets, while bonds and stocks are relatively insignificant. China's holdings of U.S. assets as a share of total reserves declined between the global financial crisis and 2014, since when the trend has reversed. The share of U.S. asset holdings currently accounts for 55% of Chinese official reserves, compared with a peak of over 70% in the early 2000s and a trough of 46% in 2014. This could also be attributable to the sharp appreciation of the U.S. dollar against other majors. The U.S. dollar carries a 42% weight in the SDR (Special Drawing Rights of the International Monetary Fund), and it accounts for about 60% of total foreign reserves managed by global central banks. These could be two relevant benchmarks to gauge China's desired level of holdings of U.S. dollar-denominated assets in its official reserves. Chart 6 Chart 7 In terms of duration, the major part of Chinese holdings of U.S. assets is long-term (with maturity more than one year), mainly in the form of government and agency bonds, corporate bonds and stocks. Chinese holdings of short-term U.S. assets were minimal in recent years but picked up notably in the past few months, while longer term assets declined. During the global financial crisis in 2008/09, China massively increased its holdings of short-term U.S. assets, amid a global drive of "flight to liquidity" at the height of the crisis. Chart 8 Chart 9 In terms of risk classification, the majority of Chinese holdings of U.S. assets are risk-free assets, including Treasurys and government agency bonds. China's holdings of these assets have plateaued in recent years. As a share of China's total reserves, U.S. risk-free assets currently account for about 45%, down from about 65% in 2003. Meanwhile, its accumulation of U.S. risky assets, including stocks and corporate bonds, has increased sharply in the past year. Chart 10 Chart 11 China currently holds US$1.16 trillion of Treasurys, which account for over 80% of total Chinese holdings of U.S. risk-free assets, or 37% of total Chinese foreign reserves. Notably, Treasurys as a share of Chinese foreign reserves have been relatively stable, ranging between 30% and 40% over the past decade. This may be the comfort zone for the Chinese authorities' asset allocation to the U.S. government paper. China's holdings of U.S. government agency bonds have picked up in the past year, but are still significantly lower than at its peak prior to the U.S. subprime debacle. Its share in Chinese foreign reserves has declined to 8% from a peak of close to 30% in 2008. Chart 12 Chart 13 Almost the entire Chinese holding of Treasurys is parked in long-term paper (with duration of more than one year). China's possession of short-term Treasurys has been negligible in recent years, but picked up notably of late. It is possible that the Chinese central bank may be increasing cash holdings to deal with capital outflows. Chart 14 Chart 15 Chinese holdings of risky U.S. assets - corporate bonds and equities - account for over 10% of China's total foreign reserves, up sharply since 2008 after China established its sovereign wealth fund. China's holdings of risky assets are predominately equities, currently standing at about USD 325 billion, little changed in recent years. Its possessions of corporate bonds are very low. Chart 16 Chart 17 China remains the largest foreign creditor to the U.S. government. Chinese holdings of U.S. Treasurys account for about 11% of total outstanding U.S. government bonds, or around 20% of total foreign holdings of U.S. Treasurys, according to our calculation. About 55% of outstanding U.S. Treasurys are held by foreigners. China is also one of the largest foreign holders of U.S. of agency bonds. While its holdings only accounts for 3% of total outstanding agency bonds, they account for around 25% of the total held by foreigners. About 12% of agency and GSE-backed securities are currently held by foreigners. Chart 18 Chart 19 Chinese outward direct investments have continued to march higher in the past year, reaching yet another record high in 2015, and will likely set a new record in 2016. Total overseas direct investments amount to USD 1.4 trillion, equivalent to about half of China's official reserves. China's overseas investments have been heavily concentrated in resources-rich regions and industries. Cumulatively, the energy sector alone accounts for almost half of China's total overseas investments, followed by transportation infrastructure and base metals, which clearly underscores China's demand for commodities. China's outbound investment was originally led by state-owned enterprises. More recently, private Chinese enterprises have become more active in overseas investments and acquisitions. Chart 20 Chart 21 Chart 22 Corporate China's interest in global resource space has waned in the past year. Total investment in energy space has plateaued in recent years. There has been a dramatic increase in investment in some consumer-related sectors, particularly in tourism, entertainment and technology. These investment deals are mainly driven by private enterprises, and also reflect the changing dynamics of the Chinese economy. The U.S. received by far the largest share of Chinese investment in 2016. Total U.S.-bound Chinese investment in the first half of the year already dramatically outpaced the total amount of 2015. Chinese investments in resource rich countries, such as Australia, Canada and Brazil have been much less robust. Chinese net purchase of Japanese government bonds (JGBs) increased sharply this year. In the eight months of 2016 China's net purchases of JGBs reached $86.6 billion, more than tripling the amount during the same period last year. Chinese cumulative net purchases of JGBs since 2014 reached JPY 14.5 trillion, or USD 140 billion. This amounts to 2% of total outstanding JGBs and 4% of Chinese official reserves. Chart 23 Chart 24 Chart 25 Cyclical Investment Stance Equity Sector Recommendations

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 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 Chart 3America Is Chaos-Proof 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 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... Chart 6And Now China ##br##Is Exporting Deflation 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 Chart 8Sino-American ##br##Symbiosis Is Over 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 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 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 Chart 12Obama ##br##The Regulator 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? 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? 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 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 Chart 17Globalization: No Friend To DM Middle Class 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. 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 Chart 19 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? Chart 21The Internet Has Killed Journalism 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 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 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 Chart 24Few Europeans Want Out Of The EU 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 Chart 26The 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? Chart 28Le Pen Will Not Be##br## Next French President 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 Chart 30Migration Crisis Is Abating Chart 31There Is A Lot Of Daylight... 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 Chart 33Italy Lags Peers On Euro Support Chart 34Italy's Next Election Is Too Close To Call 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%? Chart 36Italy Has Learned To Live With Its Debt 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 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 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 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 Chart 40Iraq Is The Big, And Cheap, Hope 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 Chart 42Oil Supply Glut Is Gone In 2017 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 Chart 44Asia Sells, America Rules 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 Chart 46China Backing Away From U.S. Treasuries 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 Chart 48China Is De-Globalizing 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 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 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 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 ECB QE has pushed the euro area's Target2 banking imbalance to an all-time high. Thereby, QE has raised the cost of euro break-up. The ECB must dial down QE because the Target2 banking imbalance is directly related to the size of asset purchases. Core euro area sovereign bonds offer poor relative value in the government bond universe. Long Italian BTPs / short French OATs is now appropriate as a tactical position. Italian bank investors might have to suffer more pain before Brussels ultimately allows a public rescue. Feature "We've eliminated fragmentation in the euro area." Mario Draghi, speaking on October 20, 2016 Mario Draghi is wrong. QE was meant to reduce economic and financial fragmentation within the euro area. But in one important regard, it has done the exact opposite. In an un-fragmented monetary union, banking system liquidity would be spread evenly across the euro area. Unfortunately, the trillions of euros of QE liquidity created by the ECB has concentrated in four northern European countries: Germany, the Netherlands, Luxembourg and Finland (but interestingly, not France). This extreme fragmentation is captured in the euro area's Target2 banking imbalance (Box I-1), which is now at an all-time high (Chart of the Week). Box 1: What Is Target2? Target2 stands for Trans-European Automated Real-time Gross settlement Express Transfer system. It is the settlement system for euro payment flows between banks in the euro area. These payment flows result from trade or financial transactions such as deposit transfers, sales of financial assets or debt repayments. If the banking system in one member country has more payment inflows than outflows, its national central bank (NCB) accrues a Target2 asset vis-à-vis the ECB. Conversely, if the banking system has more outflows than inflows, the respective NCB accrues a Target2 liability. Target2 balances therefore show the cumulative net payment flows within the euro area. Chart of the WeekQE Has Pushed The Euro Area's Target2 Imbalance To An All-Time High To be absolutely clear, this geographical polarization of bank liquidity is not deposit flight in the strictest sense (Chart I-2). Investors are simply using the ECB's €80bn of monthly bond purchases to offload their Italian, Spanish and Portuguese bonds to the central bank, and hold the received cash in banks in perceived haven countries. Nevertheless, ECB QE has unwittingly facilitated a geographical polarization of bank liquidity more extreme than in the darkest days of 2012 (Chart I-3). Chart I-2No Funding Stresses At The Moment Chart I-3Target2 Imbalances Are The Result Of QE QE Has Exposed Euro Area Banking Fragmentation To understand how this polarization has arisen, it is necessary to grasp how Eurosystem accounting works. The following section is necessarily technical, but stick with it because it is important. The ECB delegates its QE sovereign bond purchases to the respective national central bank (NCB): the Bundesbank buys German bunds, the Bank of France buys OATs, the Bank of Italy buys BTPs, and so on. When the Bank of Italy buys a BTP from, say, an Italian investor, the investor gives up the bond, but simultaneously receives a corresponding asset - cash. If the investor then deposits this cash at an Italian bank, say Unicredit, then Unicredit would have a new liability - the investor deposit. But in line with Eurosystem accounting, Unicredit would simultaneously receive a corresponding credit at its NCB, the Bank of Italy.1 Completing the accounting circle, the Bank of Italy would now have a new liability - the Unicredit claim, but it would also have a corresponding asset - the BTP that it has just bought. Therefore, all three accounts would be in perfect balance (see Figure I-1). Figure I-1Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Unicredit Now consider what happens if the Italian investor deposits the cash not at Unicredit, but at a German bank, say Commerzbank. In this case, it would be the Bundesbank that had a new liability - the Commerzbank claim. However, the Bundesbank would not have a corresponding asset. Conversely, the Bank of Italy would have a new asset - the BTP, but without a corresponding liability. In order to balance these Eurosystem accounts, the Bundesbank would accrue a Target2 asset vis-à-vis the ECB, while the Bank of Italy would accrue an equal and opposite Target2 liability (see Figure I-2). Figure I-2Italian Investor Sells A BTP To The Bank Of Italy And Deposits The Cash At Commerzbank Essentially, the Target2 imbalance captures the mismatch between a Bundesbank liability denominated in 'German' euros and a corresponding Bank of Italy asset denominated in 'Italian' euros. Aggregated over the whole euro area, these imbalances now amount to more than €1 trillion. Does any of this Eurosystem accounting gymnastics really matter? No, as long as the monetary union holds together and the 'German' euro equals the 'Italian' euro. But if Germany and Italy started using different currencies, then suddenly the Target2 imbalances would matter enormously. This is because the Bundesbank liability to Commerzbank would be redenominated into Deutschemarks, while the Bank of Italy asset would be redenominated into lira. Hence, the ECB might end up with much larger liabilities than assets. In which case, any shortfall would have to be borne by the ECB's shareholders - essentially, euro area member states pro-rata to GDP. The ECB Must Dial Down QE Unlike in the depths of the euro debt crisis, the current Target2 imbalances do not reflect deposit flight. Rather, they are the direct result of ECB QE. Nonetheless, the indisputable fact is that QE has increased the cost of euro break-up. And another six or more months of QE will just add to this cost. Some people might argue that by increasing the cost of a divorce, an actual split becomes less likely. But this reasoning is weak. As we have seen in this year's polling victories for Brexit and President-elect Trump, the biggest risk comes from a populist backlash against the status quo. And populist backlashes do not stop to do detailed cost benefit analysis. Although the ECB is unlikely to broadcast the unintended side-effects of its policy, it must be acutely aware that the costs of QE are rising while its benefits are diminishing. Given that the Target2 imbalances are directly related to the size of asset purchases, the ECB needs to indicate its intention to dial down QE purchases. And if it does need to loosen policy again in the future, it might be better off emulating the Bank of Japan - in targeting a yield rather than an asset purchase amount. The 6-9 month investment implication is that core euro area sovereign bonds offer poor relative value in the government bond universe. And within the core euro area, perhaps French OATs offer the least relative value. OATs are priced as haven sovereign bonds, yet interestingly Target2 imbalances suggest that banking liquidity flows do not regard France as a haven in the same way as Germany (Chart I-4 and Chart I-5). Chart I-4French OATs Are Priced ##br##As Haven Bonds... Chart I-5...But Banking Liquidity Flows Do Not ##br##Regard France As A Haven Another implication is that the euro should be stable or stronger against a basket of other developed economy currencies. Indeed, expect euro/pound to lurch up in the first half of next year when the U.K. government triggers Article 50 of the Lisbon Treaty to formally begin Brexit negotiations. Only then will the EU27 reveal its own negotiating strategy, and it is highly unlikely to be a sweet deal for the U.K. Italian Referendum Result: A Postscript The financial markets have shrugged off the Italian public's resounding "no" to constitutional reform, and rightly so. The current constitution, created in the aftermath of the Second World was designed to prevent a repeat of a populist like Benito Mussolini gaining power. Irrespective of whether the next General Election is in 2017 or 2018, the no vote actually reduces political tail-risk. A tactical position that is long Italian BTPs and short French OATs is now appropriate. As we discussed last week in Italy: Asking The Wrong Question the bigger issue is how Italy will unburden its banks of its non-performing loans (NPLs). Monte de Paschi's efforts at raising equity are baby steps in the right direction. But Monte de Paschi's €23 billion of sour loans2 are just the tip of Italy' NPL iceberg, which sizes up at €320 billion in gross terms and €170 billion net of provisions. These numbers, expressed as a share of GDP, show striking parallels with peak NPLs in Spain's banking system (Chart I-6 and Chart I-7). Spain ultimately unburdened its banks with a government bailout. Italy may have to do the same. But this will require Brussels to let Italy bend the EU's new bail-in rules for troubled and failing banks. Chart I-6Spain Unburdened Its Banks ##br##With A Government Bailout... Chart I-7...Italy May Ultimately##br## Do The Same The danger for investors is that Italian bank equity and bond holders might have to suffer more pain before Brussels relents. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Unicredit and all other commercial banks use their accounts at their NCLs to make interbank payments. 2 MPS NPLs amount to €45bn in gross terms and €23bn net of provisions. Fractal Trading Model* Bucking the synchronized sell-off in global bonds, Greek sovereign bonds have actually rallied strongly in the last three months. But this rally could be near exhaustion, warranting a countertrend position. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-8 * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch ##br##- Interest Rate Expectations Chart II-6Indicators To Watch##br## - Interest Rate Expectations Chart II-7Indicators To Watch ##br##- Interest Rate Expectations Chart II-8Indicators To Watch##br## - Interest Rate Expectations

Highlights Commodity prices and the dollar can occasionally rise together. The 1999-2001 and the 2005 experiences suggest a supply shock is required. If commodities were to rally alongside a strengthening dollar in 2017, this would be an oil-led move. Metals have very little potential upside as improving DM growth drains liquidity from EM economies. Favor petro currencies (CAD and NOK) relative to the antipodeans (AUD and NZD). Stay short AUD/CAD. USD/JPY is in a major bull market. However, near-term risks are to the downside. Feature It has become axiomatic among investors to assume that a dollar bull market is synonymous with a commodity bear market. While the relationships usually holds, there have been episodes where the narrow trade-weighted dollar and natural resource prices moved in tandem, not in opposite directions: 1982 to 1984, 1999 to 2001, and in 2005. The recent surge in base metals raises that possibility, but as DM economies suck in global liquidity away from EM ones, the prospect for a positive correlation between most commodities and the dollar is still remote. When Do Commodities And The Dollar Walk Together? Commodities and the dollar usually move in opposite direction. Since 1980, there has only been three episodes of consistent commodity strength despite dollar appreciation: 1982 to 1984, 1999 to 2001, and in 2005 (Chart I-1). What defines each of these episodes? 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 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 (Chart I-2). Chart I-1Commodities Can Rise ##br##Alongside The Dollar Chart I-2Early 1980s: U.S. Growth Was ##br##Able To Boost Metal Prices From 1999 to 2000, the rally in commodity was not broad based. In fact, it was concentrated in the energy sector (Chart I-3). It reflected three factors: After being decimated in 1997 and 1998, EM stock prices managed to stage a temporary rebound; one that mostly reflected bombed out equity and currency valuations. However, the muted response of non-oil commodities suggests that this rebound had little economic impact. Energy was buoyed by the vigorous growth in DM, with OECD oil consumption growing 1% annually between 1998 and 2001. Finally, as oil prices fell below US$10/bbl in late 1998 global oil production contracted sharply, plummeting by more than 4 million barrels, or 5% of total production. Not only could Saudi Arabia and Russia not withstand the pain of lower oil prices, but the latter was in the midst of a massive economic crisis that disrupted the local oil industry's ability to finance its operations. While most commodities in the 2005 episode experienced subtle upward drift, once again, energy was the true winner (Chart I-4). Supply disruptions in the Gulf of Mexico following the record-breaking 2004 and 2005 hurricane seasons contributed to removing slightly more than one million barrels from the market. Additionally, oil had captured investors' imagination, with the peak-oil theory being all the rage. This combination explains why oil was the primary beneficiary of Chinese and EM economic strength while base metals could not overcome the dollar's hurdle. Chart I-31999-2001: Commodity##br## Rally Was An Oil Rally Chart I-42005: Commodity##br## Rally Was An Oil Rally Bringing it all together, the dollar and commodities where able to rise as one in the 1980s because they responded to the same positive U.S. growth shock. However, during the 1999-2001 and 2005 commodity rallies in the face of strong dollar, the supply/demand imbalance in oil was paramount. Bottom Line: The dollar and commodity prices can occasionally move together. This happens when a supply shock affects a natural resource as important as oil, lifting its price despite the greenback hurdle. Outside of energy, in general prices still displayed little upside through these episodes. Giant Sucking Sound Our bullishness on the dollar is built on our positive outlook for U.S. growth and rates, a view only reinforced by Trump's electoral victory.1 This does not mean we expect the same boost to metal consumption that we saw in the early 1980s. Today, combined Japanese and U.S. copper consumption only accounts for 11% of global consumption. For iron ore, the U.S. represents only 4% of global consumption. Even if the U.S. were to spend $1trillion over five years on infrastructure (an extremely optimistic assumption), it will not constitute the same relative boost to global demand as the U.S. expansion during the 1980s did (Chart I-5). Additionally, metals will remain slightly oversupplied. In fact, inventories have been rising and more supply of iron ore is coming upstream in 2017, as additional Pilbara iron ore deposits are being unleashed on the markets. In the case of copper, our commodity specialists expect supply to continue to grow in the years ahead. But still, could EM lift the demand for metals enough to play the same role as the U.S. did in the early 1980s? We doubt it. When it comes to China, the current growth improvement is likely as good as it gets. The Keqiang index - a measure of industrial activity in the Middle Kingdom - is approaching post-2011 highs, but the demand for loans remains very depressed (Chart I-6). Moreover, the Chinese fiscal impulse - which has buoyed the country's economy for much of 2016 - has rolled over and is now in negative territory, suggesting that the Keqiang index will weaken in 2017. This will weigh on Chinese imports of machinery and raw materials, representing a deflationary shock for other EM. Chart I-5Metals Are About China, Not The U.S. Chart I-6China: The Best Is Behind Us At the current juncture, additional deflationary forces on EM would be an unwelcomed development. The structural headwinds plaguing EM economies are still in place. EM remain burdened by too much capacity, too much debt, and too little productivity (Chart I-7). More worryingly, strong DM growth will do very little to lift EM economies and assets out of their structural funk. Instead, DM strength is likely to hurt EM. As Chart I-8 shows, since 2009 improvements in DM leading economic indicators (LEIs) have led to falling EM LEIs. Chart I-7EM Structural Headwinds Chart I-8DM Hurting EM EM nations are not very dependent on DM as a source of growth. Intra EM trade has been responsible for most of the growth in EM exports as shipments to the DM economies and the U.S. now account for only 28% and 15% of EM total exports, respectively. While this explains why DM growth cannot lift EM growth, it still does not explain why DM growth leads to deteriorating EM activity. The glue binding this paradox is global liquidity. In a nutshell, when DM growth improves, DM economies suck in global liquidity, which results in a tightening of EM monetary and financial conditions. This combined constriction acts as a large brake on EM growth. Underpinning the relationship between liquidity and growth are a few relationships: First, DM real rates are a relatively clean measure of growth expectations. As Chart I-9 shows, U.S. real yields and the growth expectations embedded in U.S. stocks prices correlate closely with each other. Second, when DM real yields rise, EM reserve accumulation - a measure of high-powered liquidity - moves into reverse (Chart I-10). This suggests that rising DM real yields prompt investors to abandon EM markets, attracted by improving risk-adjusted returns in DM. Chart I-9Real Interest Rates: ##br##A Read On Expected Growth Chart I-10The Liquidity ##br##Channel Third, rising DM rates puts downward pressure on EM FX (Chart 10, bottom panel). Being associated with a reversal of carry trades this is another indication that capital is leaving EM economies. Additionally, falling EM exchange rates tighten EM financial conditions by hampering the financial viability of EM borrowers with foreign currency debt. Fourth, given that the exogenously-driven fall in liquidity already hurts EM growth, rising EM borrowing costs in response to increasing DM real rates amplify the economic drag. By causing the return on EM bonds to fall (Chart I-11), this generates further outflows from EM, and also tightens EM financial conditions. Finally, rising DM yields have been associated with underperforming EM equities relative to DM equities (Chart I-12), giving investors another reason to pull money out of EM. These dynamics have implications for commodity currencies. BCA's view is that DM real yields have upside from here, and therefore EM liquidity and financial conditions are set to tighten. Not only will this hurt EM assets, but a flattening BRICs yield curve should also lead to falling commodity currencies (Chart I-13). Chart I-11The Financial ##br##Channel Chart I-12EM/DM Stocks: A Function ##br##Of DM Real Rates Chart I-13Tightening EM Liquidity Conditions##br## Hurt Commodity Currencies However, differentiation is needed. Tightening EM liquidity and financial conditions are likely to hurt the metal market where there is no broad-based supply deficit. However, like in the late 1990s, oil could actually do well under a strong dollar scenario. For one, the OECD and the U.S. represent much larger shares of oil demand than they do for industrial metals (Chart I-14). In the context of robust U.S. economic growth and consumer spending, we could see continued upward momentum in global oil demand. This is crucial as the oil market is already in a deficit following the collapse in oil capex in 2015 and 2016 (Chart I-15). Additionally, our Commodity and Energy Strategy team argues that OPEC and Russia are very likely to cut production next week. Economic strains and the desire for asset sales in Saudi Arabia and Russia are creating the needed incentives.2 In this environment, oil currencies (CAD and NOK) should outperform antipodeans (AUD and NZD). The outlook for the AUD is the poorest. It is the currency most exposed to metals, the segment of the commodity market most aligned with EM growth. NZD could be at risk too. While it is not exposed to metals like the AUD, the kiwi is very exposed to EM spreads, a variable that is likely to suffer if DM yields continue to rise.3 Buying a basket of CAD and NOK relative to AUD and NZD makes sense here. In terms of our trades, we shorted AUD/CAD too early. However, the economic backdrop described above suggests that the economic rationale for this trade is growing ever more potent. In fact, from late December 1998 to January 2000, CAD rallied against the USD, while the AUD was flat. Additionally, technicals and positioning point to a favorable entry point at the current juncture (Chart I-16). Chart I-14Oil Is Still About The U.S. Chart I-15Favorable Supply/Demand Backdrop For Oil Chart I-16A Good Entry Point For Shorting AUD/CAD Bottom Line: In 2017, the relationship between commodity prices and the dollar is likely to resemble the 1999-2001 outcome. While tightening EM liquidity conditions could weigh on metals, supply concerns and a strong U.S. economy could lift oil prices. This environment would favor the CAD and the NOK relative to the AUD and the NZD. A Countertrend Bounce In The Yen? As we discussed last week, the move in USD/JPY makes sense based on the BoJ policy dynamics we analyzed in our September 23 report titled "How Do You Say "Whatever It Takes" In Japanese?". However, despite our bearish disposition toward the yen, we worry that a countertrend correction in USD/JPY is in the offing. USD/JPY is approaching a formidable resistance. The tell-tale sign of a USD/JPY bull market has been when the pair moves above its 100-week moving average (Chart I-17). We do expect such a move to ultimately materialize. However, with the 100-week MA currently at 114.8, this key indicator is a stone throw away from the present exchange rate of 113.39 and might prove to be a temporary resistance. Additionally, a congestion zone exists between 113 and 114.5, reinforcing this risk. Increasing the danger at the 114 level is the recent high degree of groupthink behavior displayed by this pair. As was the case for the U.S. bonds, the fractal dimension measure for USD/JPY is now below 1.25, highlighting the risk of a countertrend move (Chart I-18). Chart I-17USD/JPY: Key Resistance In Sight Chart I-18A Countertrend Move In USD/JPY Moreover, we agree with our U.S. Bond Strategy service and expect a pause in the U.S. bond sell-off.4 With the tight relationship between USD/JPY and 10-year Treasury yields fully alive, any rebound in bond prices would imply a rebound in the yen. Finally, our intermediate-term timing indicator shows that USD/JPY is 5% overvalued on a tactical time frame, a level where the likelihood of a temporary reversal is heightened. Based on the above observations, today we are opening a tactical short USD/JPY position at 113.39, with a target of 107 and a stop at 115.2. We are also closing our long NOK/JPY trade at a profit of 5.3%. Bottom Line: While the cyclical outlook for USD/JPY continues to point upward, tactically, USD/JPY is facing some downside risk. We are implementing a tactical short USD/JPY trade with a target at 107 and closing our long NOK/JPY trade. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, "Dollar: The Great Redistributor", dated October 7, 2016, and Foreign Exchange Strategy Weekly Report, "Reaganomics 2.0?", dated November 11, 2016, available at fes.bcaresearch.com 2 Please see Commodity & Energy Strategy Weekly Report, "The OPEC Debate", dated November 24, 2016, available atces.bcaresearch.com 3 Please see Foreign Exchange Strategy Special Report, "Global Perspective On Currencies: A PCA Approach For The FX Market", dated September 16, 2016, available at fes.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, "Toward A Cyclical Sweet Spot?", dated November 22, 2016, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 The dollar has crossed a crucial resistance level, and the DXY is now trading close to 102. Positive data this month have contributed to this rally. Durable goods orders came in at 4.8% for October, up from 0.4% in September. This has lifted manufacturing PMI for November to 53.9, showing strength in the supply side of the U.S. economy. Minutes from the November 1-2 FOMC meeting indicate a clear hawkish consensus for December's meeting. A probability of a hike is now fully priced in and is reflected in the almost 14-year high reached by the DXY following the release of the minutes. We should see some stability in the DXY coming up to the December meeting. Otherwise, the U.S. economy seems strong. Upcoming data should ultimately buoy the strength in the dollar, but short-term movements will be limited. Report Links: One Trade To Rule Them All - November 18, 2016 Reaganomics 2.0? - November 11, 2016 When You Come To A Fork In The Road, Take It - November 4, 2016 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Draghi remains resolute in his commitment to reach the inflation target. Easy monetary policy has helped support recent growth in the euro area. Low policy rates have increased credit supply, leading to higher lending volumes to households, NFCs and SMEs. Key indicators, such as this month's composite PMI which went up to 53.7, from 53.3, highlight continued decent growth in Europe. Nevertheless, core inflation remains weak at 0.75%, which entails a high likelihood for easy policy going forward. Persistently low rates and structural weaknesses will continue to weigh on bank profitability. Banks may eventually respond by limiting credit growth in the future and hampering overall activity. The short-run outlook for the Euro still remains solid against crosses. EUR/USD has hit a support level, but momentum indicates strong downward pressure against the dollar, so attention to this resistance level is warranted. 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-5JPY Technicals 1 Chart II-6JPY Technicals 2 USD/JPY has appreciated by more than 7% since the day Donald Trump was elected president. From 1990 up until the day Trump got elected, the yen depreciated at such a high rate in such a short time frame in only 4 occasions. We are taking a tactical short position in USD/JPY, because although we continue to be yen bears on a cyclical basis, the current sell-off seems overdone. USD/JPY has reached highly overbought technical levels and it is near its 100-week moving average of 114.8, which should act as a temporary resistance. More importantly, the sell-off in U.S. bond yields, a major driver of the recent plunge in the yen is likely to pause for the time being. USD/JPY will once again become an attractive buy at around 107. 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 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 On Wednesday the Treasury released its Autumn Statement, outlining fiscal policy for the coming year. Philip Hammond, Chancellor of the Exchequer, offered no surprises as he vouched to continue to rebalance the budget, albeit at a slower pace. The fiscal impulse looks to increase slightly, yet stay negative for the next 4 years. Such a hawkish fiscal stance should be a drag on growth in an economy that cannot afford any setbacks as it prepares to exit the European Union. However, despite this grim outlook we are still monitoring the pound as an attractive buy, given that it is very cheap. In fact GBP/USD had very little movement after the announcement, which suggests that much of the risks for the U.K's economic outlook are already priced into the cable. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 The Australian economy continues to encounter structural weaknesses from a deteriorating mining sector, for which the outlook remains pessimistic. An interesting observation is that the mining investment-cut is considerably mature, as RBA Assistant Governor Christopher Kent states "about 80% of the adjustment" is done. However, weak Asian EM fundamentals and a questionable outlook for China imply impending demand-side problems, which will weigh, not only on Australian terms of trade, but also the Australian economy, as emerging Asia represents 66% of Australia's total exports. An additional hurdle for the terms of trade is a rising USD, which could drag down commodity prices and the AUD. In the short run, the MACD line for AUD/USD also points to downside in the near future, as the currency approaches a possible resistance level at 0.72. 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-11NZD Technicals 1 Chart II-12NZD Technicals 2 We continue to hold a bearish stance towards NZD/USD, as the dollar bull market and weakness in Asian currencies will ultimately weigh on the kiwi. However, the outlook for the NZD against other commodity producers is not as clear. Prices for dairy products, which constitute over 30% of New Zealand exports, have skyrocketed and are now growing at 46% YoY. This trend is set to continue in the short term, as Chinese dairy imports continue to rebound, recording a 9.7% growth rate compared to last year. Furthermore, real GDP is growing at a 3.5% pace, the highest in the G10. That being said, we are reticent to be too bullish on this currency, as inflation remains very low and increasing migration is putting a lid on wages. However if inflation picks up, the NZD could become attractive relative to its commodity peers. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 The Fed is Trapped Under Ice - September 9, 2016 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data has come out below expectations: Core CPI came in at 1.7%. Wholesale sales are contracting at -1.2%. Retail sales excluding autos are at 0%. These figures support the view that there is an underlying weakness in the Canadian economy which will keep the BoC from reaching its inflation target. However, as the U.S. continues to be the largest consumer of oil in the world, with around 20% of global consumption, stronger U.S. growth will support oil demand, which in conjunction with tighter supply, will support oil prices. This will support the CAD against other commodity producing currencies. Structural weaknesses and an upward trend in USD/CAD since May suggest that the CAD could experience more downside momentum against USD. Nevertheless, it is important to monitor next week's OPEC meeting, the outcome of which will dictate the CAD. 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-15CHF Technicals 1 Chart II-16CHF Technicals 2 The decline in EUR/CHF appears to have subsided for the time being. Last week we mentioned that the SNB would not tolerate much more downside on this cross, and would not be shy to intervene if necessary. This view has shown to be valid, as EUR/CHF has found support around 1.07. This floor imposed by the SNB means that the performance of the franc against the dollar should mirror EUR/USD for the time being. This implies that USD/CHF should have limited upside in the short term, as EUR/USD has hit a major support level around 1.05 that has been in place for the last 2 years. On a cyclical basis, monetary divergences should continue to weigh against the euro, which makes us bullish on USD/CHF on this time frame. Report Links: Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Global Perspective On Currencies: A PCA Approach For The FX Market - September 16, 2016 Clashing Forces - July 29, 2016 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 The U.S. continues to be world's largest consumer of crude oil, with 20% of total consumption, while China leads in both the copper and nickel markets, accounting for nearly half of global consumption and consuming over 5 times as much as the U.S. in both markets. This divergence implies that if U.S. outperforms the rest of the world, and if the rising dollar continues to weigh on EM economies, oil should outperform base metals in the commodity space and consequently petro currencies like the NOK should outperform other commodity currencies. Additionally the NOK is supported by a current account surplus of 6%, and high inflation is prompting Norges Bank to back off from its dovish stance. While we like the NOK on its crosses, we are more bearish on the NOK versus the USD, as USD/NOK remains very sensitive to the dollar. Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 The Dollar: The Great Redistributor - October 7, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 The Swedish economy continues to show signs of strength. Recent data supports this view: Consumer confidence for November is at 105.8, compared to 104.8 for October. Producer Price Index came in at 2.2% annually for October. A strong consumer sector has lifted inflation expectations in Sweden. Strong PPI numbers validate this, as they foretell a potential rise in CPI as producers pass on their costs to consumers. Despite this strength, SEK may see limited upside. As mentioned last week, most of the movement in the SEK can be attributed to the USD. Rate hike expectations have now been fully priced in for the Fed, so it is likely that movements in the USD will be muted, and hence the SEK could find some support, at least for now. 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 Trump's Win: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. Trump Stimulus & The Yield Curve: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Feature Chart of the WeekTrump Turmoil For Bonds America has been treated to a pair of major shocking events over the past couple of weeks. The Chicago Cubs won baseball's World Series for the first time in 108 years. And now, Donald Trump - real estate tycoon, reality TV star, Twitter addict - has become the 45th President of the United States. In the aftermath of that stunning election victory, investors are being treated to one more shocker that seemed impossible even just a few months ago - rapidly rising bond yields. Trump's victory has not only changed the political power structure in the U.S., but has seemingly altered many of the familiar financial market narratives as well. The idea of "deficit spending" by the government to boost growth has not been heard for many years in Washington, but Trump has made it clear that a big fiscal stimulus is coming soon to America. He has laid out a combination of large tax cuts and infrastructure spending that could result in both a surge in U.S. Treasury issuance in the coming years and a more structural rise in inflation - again, developments that have not been seen in the U.S. in quite a while. The prospect of fiscal easing amid still-accommodative monetary conditions in the U.S., with the economy running at full employment, has sent Treasury yields surging back to pre-Brexit levels, wiping out six months of positive bond returns in the process (Chart of the Week). While many details are still to be worked out with regards to Trump's proposed fiscal policy shift, the markets have taken its pro-business tilt as a bullish sign for growth and a bearish sign for bonds. There is more scope for yields to rise in the near term, in the U.S. and elsewhere, with the Fed likely to deliver another rate hike next month and the global economy now in a cyclical upswing. Duration risk remains the biggest immediate threat for bond investors, and we continue to recommend a below-benchmark portfolio duration stance. A New Sheriff In Washington Chart 2Markets Cheer Trump 'Bigly' The consensus opinion among investors going into the U.S. election was that a Trump victory would result in considerable market turmoil. This was a reasonable argument, as Trump ran a disruptive, anti-status-quo campaign that, by definition, would be expected to generate far more changes and uncertainty than a victory by Hillary Clinton. Yet outside of a few shaky moments in the wee hours of Election Night as markets began to realize that Trump would win, the big bond-bullish/equity-bearish risk-off moment never arrived. Perhaps Trump's more conciliatory tone in his victory speech helped to calm investors' fears that his caustic campaign demeanor would continue in the White House. More likely, investors saw the results in the U.S. Congressional elections and realized that the Republican Party had won a clean sweep in D.C. that would allow Trump to implement many of his campaign promises. Markets have been rapidly pricing the potential implications of a Trump presidency into many financial assets (Chart 2), from bank stocks (which would gain from Trump's proposed rollback of the Dodd-Frank regulations on bank activities and, more importantly, from the impact of higher bond yields and a steeper yield curve on profitability) to the U.S. dollar (which would benefit from Trump's protectionist trade agenda through narrower U.S. trade deficits and stronger U.S. growth that would raise the future trajectory of U.S. interest rates). Higher-quality USD-denominated credit spreads have been surprisingly well behaved, given the moves higher in U.S. yields and the USD itself. This may reflect an optimistic belief that Trump's pro-business, pro-growth policies can offset the negative impact on corporate profits from higher yields and a stronger USD. Markets are right to assume that Trump can actually deliver on his economic agenda. A detailed analysis of the implications of the Trump victory was laid in a Special Report sent last week to all BCA clients by our colleagues at BCA Geopolitical Strategy.1 One of their main conclusions was that Trump's ability to enact his plans will not be hindered much by the U.S. Congress. Republicans now control both the House of Representatives and Senate after last week's elections and Trump has been strongly supported even by the small government fiscal conservatives in Congress. After delivering such a stunning victory for the Republicans, Trump shouldn't face much serious resistance to his economic initiatives. Investors are starting to price in the potential inflationary implications of a President Trump, with the 5-year inflation breakeven, 5-years forward from the U.S. TIPS market now sitting at 1.84%. This is still well below the Fed's 2% inflation target (after adjusting for the usual historical difference between the CPI used to price TIPS and the Fed's preferred inflation gauge, the PCE deflator, which is around 0.4-0.5%). This measure can keep moving higher over the medium-term, given the timing of Trump's proposed fiscal stimulus. Bottom Line: The Republican sweep of both the White House and Congress in the U.S. elections will allow President-elect Donald Trump to implement much of his planned policies, including a major fiscal stimulus package. The 1980s Called - They Want Their Economic Policy Back The U.S. economy is now showing few internal imbalances that would require wider government deficits as a counter-cyclical policy measure. The private sector savings/investment balance is close to zero, as the post-crisis household deleveraging phase has ended and corporate sector borrowing has skyrocketed in recent years (Chart 3, top panel). Also, measures of spare capacity in the U.S. economy like the output gap or the unemployment gap are also near zero (bottom panel), suggesting that any pickup in aggregate demand from current levels could trigger a rise in wage inflation and domestically-focused core inflation. Chart 3Deficit Spending At Full Employment: Back To The Future? The last time that such a combination of fiscal stimulus and full employment occurred was in the mid-1980s during the presidency of Ronald Reagan. Trump's plans for aggressive tax cuts and sharp increases in discretionary government spending do echo the policies of Reagan, who presided over one of the nation's largest peacetime run-ups in discretionary government budget deficits and debt (Chart 4). Perhaps there was a kernel of truth in the Trump/Reagan comparisons made during the election campaign! Chart 4Less Fiscal Space Than In The 1980s Clearly, a sharp run-up in federal budget deficits could have a much greater impact on longer-term interest rates and the shape of the yield curve, given the much higher starting point for federal debt/GDP now (74%) compared to the beginning of the Reagan presidency (26%). Especially given the potentially large budget deficits implied by Trump's campaign promises. Back in June, Moody's undertook an economic analysis of Trump's economic policies based on publically available information (i.e. Trump's campaign website) and their own assumptions based on Trump's campaign speeches.2 Moody's ran policies through its own U.S. economic model, which is similar to the forecasting and policy analysis models used by the Fed and the U.S. Congressional Budget Office. This model allows feedback from fiscal policy changes to the expected swings in growth and inflation and the likely shifts in monetary policy. The Moody's analysts used a variety of scenarios, ranging from full implementation of Trump's proposals3 to a heavily watered-down version if he faced a hostile Congress (which is clearly not the case now). We show the Moody's model forecasts for the U.S. Federal budget deficit as a percentage of GDP in Chart 5, along with the slope of the very long end of the U.S. Treasury curve. We also show the 10-year/30-year slope versus a measure of the Fed's policy stance, the real fed funds rate. According to Moody's, a full implementation of the Trump platform would push the U.S. budget deficit to double-digit levels by 2020, and would add nearly $7 trillion in debt over that time, pushing the federal debt/GDP ratio to 100%. The less extreme scenarios show smaller increases in deficits and debt, but the main point is that even if Trump implements only some fraction of his policies, the U.S. budget deficit will go up significantly during his first term in office. Looking at the historic relationship between the deficit and the slope of the Treasury yield curve, this implies that Trump's policies should put steepening pressures on the long-end of the curve as the bond market prices in greater Treasury issuance and higher future inflation rates. Of course, the bottom panel of Chart 5 shows that Fed policy also matters for the shape of the curve, and this is where the current debate over the Fed's next moves comes into play. Chart 5Trump's Deficits Will Steepen The Curve (Fed Permitting) The market is currently discounting a 70% probability that the Fed will hike at the December FOMC meeting, which has been our call for the past few months. The Fed has been projecting an increase next month and another 50bps of hikes in 2017, but these were forecasts made in the BT (Before Trump) era. The pricing from the Overnight Index Swap (OIS) curve shows that the market's expectations have started to shift upward towards the Fed's forecasts, in contrast to the BT dynamic where the Fed was having to cut its forecasts down towards the lower levels implied by the market (Chart 6). Will the Fed now look at the fiscal stimulus proposed by Trump as a reason to hike rates higher, or faster, than their latest set of projections? A big fiscal stimulus at full employment would certainly give the FOMC cover to raise its forecasts for growth and inflation, which would require a shift upwards in its interest rate projections. We do not expect that outcome at next month's FOMC meeting, as the Fed would likely want to see more specific budget details from the Trump administration in the New Year. More importantly, the Fed will want to avoid any additional strength in the U.S. dollar by moving to a more hawkish stance too soon, which would turn the dollar once again into a drag on U.S. growth, inflation and corporate profits, potentially disrupting financial markets. With the Fed unlikely to become more hawkish in the near term, the Treasury market will remain focused on the fiscal implications of Trump, placing bear-steepening pressures on the Treasury curve. For that reason, we are exiting our current Treasury curve flattener positions (2-year vs 10-year, 10-year vs 30-year) this week and moving to a neutral curve posture. We continue to maintain a below-benchmark stance on overall portfolio duration, as well as an underweight bias toward U.S. Treasuries within the developed market bond universe (on a currency-hedged basis). Treasuries are still not cheap, despite the recent run-up in yields, according to our global PMI model which incorporates variables for growth, U.S. dollar sentiment and policy uncertainty (Chart 7). Fair value has risen to 2.25% on the back of improving global growth and reduced uncertainty post-Brexit, with rising dollar bullishness providing a downward offset. Chart 6Markets Moving UP To The Fed Forecasts Chart 7USTs Not Yet Cheap If the Fed were to move too quickly to a more hawkish stance, dollar bullishness would increase and limit the cyclical rise in yields. At the same time, greater policy uncertainty under a new President could also limit yield increases although, as we have laid out above, the nature of the Trump uncertainty is not bond-bullish if it results in rising levels of government debt. For now, it is best to maintain a cautious investment stance until there is greater clarity on the U.S. policy front, while being aware that Treasuries are no longer as sharply undervalued as they were just a week ago. Looking ahead, this bond bear phase could end if the ECB announces an extension of its bond-buying program beyond the March 2017 deadline. As we discussed in a recent Weekly Report, the ECB will not be able to credibly declare that European inflation will soon return to the 2% target.4 This will force the ECB to extend the bond buying for at least another six months, with some changes to the rules of the program to allow for smoother implementation of future purchases. If, however, the ECB does indeed announce a tapering of bond purchases starting in March, bond yields will reprice higher within the main developed bond markets, led by rising term premiums (Chart 8). Given the global bond market's current worries about the inflationary implications of a switch away from extremely accommodative monetary policy to greater fiscal stimulus, a spike in yields related to a less-accommodative ECB could turn nasty fairly quickly. Chart 8A Dovish ECB Will Prevent A Deeper Global Bond Rout Bottom Line: Trump's proposed aggressive fiscal stimulus package will continue to put bear-steepening pressure on the U.S. Treasury curve. However, the future direction of global bond yields will be more influenced by the upcoming monetary policy decisions in the U.S. & Europe. Maintain a below-benchmark overall duration stance, while exiting curve flattening positions in the U.S. U.S. High-Yield: More Growth, Fewer Defaults In recent discussions with clients, many have asked whether the implications of Trump's pro-growth policies, coming at a time of a cyclical upturn in the U.S. economy and inflation, should provide a boost to corporate profits that will, by extension, reduce the default risk in U.S. high-yield bonds. Chart 9Higher Nominal Growth Is Good For Junk (During Expansions) Chart 10High-Yield Valuations Have Improved Slightly It is a valid question to ask, as the excess returns on U.S. junk bonds have been historically been higher during expansions when nominal GDP growth (currently 2.8%) has been 4% or greater (Chart 9).5 With real U.S. GDP growth likely to expand by at least 2.5% in 2017, with moderately higher inflation, nominal growth should accelerate to a pace that has historically been friendlier for junk returns. Chart 11Corporate Balance Sheets Are Still A Problem Of course, the state of the corporate leverage cycle matters too, and that remains the biggest problem for high-yield. We have been maintaining an extremely cautious stance on U.S. junk bonds over the past few months, as a combination of highly-levered balance sheets and unattractive valuations led us to expect an underwhelming return performance from junk, especially with a volatility-inducing Fed rate hike likely to occur by year-end. That has not been case, however, as junk spreads declined steadily as the summer turned to autumn and have been relatively stable during the U.S. election uncertainty. Our colleagues at our sister publication, BCA U.S. Bond Strategy, recently introduced a simple model to predict junk bond excess returns as a function of lagged junk spreads and realized default losses.6 That model had been predicting excess returns over the next year of close to zero, but at today's spread levels the expected excess return over duration-matched U.S. Treasuries during the next year is closer to 157bps (Chart 10). While this is not the usual return that investors expect from an allocation to high-yield, it is better than the previous model prediction. Given this slightly more attractive level of spreads, a bond market now more prepared for a Fed rate hike, and with the default risks potentially narrowing somewhat on the back of a better nominal growth outlook for 2017, we no longer see the case for a maximum underweight position in high-yield. We still have our concerns about the state of the corporate credit cycle, and the valuations have not improved enough to justify a move back to neutral (Chart 11). Thus, we are only moving our U.S. high-yield allocation to below-benchmark (2 of 5) from maximum underweight (1 of 5). We are maintaining our below-benchmark stance on Euro Area and Emerging Market high-yield within our model portfolio, in line with our stance on U.S. junk. Bottom Line: U.S. junk bond valuations have improved slightly in recent weeks, especially in light of an improving U.S. nominal growth outlook for 2017 that will reduce default risk to some degree. Upgrade U.S. high-yield allocations to below-benchmark (2 of 5) from maximum underweight. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: Outcomes & Investment Implications", dated November 9, 2016, available at gps.bcaresearch.com. 2 https://www.economy.com/mark-zandi/documents/2016-06-17-Trumps-Economic-Policies.pdf 3 Aggressive income tax cuts, no changes to entitlement spending, increased defense outlays, and even the more controversial protectionist promises such as a 46% tariff on Chinese imports and the deportation of 11 million undocumented immigrant workers. 4 Please see BCA Global Fixed Income Strategy Weekly Report, "The ECB's Next Move: Extend & Pretend", dated October 25, 2016, available at gfis.bcaresearch.com. 5 Excess returns are the highest during low growth or recession periods, as this is when credit spreads are at their widest and companies are deleveraging and actively acting to reduce default risks. That is not the case at the moment. 6 Please see BCA U.S. Bond Strategy Special Report, "Don't Chase The Rally In Junk", dated November 1, 2016, available at usbs.bcaresearch.com. The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Most narratives surrounding G7 bond yields, the U.S. dollar, Chinese credit/fiscal impulses, and the RMB exchange rate - which justified the EM rally from February's lows - have been overturned. To be consistent, this warrants a relapse in EM risk assets. In China, recent property market and marginal credit policy tightening will weigh on growth. Feature The more recent strength in Chinese and emerging markets' (EM) manufacturing PMI indexes as well as the bounce in industrial metals prices have gone against our negative view on EM/China growth and related markets. While it is hard to predict market patterns over the next several weeks, we maintain that the EM rally is on borrowed time, and that the risk-reward profile for EM risk assets (stocks, credit markets and currencies) remains very unfavorable. Tracking Correlations And Indicators The overwhelming majority of indicators and variables that supported the rally in EM since February have reversed in recent months. Specifically: China's credit and fiscal spending impulses have rolled over (Charts I-1 and Chart I-2, on page 1). This will likely lead to a rollover in mainland industrial activity early next year (Chart 1, top panel). Similarly, this bodes ill for much-followed Chinese ex-factory producer prices - i.e., producer price deflation will probably recommence early next year (Chart I-1, bottom panel). Chart I-1China: Industrial Sectors To Retreat? Chart I-2China: Credit And Fiscal Impulses In a nutshell, the strong credit and fiscal impulses of late 2015 and early 2016 explain the stabilization and mild improvement in the Chinese economy during the past few months. However, these same impulses project renewed weakness/rollover in the economy in early 2017. If financial markets are forward looking, they should begin pricing-in deteriorating growth momentum sooner than later - especially as Chinese policymakers are announcing marginal tightening policies (see below for more details). One of the narratives that triggered the EM and global equity rally in February was speculation that there was a "Shanghai accord" between global central banks. According to this narrative, the People's Bank of China (PBoC) promised not to devalue the RMB in exchange for the Federal Reserve not hiking rates. Since then, the RMB has continued to depreciate, both versus the greenback and the CFETS1 basket. Yet EM and global stocks have completely disregarded the RMB depreciation (Chart I-3). We do not have good explanation as to why. Indeed, the RMB has weakened meaningfully, despite the PBoC's massive currency defense: the latter's foreign exchange reserves have shrunk further since then (Chart I-4), as capital flight has exceeded the enormous current account surplus by a large margin. Chart I-3Investors Are ##br##Complacent About RMB Chart I-4China: Foreign Exchange ##br##Reserves Still Shrinking Chart I-5PBoC Liquidity Injections ##br##Have Been Enormous The PBoC's selling of U.S. dollars to prop up the yuan has drained domestic currency liquidity and one would expect interbank rates to rise. However, the PBoC has been re-injecting RMBs into the system to keep interest rates low (Chart I-5). Such RMB liquidity proliferation makes further declines in the currency's value all the more likely. We expect the RMB to continue depreciating. Yet global financial markets have become extremely complacent about the potential for additional RMB depreciation. After having been bullish on U.S./G7 bonds for the past several years, in our July 13 Weekly Report,2 we highlighted that U.S./G7 bond yields would rise and closed our strategic short EM equities/long 30-year U.S. Treasurys position. Even though U.S./G7 bond yields have risen since July, EM equities have not declined. Given that falling G7 bond yields were used as justification for the EM rally, the opposite should also hold true. We expect U.S. bond yields to rise further. Our EM Corporate Health Monitor - constructed using bottom-up financial variables of companies with outstanding U.S. dollar corporate bonds - points to a reversal in the EM corporate credit market rally (Chart I-6). Furthermore, EM sovereign and corporate credit spreads have tightened considerably and are now very overbought and expensive. As we argued in our Special Report titled EM Corporate Health Is Flashing Red3 that introduced the EM Corporate Financial Health (CFH) Monitor, EM corporate credit spreads are as expensive as they were before they began widening in 2013 and 2014 (Chart I-7). Chart I-6EM Corporate Bond Rally To Reverse? Chart I-7EM Corporate Spreads Are Too Tight Finally, the U.S. dollar sold off early this year, but it has held firm in recent months. Nevertheless, EM risk assets have not retreated, despite the greenback's strength (Chart I-8). Few would argue that sharp U.S. dollar appreciation is negative for EM risk assets, but there is a debate among investors and analysts about whether EM risk assets can rally amidst a gradual appreciation in the U.S. dollar. Turning to the empirical evidence, Chart I-9 reveals that in the past 30 years any U.S. dollar appreciation - whether gradual or not - even versus DM currencies has coincided with weakness in EM share prices. Chart I-8EM Investors Have ##br##Ignored U.S. Dollar Strength Chart I-9EM Equities And ##br##U.S. Dollar: A 30 Year History Bottom Line: The majority of narratives that justified the EM rally from February's lows have been overturned. To be consistent, this warrants a relapse in EM risk assets. China's Credit And Property Tightening In recent weeks, there have been numerous policy tightening efforts in China. In particular: At the annual World Bank/IMF meetings in Washington last month, PBoC Governor Zhou Xiaochuan stated that once markets stabilized there would no longer be additional large increases in bank credit. His exact words were: "With the gradual recovery of the global economy, China will control its credit growth".4 As U.S. and European PMIs have firmed up and U.S. employment and wage growth is robust, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not to 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 on October 255 that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Marco Prudential Assessment ratios, starting from the third quarter. The clampdown on WMP accounting will reduce banks' capital adequacy ratios (CARs). One key reason that banks had aggressively boosted the size of their off-balance-sheet WMP assets was that they were not required to have capital charges against them, helping banks extend more credit while complying with CARs. In short, Chinese banks' CARs are inflated. This policy measure along with provisioning and writing-off non-performing loans, if reinforced, could meaningfully reduce the CARs of all Chinese banks, especially small- and medium-sized ones, as well as force them to reduce the pace of credit expansion. Given that the majority of medium and small banks have been more aggressive than the country's five biggest banks in expanding credit in recent years, this may have a damping effect on credit growth in 2017. In fact, the 110 medium and small banks retain 60% of on- and off-balance-sheet credit claims on companies, while the five largest banks hold 40% (Table I-1). Hence, credit trends in small and medium banks are at least as important as those among large banks. Table I-1China: Five Largest Banks Hold Only 40% Of Credit Assets Finally, a number of cities have announced various tightening measures on property markets of late, including the re-launch of house purchasing restrictions and increases in minimum down payments. Similar restrictions on home purchases served as an efficient tool for curbing property purchases in 2013-14, and there is no reason why it will be different this time around. This is especially true given the market is more expensive than it was back in 2013. In addition, the government has curbed financing for property developers. The biggest economic risk remains construction activity. Even though housing sales and prices have skyrocketed by 20-40% in the past 12 months (Chart I-10, top and middle panels), residential floor space started has been very timid - it has in fact failed to recover (Chart I-10, bottom panel). As residential property sales contract again due to new purchasing restrictions, property developers will certainly curtail new investment, and housing construction activity will shrink anew. The same is true for commercial properties (Chart I-11). Chart I-10China's Residential Market: ##br##Demand, Prices And Starts Chart I-11China's Non-Residential ##br##Market: Demand And Starts An interesting question is why property starts have been so weak, as indicated in the bottom panels of Chart I-10 and Chart I-11 - particularly when both floor space sold (units) and property prices have surged exponentially in the past 12 months. Our view is that there is a large hidden inventory overhang in the Chinese property market. For example, government data on residential floor space started, completed and under construction attest that there is still a large gap between floor space started versus completed (Chart I-12). From these data/charts and the enormous leverage carried by property developers, we infer the latter have been accumulating / carrying on their balance sheets vast amounts of inventory in excess of what market-based sources suggest, and what is widely followed by analysts. It is very hard to make sense of the Chinese property inventory data, but we suspect these market-based data sources may track only inventories that have been completed and released to the market - and do not account for inventories classified as "under construction". For residential housing, according to government data the "under construction floor space" is 5 billion square meters (Chart I-13, top panel), which is equal to 3.5-4 years of sales at the fervent pace of the past 12 months (Chart I-13, bottom panel). Another way to assess this is as follows: Assuming an average construction cycle of three years, there will be supply of new housing in amounts of 16.7 units in each of the next three years. This compares with sales of 13.3 million units in the past 12 months that occurred amid a buying frenzy and booming mortgage lending. Faced with a potential drop in sales due to the recent purchasing restrictions, elevated inventories, enormous leverage (Chart I-14), and tighter financing, property developers will most likely curtail new starts. In turn, a reduction in property starts means less construction activity next year, and weak demand for commodities. Consistent with the rollover in the fiscal spending impulse, infrastructure spending will likely also lose its potency in early 2017. Chart I-12China's Residential ##br##Market: Hidden Inventories Chart I-13Chinese Real Estate: Massive ##br##Volumes Under Construction Chart I-14Leverage Of Chinese ##br##Listed Property Developers Bottom Line: Recent property market and marginal credit policy tightening will weigh on construction activity and depress Chinese demand for commodities and industrial goods next year. Confirmation Bias, Or Bias Based On Fundamentals? Why did we not follow the indicators discussed above from February through June, when the EM rally emerged and these indicators bottomed? Do we have a confirmation bias? We did not recommend playing the EM rebound early this year because we did not believe the rally would last this long or go this far. If we had had conviction about the duration and magnitude of the rally, we would have changed our strategy - tactically upgrading EM risk assets despite our negative structural and cyclical views. Simply put, we were wrong on strategy. In our April 13, 2016 Weekly Report,6 we argued that based on China's injection of massive amounts of fiscal and credit stimulus, growth would marginally improve in the months ahead. Yet, we stopped short of recommending chasing the EM rally given the menace of numerous cyclical and structural negatives surrounding the EM/China growth outlook. As to the reasons why we put more emphasis on some indicators and less on others at various times, we have the following points: We are biased in so far as our assessment and analysis of EM/China is based on fundamentals. In this sense, we are biased towards centering our investment strategy on fundamentals. Specifically, given our view/analysis that EM/China have credit bubbles/excesses, rapidly falling or weak productivity growth and record-low return on capital (Chart I-15), we cannot help but to have a fundamentally bearish bias on EM. This, in turn, means that we view any rally in EM risk assets or uptick in EM/China economic indicators with suspicion and likely as unsustainable. The opposite also holds true. All in all, if we are wrong on our fundamental view and analysis, we will be wrong on financial markets. When investors expect a bear market, they are better off selling rallies and not buying dips. When an asset class is in a multiyear bull market, it pays off to buy dips rather not sell rallies. Unless one can time market swings well, it is hard to make money on the long sides of bear markets. Similarly, it is difficult to profit from short positions in bull markets. In brief, countertrend moves are about timing. Timing does not depend on fundamentals. It is often a coin toss. Typically we do not recommend clients invest based on a coin toss. For example, it is impossible to rationalize why the EM rally did not begin following the August 2015 selloff, but instead started in February 2016. In late August 2015, with carnage in EM risk assets pervasive, it was clear that Chinese policymakers would stimulate and in fact the massive fiscal stimulus was initiated in August/September 2015 not in 2016. Similarly, China's manufacturing PMI bottomed in September 2015, not in 2016 (Chart I-16). Chart I-15EM Non-Financial Return ##br##On Equity Is At All Time Low Chart I-16China's Manufacturing PMI ##br##Bottomed In October 2015 In September 2015, EM and global equities rebounded, but chasing momentum at that time did not pay off as risk assets cratered in the following months. This is all to say that timing markets is often a random walk. We do attempt to time market moves that go along with our fundamental bias, but prefer not to time market moves that go against the primary trend. We assume any countertrend move is typically short-lived and unsustainable. That said, we also realize these moves can be very painful for investors if they last long enough, like this EM rally. Finally, we often get questions on fund flows. We do not make investment recommendations based on fund flows - even though we recognize they are very important in driving markets. The reason is that there is no comprehensive data on global fund flows that one can analyze and make reasonably educated bets. The often-cited EPRF dataset only tracks inflows and outflows of mutual funds and ETFs. It does not account for flows and positioning of various asset managers, sovereign funds, pension funds, insurance companies, hedge funds and private wealth managers, among many others. What's more, the EPRF dataset only covers the funds located in advanced countries and offshore jurisdictions, but not emerging countries where investment pools have become large and important. In brief, the available investment flow and portfolio positioning data are not comprehensive at all, and they cannot be relied upon too much to make investment recommendations. In this vein, a question arises: Why can't flows into EM sustain the current rally for a while even though it is not based on fundamentals? In this context, let's consider the case of the rally in euro area share prices when markets sensed the arrival of the European Central Bank's quantitative easing efforts at the beginning of 2015. There was a fervent rush to buy/overweight euro area stocks heading into the QE announcement by the ECB. European bourses surged. Nevertheless, euro area equity prices have been sliding and massively underperforming the global equity benchmark since March 2015 (Chart I-17). The reason the ECB's QE has not helped euro area stocks is because their fundamentals were bad - profits have been shrinking despite the ECB's QE. We suspect EM stocks and currencies will have a similar destiny: EM profits will disappoint considerably, and the current rally will prove unsustainable. Notably, net EPS revisions have so far failed to move into the positive territory (Chart I-18). Chart I-17Euro Area Stocks And EPS: ##br##Why The QE Rally Proved To Be Bogus Chart I-18EM Stocks And EPS: ##br##Earning Revisions Are Still Contracting Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 China Foreign Exchange Trading System. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 15. 3 Please refer to the Emerging Markets Strategy Special Report, titled "EM Corporate Health Is Flashing Red," dated September 14, 2016; a link is available on page 15. 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 5 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 6 Please refer to the Emerging Markets Strategy Weekly Report titled, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016; a link is available on page 15. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights Lesson 1: Don't fear the end of the debt super cycle. Lesson 2: The ECB will ultimately target the long-term bond yield. Lesson 3: Financials will structurally underperform. Lesson 4: Personal Products (Beauty) will structurally outperform. Feature Striking similarities exist between the post debt super cycle economies in the euro area and Japan. Feature ChartPersonal Products Will Outperform Structurally... Financials Will Not In many regards, the euro area looks remarkably like Japan with a 17 year lag. Line up the 2007 peak in the euro area credit boom with the 1990 peak in the Japan credit boom - and the subsequent evolutions of many economic and financial metrics also line up almost perfectly: for example, the policy interest rate; the 10-year bond yield; inflation; and nominal GDP (Chart I-2, Chart I-3, Chart I-4, Chart I-5). Chart 2Striking Similarities Between The Euro Area... Chart 3...And Japan, Advanced By 17 Years Chart I-4Striking Similarities Between The Euro Area... Chart I-5...And Japan, Advanced By 17 Years This is very useful because if the euro area continues in Japan's footsteps, Japan's experience can teach us several important lessons about the euro area economy and financial markets out to the year 2034. Lesson 1: Don't Fear The End Of The Debt Super Cycle Does the euro area economy have "lost decades" ahead of it? Not exactly. Japan's so-called lost decades describe its stagnant nominal GDP since the mid-1990s. But this emphasis on nominal income is misleading (Chart I-6). The average citizen's standard of living does not depend on nominal GDP or even on real GDP. What truly matters is real GDP per head combined with the absence of extreme income inequality. Real incomes must grow and the growth must be reasonably distributed across society. On both counts, the euro area can be encouraged by Japan's experience. Since the late 1990s, Japan's real GDP per head has averaged close to 1% growth a year, broadly in line with the expected real productivity growth in a developed economy. This is exactly the real growth rate to be expected when there is no artificial and unsustainable tailwind from credit expansion. It is an economy's natural state of growth when the debt super cycle comes to an end, as it did in Japan more than 20 years ago.1 And it is good growth because it comes entirely from productivity improvements. Mankind's persistent ability to learn, experiment, and innovate produces more and/or better output from a fixed set of inputs. Furthermore, unlike other major economies, income inequality in Japan has not increased through the past 20 years and remains amongst the lowest in the developed world (Chart I-7). Again, this is not surprising. It is credit expansions that inflate bubbles in financial assets and exacerbate income and wealth inequalities. Therefore, unlike bad growth fuelled by credit booms, real growth that comes from productivity improvements is sustainable and unpolarising. The first lesson from Japan is that the euro area can expect structural growth in real GDP per head of around 1% a year. Chart I-6What ##br##"Lost Decades"? Chart I-7Income Inequality In Japan ##br##Has Not Increased Lesson 2: The ECB Will Ultimately Target The Long-Term Bond Yield One objection to Lesson 1 is that in a highly indebted economy, nominal GDP growth does matter. As debt is a nominal amount, it is nominal incomes that determine the ability to service and repay the high level of debt. So given a free choice, policymakers would prefer to have inflation at 2% or 4% rather than at -1%; and nominal GDP growth at 3% or 5% rather than zero. Unfortunately, policymakers do not have this free choice. Contrary to what central bankers promise, inflation and nominal GDP growth cannot be dialled up or down at will to hit a point-target. As we explained in The Case Against Helicopters,2 inflation is a notoriously non-linear phenomenon which is extremely difficult, if not impossible, to control. As a reminder, look at the standard identity of monetary economics: MV = PT M is the broad money supply, V is its velocity of circulation, P is the price level and T is the volume of transactions. PT is effectively nominal GDP. The big problem is that both the broad money supply M and its velocity V - whose product determines nominal GDP - are highly non-linear. M is non-linear because the commercial banking system money multiplier - the ratio of loans to reserves - is non-linear (Chart I-8). At a tipping point of inflation, the onus suddenly flips from lending as little as possible to lending as much as possible. Chart I-8The Money Multiplier Is Non-Linear Admittedly, the central bank (in cahoots with the government) could by-pass the commercial banking system to control the money supply M directly. But it can do nothing to change the extreme non-linearity of the other driver of nominal GDP, the velocity of money V. Again, at a tipping point of inflation, the onus suddenly flips to spending money - both newly created and pre-existing balances - as fast as possible. At which point, nominal GDP growth and inflation suddenly and uncontrollably phase-shift from ice to fire with little in between. Therefore in the highly indebted euro area economy with near-zero inflation, the prudent course of action is not to risk uncontrolled inflation with so-called "helicopter money". Instead, the second lesson from Japan is to expect the ECB ultimately to emulate the BoJ and target the long-term bond yield. But which bond yield? Most likely, it would be the euro area synthetic 10-year yield, which the ECB already calculates and publishes, or a close proxy. In combination with the ECB's (as yet unused) OMT program - whose mere presence limits individual sovereign yield spreads - expect euro area government bond yields to remain structurally well anchored. Lesson 3: Financials Will Structurally Underperform Japanese financial sector profits today stand at less than half their level in 1990. For euro area financial sector profits, the concerning thing is that their evolution is tracking the Japanese experience with a 17 year lag. If euro area financial profits continue to follow in Japan's footsteps, expect no sustained growth over the next 17 years (Chart I-9). Chart I-9Euro Area Financial Profits May Experience No Sustained Growth In a post debt super cycle world, banks lose the lifeblood of their business: credit creation. And this becomes a multi-decade headwind to financial sector profit growth and share price performance. Euro area financials face two other headwinds similar to those in post debt super cycle Japan. As explained in Lesson 2, high indebtedness makes the economy hyper-sensitive to rising bond yields. The upshot is that the interest rate term-structure, which drives banks' net lending margins, cannot sustainably steepen. Also, just like Japan's 'zombie' banks, many European banks will take a long time to fully recognise the extent of their non-performing loans. The consequent squeeze on new lending combined with a requirement for additional capital further weighs down banks' return on equity. So the third lesson from Japan is that euro area financials is not a sector to buy and hold for the long term. Rather, it is a sector to play for periodic strong countertrend rallies. Now is not the time for such a play. Lesson 4: Personal Products (Beauty) Will Structurally Outperform Over the past 20 years, Japan's nominal GDP has gone sideways. But over this same period, the sales of skin cosmetics and beauty products have almost tripled (Chart I-10). This has helped the personal products sector to outperform very strongly. While Japanese financial profits have halved since 1990, Japanese personal products profits have quintupled (Feature Chart). Once again, the useful thing is that euro area personal product profits are uncannily tracking the Japanese experience with a 17 year lag. If euro area personal product profits continue to follow in Japan's footsteps, expect them to almost triple over the next 17 years (Chart I-11). Chart I-10Beauty Sales Have Boomed In Japan Chart I-11Euro Area Personal Products Profits Might Triple The very strong growth in beauty sales and profits in Japan is an extended example of the phenomenon known as the lipstick effect. Our Special Report Buy Beauty: The Lipstick Effect Stays Put3 provides the detail. But in a nutshell, the demand for beauty products and cosmetics - epitomised by lipstick - experiences a surge when the economic environment feels harsh. For many people, the post debt super cycle world of 1% real income growth with high indebtedness and no more bingeing on credit does feel like an extended hangover - at least compared to the spendthrift era that preceded it. Hence, it creates the ideal backdrop for an extended play of the lipstick effect, as witnessed in Japan. The fourth lesson from Japan is that euro area personal products is a sector to buy and hold for the long term. Expect profits to trend up at around 6% a year, and the sector to strongly outperform the broader market. Dhaval Joshi, Senior Vice President European Investment Strategy dhaval@bcaresearch.com 1 Admittedly, after the debt super cycle ended in Japan, government levering was needed to counter the impact of aggressive de-levering in the private sector. But in the euro area, this will not be needed to the same extent as the de-levering in the private sector is not as aggressive. 2 Please see the European Investment Strategy Weekly Report 'The Case Against Helicopters' published on May 5, 2016, available at eis.bcaresearch.com 3 Please see the European Investment Strategy Special Report 'Buy Beauty: The Lipstick Effect Stays Put' published on April 14, 2016, available at eis.bcaresearch.com Fractal Trading Model This week's recommended trade is to go short French banks versus the CAC40. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. * For more details please see the European Investment Strategy Special Report "Fractals, Liquidity & A Trading Model," dated December 11, 2014, available at eis.bcaresearch.com The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations

Special Report

Incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages. Some are comparing this trend to the housing subprime crisis, arguing that student debt is a major drag on growth at a minimum, and the source of another financial crisis at worst. Delinquency rates have surged and the 5-year cumulative default rate on student debt has reached almost 30%. Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%. Sticker prices at most institutions have mushroomed, although few students pay the full fare. Rising tuition fees only explain about half of the surge in student debt. Education still pays, although the benefits have waned versus the costs. Moreover, students with debt lag significantly those with no debt in terms of wealth accumulation and home ownership after graduation. The rise in default rates have been due to the influx of non-traditional student borrowers after 2007, who come from lower income families and have had poorer educational and employment outcomes. However, the wave of such borrowers has faded, which means that overall delinquency and default rates will decline in the coming years. Debt service payments, while onerous for many families, are not a major drag on overall real GDP growth. The increased propensity of 18-35 year-olds to live with their parents has trimmed annual real GDP growth by 0.14% per year since 2007, although student debt is only one of many underlying causes. The student loan program is at worst only a minor drain on the Federal government's coffer because of the high recovery rate. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Student debt is not the next subprime. "We are not doing these young people any favors by giving them loans that they cannot afford, that they cannot discharge in bankruptcy, and that could be a drag on their financial well-being even into retirement". - Sheila Bair, former FDIC chief, Bloomberg interview, September 26, 2016 Ms. Bair was one of the first to warn about the risks posed by the U.S. subprime MBS market, well before Lehman went bust. Few were listening then, but more are listening now as she sounds the alarm bell regarding student loans. About 43 million Americans owe a total of almost $1.2 trillion for their education, making student loans the second largest category of consumer debt next to mortgages (Chart II-1). Ms. Bair notes that, like the MBS market before 2007, cheap and freely available credit is fueling prices (tuition in this case). Banks handed out mortgage loans to many who could not afford them in the 2000s, just as the Department of Education (DoE) is doing today with student loans. It is difficult to assess borrowers' ability to repay student loans. Some argue that the DoE is not even trying. The trajectory of student debt is indeed alarming (Chart II-2). In inflation-adjusted terms, the total value of loans outstanding has quadrupled since 2000, representing an annual average compound rate of 9.4%. The rise reflects both an increase in the number of borrowers and more borrowing per person. Average debt/person has jumped from $17,300 in 2007 to almost $28,000 in 2015 (amounts vary across data sources). Rising debt levels occurred across the family income distribution. Chart II-1Student Debt: The Next Subprime? Chart II-2Student Loan Statistics These figures understate the true debt levels because they include only loans that are made under the federal loan program, representing 81% of the total. The remainder are private loans, mostly originated by banks. Private loans do not enjoy the same borrower protection afforded to federal loans, and carry a significantly higher interest rate (average of almost 14% in 2016, compared to federal loan rates of 3.76%). The data on private loans are sparse due to limited reporting, but a study based on 2012 data showed that the average amount of debt for students with private loans was almost $40,000 at that time.1 Sticker Shock It is easy to blame rising tuition fees given soaring "sticker prices" at most institutions. The average posted fee for tuition and room & board has increased by 30% in inflation-adjusted terms since 2007 at public universities, and by 23% at private non-profit institutions (Charts II-3A & II-3B). However, due to grants, tuition discounts and tax credits for education, only a small fraction of students pay the posted rate. For the 2015/16 school year, the net price that the average student paid at a private non-profit institution was $26,400, far less than the almost $44,000 sticker price. Chart II-3ATuition & Fees: Public Institutions Chart II-3BTuition & Fees: Private Institutions The Brookings Institute estimates that only about 50% of the escalation in student debt in the past two decades can be explained by rising tuition costs.2 Another quarter reflects rising educational attainment; kids are staying in school longer to get a leg up in the highly competitive workplace. The remainder of the total rise in debt was left unexplained in the study. Other possible contributing factors include policy changes that expanded eligibility for federal loans programs, and the housing bust that made it more difficult for families to borrow against the value of their homes for education purposes. There was also a change in the background characteristics of borrowers after the Great Financial Crisis (see below). Chart II-4The Distribution Of Student Debt The share of students suffering with an extraordinary amount of debt is growing, although they still represent a small portion of the total for federal loans (Chart II-4). Five percent of student debtors owe more than $100,000 each, up from 2% in 2007. Another 10% hold between $50,000 and $100,000. About two-thirds of student borrowers owe less than $25,000. A Student Debt Crisis? Another Brookings paper provides estimates for the debt service burden associated with federal student loans. The burden is calculated as the median debt service payment divided by median earnings of employed borrowers for two years after entering the repayment period (Chart II-5).3 This ratio rose from about 4½% in 2004 to 7.1% in 2013. Unfortunately, more recent data are not available. The average interest rate on the outstanding loans has moderated since 2011, although not nearly as quickly as the drop in market interest rates.4 Nonetheless, the continued escalation in the stock of debt per person in recent years means that the debt service-to-income ratio has likely continued to escalate since 2013, despite the moderation in the average interest rate paid. The jump in student loan delinquencies has raised red flags regarding the number of borrowers in financial distress, feeding concerns that a student loan debt crisis is on the horizon. The 90-day delinquency rate for student loans has increased from about 7% in 2007 to 11% in 2012, where it has hovered ever since according to the Federal Reserve Bank of NY data (Chart II-1). However, since only about 55% of all loans are in the repayment period, the actual delinquency rate among those in repayment is almost double the official figures. Loans are considered to be in default when they are more than 270 days past due. Brookings estimates that the 5-year default rate for student loans entering the repayment period five years earlier reached 28% in 2014, up from 16% for the five-year period ending in 2007 (Chart II-6).5 Perhaps surprisingly, the default rate is still far below the peak rate of more than 40% in the late 1990s. Thankfully for the taxpayer, the recovery rate on defaulted student loans is extremely high, at around 80%.6 This is because borrowers are not able to discharge federal student debts during bankruptcy. Congress has passed legislation making it very difficult for borrowers to avoid repaying. The DoE has the authority to use a number of extraordinary collection means. These include garnishing a portion of borrower's wages or seizing any payment a borrower may receive from the federal government. Chart II-5Debt Service Burden Is Rising Chart II-6Defaults Are Rising Education Still Pays, But Not For Everyone The good news is that education still pays for the average or median borrower. Chart II-7 shows that, while the average amount of student loans has escalated, it is still well below the average wage for those borrowers in the 20 to 40-year age group.7 The gap between wages and debt has narrowed over the past 15 years, but the increase in lifetime earnings potential still far exceeds the rise in accumulated debt for the average or median student. Chart II-7Debt And Wages For 20-40 Year Olds Of course, student loans have not paid off for everyone. News reports have highlighted plenty of examples of students that have graduated with crushing debt burdens and poor job prospects. Nonetheless, the Brookings study found that, for the vast majority, "the increase in borrowing would be made up for relatively early in the career of a worker with mean earnings".8 The Digest of Education Statistics show that, in 2013, the median annual earnings for full-time workers with a Bachelor's degree in the 25 to 34 age group was $48,530, compared with $30,000 for workers with just a high-school diploma. The bad news is that it is taking much longer to repay these debts. The mean term of repayment has increased from 7½% in 1992 to about 13½ years in 2010.9 Extended repayment and income-driven repayment plans can increase the loan term to 20, 25 or even 30 years. In some cases, borrowers will still be paying for their education when their children enter college!10 There is also evidence that the debt burden is causing some young adults to delay marriage and live with their parents for longer than they otherwise would. More Debt And Less Wealth Young student debtors also lag significantly relative to their peers in terms of wealth accumulation. A Pew Research Center study found that households headed by a young, college-educated adult without any student debt obligations have about seven times the typical net worth ($64,700) of households headed by a young, college-educated adult with student debt ($8,700; Chart II-8).11 Net worth is lower for those with student loans not just because their overall debt levels are higher; the value of their assets trailed as well. This gap is despite the fact that those households with a degree had almost double the annual income of those in the study that did not. Even comparing only households headed by young adults that did not attain a degree, accumulated wealth for those with student debt fell far short of those who avoided debt. One explanation is that money being absorbed by student debt repayment is unavailable to accumulate assets. A Federal Reserve Bank (FRB) of Boston study12 estimated that a 10% increase in student loan debt per household is associated with a 0.9% decline in the value of total wealth. Student loan burdens also mean that households end up relying more on other types of debt, such as auto loans and credit cards, according to the Pew study. Chart II-8Higher Debt, Lower Wealth... Table II-1...And Lower Homeownership Student debtors are also less likely to own a home after 2009 (Table II-1). Before 2009, the FRB of Boston study found that 30-year olds with a history of student loans had a higher homeownership rate than those without student debt. This makes sense because the boost to household income from obtaining more education should make it easier to quality for a mortgage. However, the relationship between student debt and homeownership switched after the Great Recession. The economy-wide homeownership rate has fallen sharply since home prices peaked in 2006, but the drop was more severe for those with student loans. This is probably due to the erosion in future income expectations following the recession for those with student debt, as well as more limited access to additional credit based on these individuals' existing debt loads (i.e. lower credit scores). Alternatively, student debtors may simply be reluctant to add to their overall leverage in light of the more uncertain economic outlook. A Fed study estimated that every 10% increase in student debt per person now results in a 1 percentage point drop in the homeownership rate for the first five years after graduation.13 Non-Traditional Borrowers Led The Surge In Delinquencies... While student debt burdens are unlikely to ameliorate anytime soon, the default rate should moderate in the coming years. Brookings (2015) conducted a detailed assessment of the characteristics of student loan borrowers and how they changed after 2007, by matching administrative data on federal student borrowers with earnings data from tax records. The study split the sample into "traditional" and "non-traditional" borrowers. Traditional borrowers are defined to be those attending 4-year public and private institutions because they tend to be typical in nature; they start college in their late teens, soon after completing high school, are dependent on their parents for aid purposes, pursue 4-year degrees and, frequently, head on to graduate study. This group historically represented the majority of federal borrowers and loan amounts. Non-traditional borrowers historically made up only a small portion of the total. These are defined to be those borrowing for 2-year programs (primarily community college) or to attend for-profit schools. The study found that non-traditional borrowers have largely come from lower-income families, tended to be older (i.e. not supported by parents), attended institutions with relatively low completion rates and faced poor labor market outcomes after leaving school (Chart II-9). Lower median wages and higher rates of unemployment meant that non-traditional borrowers tended to default on their student loans at a higher rate than traditional students. Student borrowing is counter cyclical; it tends to accelerate during recessions as unfavorable labor market conditions encourage people to return to school or to stay in school longer. The flow of new borrowers accelerated particularly sharply during the Great Recession, as intense pressure on State budgets led to cuts in scholarships by public institutions. Access to alternative credit markets was also curtailed during and after the Great Financial Crisis. Student loan inflows (i.e. the number of new borrowers) and outflows (the number paying off loans) are shown in Chart II-10. Inflows trended higher from 2000 to 2007, while outflows were fairly flat, leading to an upward trend in the net inflows. Inflows subsequently surged during the recession, reaching a peak in 2010. The jump in new borrowers was concentrated among non-traditional students. The number of non-traditional borrowers grew to represent almost half of all new borrowers soon after the recession. The wave of students who had begun to borrow during the recession entered the repayment period in increasingly large numbers from 2011 to 2014. The early years of repayment are the most precarious because debtors are just starting their careers and their earnings are the most variable. Chart II-9Non-Traditional Students Had Poor Labor Market Experience Chart II-10Surge In Non-Traditional ##br##Borrowers After 2007 The rise in the share of non-traditional borrowers largely explains the surge in the overall default rate since 2011. In contrast, the majority of traditional borrowers have experienced strong labor market outcomes and relatively low rates of default. Of all the students who left school, started to repay federal loans in 2011, and had fallen into default by 2013, about 70% were non-traditional borrowers. ...But The Worst Is Over The situation has since begun to reverse. Inflows and the net change in the number of borrowers has declined since 2012, particularly at 2-year and for-profit institutions. The moderation of the pace of inflows, the change in the composition of borrowers (less non-traditional), and efforts by the DoE to expand the use of income-based repayment programs will put downward pressure on delinquency and default rates in the coming years. Economic Impact Of Student Debt There are several channels through which rising student debt can affect overall economic growth. Spending by households with student debt will be curtailed both by the need to service the loans and by the fact that these households have lower levels of net worth. They are also less likely to own a home or form a small business. (1)Debt Service Burden And The Wealth Effect Table II-2 presents estimates of the value of aggregate debt service payments as a percent of GDP. This is based on the median debt service-to-earnings estimates from the Brookings Institute and median income for households where the head is less than 35 years of age in the Survey of Consumer Finances. If we assume that every dollar paid to service student loans is a dollar not spent on goods and services, then Table II-2 implies that the resulting drag on the level of real GDP has doubled from 0.17% of GDP in 2004 to 0.34% in 2013 (latest year available). However, it is the increase over time that matters for GDP growth, not the level. The rise of 0.17% was spread over nine years, suggesting that the drag on GDP growth was minimal. Moreover, this represents an overestimate of the actual drag, because households with student debt have leaned more heavily on other types of debt in an attempt to maintain their living standards. Table II-2 The Debt Service Drag On GDP Lower levels of asset accumulation and net worth will also undermine consumer spending. However, we believe that accounting for both the "wealth effect" and the debt-service effect on GDP would be double counting. Chart II-11Spending On Education ##br##Not A Growth Driver Education spending also provides a possible offset to the negative impact of debt service on GDP growth. However, in terms of household spending on education, in inflation-adjusted terms there has been virtually no growth in consumer spending on higher education over the past 15 years despite all the extra spending in nominal dollars (Chart II-11). Data on government spending specifically on higher education is not available, but spending on all levels of education including primary and secondary schools has declined as a fraction of real GDP since the early 2000's. The implication is that total spending on higher education by households and governments has not provided any offset to the drag on GDP growth from student debt since 2007. (2)Housing Market Earlier, we cited Fed estimates that every 10% increase in student debt per person results in a 1 percentage point drop in the homeownership rate for the first five years after graduation. The economy-wide homeownership rate has fallen by 5.5 percentage points since the beginning of 2007, reaching 62.9% in the second quarter of 2016. We estimate that rising student indebtedness could account for as much as 1½ percentage points of the total 5½ percentage point drop. This is based on the Fed's estimates, the rise in the share of student loan borrowers among the total number of households and the increase in student debt-per-person. Again, this estimate likely overstates the impact because we are implicitly assuming that every new student borrower since 2007 ultimately forms a new household upon graduation. Undoubtedly, a portion of student borrowers formed a household with other student borrowers. Even if this estimate is close to the truth, it is not clear that there is a large impact on GDP growth. The formation of new households will result in an expansion in the housing stock one-for-one (assuming no change in inventories). Whether they decide to rent or buy, this will boost the residential investment portion of GDP. Buying a home or condo often results in home renovation and purchases of new furnishings, thus providing the economy with a larger boost compared to new households that rent. Nonetheless, the difference is difficult to estimate and is probably small enough to ignore. Another way to approach the issue is to gauge the impact on the housing market of the greater propensity of 18-35 year olds to live with their parents. Those living at home jumped from 19.2 million in 2007 to 23.0 million in 2015. The proportion of those living at home of the total population of 18-35 year olds rose from 28% to 32%. If the ratio had not increased over the period, it would have resulted in an extra 2½ million young people leaving home. If we assume that one-quarter of them move in with someone else who is also leaving home, then it would result in an increase in the housing stock of more than 1.8 million units since 2007 (condos or single family homes). We estimate that the resulting boost to residential construction growth would have added an average 0.14 percentage points to real GDP growth each year since 2007. Of course, it is not clear how much of the "living at home" trend is due to student loans as opposed to low earnings or poor job prospects. This estimate thus overstates the direct impact of student loans on the housing market. Nonetheless, it is instructive that the living-at-home phenomenon has been a non-trivial drag on economic growth via new home construction. (3) New Business Creation Academic research has also linked rising student indebtedness to a slower pace of new business creation. Research by the Federal Reserve Bank of Philadelphia points out that approximately 60% of new jobs in the private sector are created by small business.14 The U.S. Small Business Administration states that small firms receive approximately three-quarters of their capital needs in the form of loans, credit cards and lines of credit, which often have a personal liability attached. Having student loans reduces one's debt capacity and thus the ability to obtain small business loans. The Fed study compared student loan data and new business formation across U.S. counties. The Fed estimates that an increase of one standard deviation in student debt results in a decrease of 70 in the annual pace of new small business creation, representing a decline of approximately 14½%. Chart II-12 shows the inverse correlation between student debt and new business formation across U.S. states. Chart II-12Student Debt Hinders Small Business Creation The impact of a slower pace of new business creation on overall economic growth is unclear. A student that does not create a new business for whatever reason will likely end up working for an already existing company that is growing, expanding the supply side of the economy anyway. True, small businesses create a lot of jobs, but they lose a lot too because the failure rate for these firms is high in the early years. Some claim that the less vibrant new business environment since 2007 reflects a less dynamic economy, helping to explain the dismal productivity record since that time. However, this flies in the face of the fact that the small business sector is less productive overall than large businesses. Chart II-13 demonstrates that there is a rough correlation between the new firm creation rate and real GDP growth per capita at the state level. However, it is not clear which one is driving the other. Our sense is that, while a less vibrant new business backdrop likely contributed to the poor post-Lehman economic record, it is far from the major driving factor. Chart II-13GDP Growth And Small Business Creation: Which One Is The Driver? (4) The Federal Budget Could the surge in delinquency rates wind up costing the taxpayer a bundle? Eighty percent of all student loans are either made directly by or are backed by the federal government, generating a potentially large contingent liability. Fortunately for the taxpayer, the recovery rate on student loans is extremely high. Moreover, the Federal government makes money on the spread between the student loan rate and the rate at which it finances these loans (Treasury yields). Congress sets the loan rates and they are kept well above Treasury yields. Under Congressional accounting rules, the cost of a student loan is recorded in the federal budget during the year the loan is disbursed, taking into account the amount of the loan, expected payments to the government over the life of the loan, and other cash flows, all discounted to the present value using interest rates on U.S. Treasury securities. By this accounting rule, the Congressional Budget Office estimates that the Federal government will make a net profit of almost $200 billion over the 2013-2023 period.15 However, a more reasonable "fair value" accounting method, which includes the costs of collection and other items, shows that the student loan program will cost the taxpayer roughly $100 billion over the same period. Either way, the bottom line is that the student loan program is at worst only a minor drain on the Federal government's coffer. Delinquency and default rates are likely to moderate in the coming years. But even if default rates were to surge to new highs for some reason, the recovery rate is so elevated that the impact on the Federal budget balance would be lost in the rounding. Conclusion It seems clear that incentives ingrained in the U.S. higher-education system have contributed to an alarming escalation in student debt over the last 15 years. There has been a vicious circle in which increased federal loan limits supported institutions' ability to raise tuition fees, resulting in a greater need for federal loans. Some for-profit institutions have been criticized for offering shoddy education, for graduating too many students in disciplines for which job prospects are poor, and for encouraging students to load up on high-cost debt. The U.S. spends almost 80% more per pupil on higher education than the OECD average, and yet some argue that this has not resulted in better educational outcomes. The social impact of student leveraging is clearly negative. The benefits of education have narrowed relative to the costs. Financial stress has increased along with debt service burdens, especially for non-traditional borrowers, and repayment periods have been extended to an average of over 13 years. These trends have caused young people to delay marriage and home purchases. This is a serious political and social issue that needs to be addressed. That said, we do not agree with Ms. Bair that student debt is the next "subprime" crisis. Delinquency and default rates are likely to fall in the coming years. These loans have not been packaged into opaque financial instruments and distributed throughout the investment world. The vast majority of the loans are federally backed and the recovery rate is very high. Even if there is a wave of mass defaults, the federal deficit might rise slightly but there is no channel through which the shock can propagate through the financial system. The bottom line is that student debt is a social issue, and to a lesser extent, a macro issue. But it is not a financial stability issue. Mark McClellan Senior Vice President The Bank Credit Analyst 1 "Student Debt and the Class of 2015," Annual Report of the Institute for College Access & Success, October 2016. 2 Beth Akers and Matthew Chingos, "Is a Student Loan Crisis on the Horizon?" Brown Center on Education Policy at Brookings, June 2014. 3 Adam Looney and Constantine Yannelis, "A Crisis in Student Loans? How Changes in the Characteristics of Borrowers and in the Institutions They Attended Contributed to Rising Loan Defaults," Brookings Papers on Economic Activity, Fall 2015. 4 Most federal student loans are at a fixed rate set by Congress. 5 Brookings (2015). 6 http://www.edcentral.org/edcyclopedia/federal-student-loan-default-rate… 7 The data are only available to 2010, but we have estimated figures to 2013. 8 Brookings (2014). 9 Brookings (2014). 10 Student loans generally have a 10-year term, but loans consolidated with the federal government are eligible for extended repayment terms based on the outstanding balance, with larger debts eligible for longer repayment terms. 11 "Young Adults, Student Debt and Economic Well-Being," Pew Research Center, May 14, 2014. 12 Daniel Cooper and J.Christina Wang, "Student Loan Debt and Economic Outcomes," Federal Reserve Bank of Boston, October 2014. 13 Alvaro Mezza, Daniel Ringo, Shane Sherlund and Kamila Sommer, "On the Effect of Student Loans on Access to Homeownership," Finance and Economic Discussion Series of the Federal Reserve Board. 2016-2010. 14 Brent Ambrose, Larry Cordell, and Shuwei Ma, "The Impact of Student Loan Debt on Small Business Formation," Federal Reserve Bank of Philadelphia Working Paper, July 2015.