Trade / BOP

Highlights Investors continue to overstate the constraints the Trump administration faces; Tax reform will happen, likely much sooner than the markets appreciate; Infrastructure spending will be modest, but will also face no constraints; Trump's de-globalization agenda - on both immigration and trade - faces few, if any, constraints; Book gains on long S&P 500 / short gold, long Japanese equities, long USD/JPY, and close long European versus global equities for a small loss. Maintain a long SMEs / short MNCs strategic outlook as a play on de-globalization. Feature "It used to be cars were made in Flint, and you couldn't drink the water in Mexico. Now, the cars are made in Mexico and you can't drink the water in Flint." - President-Elect Donald J. Trump, Flint, Michigan, September 14, 2016 Regular readers of BCA's Geopolitical Strategy know that our methodology emphasizes policymakers' constraints over their preferences. We abide by the simple maxim that preferences are optional and subject to constraints, while constraints are neither optional nor subject to preferences. President-elect Donald J. Trump is not unique. In the long term, his preferences will be cajoled and imprisoned by his constraints. However, investors may be overstating the impact of constraints in the short term. This is because Trump is a transformational - rather than merely transactional - leader whose election is a product of the yearning for significant change by the U.S. electorate.1 The key difference between the two leadership styles is that transformational leaders seek change by influencing and motivating their followers to break with convention. They make an appeal on normative and ideological grounds. Meanwhile, transactional leaders seek to maintain the status quo by satisfying their followers' basic needs. The latter use sticks and carrots, the former inspire. In the long term, even transformational leaders like Trump will be whipsawed by their material and constitutional constraints into the narrow tunnel of available options. But as we discuss in this Special Report, President-elect Trump will have a lot more room to maneuver than investors may think. That will be good for some assets, bad for others. Trump's Blue-Collar Base To understand the priorities of the Trump administration - as well his lack of political constraints - investors need to respect Trump's shock victory on November 8. Trump won the election because he was able to extend his "White Hype" strategy to the Midwest states of Ohio, Michigan, Wisconsin, and Pennsylvania (and came close to winning Minnesota) (Map 1).2 Map 1Electoral College Vote, Nov. 29, 2016 Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency To extend the Republican voting base into these traditionally "blue" states, Trump appealed to white blue-collar workers, many of whom voted for President Obama in 2012. Though he squeaked by with narrow vote-margins, he was not expected to be competitive in these states at all: Hillary Clinton did not visit Wisconsin once during her campaign (Chart 1). Trade was a chief concern of these disenchanted "Rust Belt" voters. Exit polls show that they agreed with Trump's message that globalization and neoliberal trade policies have sapped the U.S. of jobs, wages, and job security (Chart 2). Chart 1Hillary Failed To##br## Ride Obama's Coattails Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 2Trump's Winning Constituency##br## Angry About Trade Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Infrastructure, and government spending more broadly, were also major concerns - Trump's election was effectively an "anti-austerity" vote. Throughout the campaign Trump showed himself to be indifferent to budget deficits and debt, at least relative to the GOP leadership of the past six years. Instead he shattered GOP orthodoxy by promising to avoid any cuts to entitlement spending and contravened the party's fiscal hawks by promising to spend $1 trillion (later $550 billion) on infrastructure, e.g. the "bad drinking water" problem referred to in the quote at the start of this report. By contrast, Trump paid less attention to tax reform. Yes, he promised to slash taxes, even after reducing the scope of his extravagant September 2015 tax cut proposal. But no, this was not the focus of his campaign and did not get him elected. Instead, it is an area of common ground between himself and the GOP, and it has been the party's main pursuit in recent years. No one knows what Trump is going to do when he takes office. His statements are famously all over the place and he often positions himself at the opposite sides of a policy issue at the same time, prompting us to label him America's first "Quantum Politician."3 His cabinet is only beginning to take shape. Therefore, his main agenda and priorities - traditionally outlined in the upcoming Inaugural Address on January 20 - remain inchoate at best. Nevertheless, trade protections and better infrastructure were core demands of Trump's blue-collar electoral coalition and we expect him to follow through with actions, not least because he needs these states for upcoming elections in 2018 and 2020. Bottom Line: Trump's personal policy preferences are shrouded in mystery. However, investors should assume that he will take the preferences of the Midwest blue-collar voters seriously. They delivered him the presidency. Tax Reform The main reason for the market's exuberance since the election - aside from a "relief rally" given that the sky has not fallen4 - has been the prospect of substantial tax cuts. With Republicans holding all levels of government - and Democrats unable to filibuster tax reform in the Senate due to the "reconciliation procedure"5 - investors are rightly optimistic that the U.S. will finally see significant reforms. We review the plan, investigate its constraints, and assess the impact below. The Plan Trump is asking for much bigger tax cuts than the Republican Party's major alternative, House Speaker Paul Ryan's "A Better Way" plan.6 Trump would slash the corporate tax rate to 15% for all businesses, with flow-through businesses (80% of all U.S. businesses) eligible to pay the 15% rate instead of being taxed under the individual income tax rate (as currently).7 The GOP, by contrast, would set the corporate rate at 20% and the flow-through business rate at 25%. Trump and the GOP agree that the individual income tax should be reduced from seven to three brackets, with the marginal rates at 12%, 25%, and 33%. This would cut the top marginal rate from 39.6% to 33%, but would also leave a significant number of Americans with an increase, or no change, to their marginal tax rate.8 Where Trump and the GOP differ is on how to handle deductions, the flow-through businesses, child tax credits, and other issues - with Trump generally more inclined toward government largesse. Another element of tax reform is the proposed repatriation tax on overseas corporate earnings. An estimated $2.6-$3 trillion is stashed "abroad" (often only in a legal sense), which enables companies to defer paying the corporate tax rate due upon repatriation. Trump is following in the footsteps of President Obama and presidential candidate Hillary Clinton in attempting to collect these taxes - with the Republicans also broadly on board.9 Overall, Trump's plan would cut taxes and tax revenues much more aggressively than the GOP plan. Trump would see $1.3 trillion more in personal tax cuts and $1.7 trillion more in corporate taxes than the GOP plan over the coming decade (Chart 3). The country's debt-GDP ratio would grow by 25%, well above the GOP's 10-12% increase (Chart 4). Chart 3Trump Would Outdo##br## The GOP On Tax Cuts Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 4Trump Would Outdo##br## The GOP On Debt Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency The Constraints We see no significant political or constitutional constraints facing the GOP and Trump. If we had to pick, we would assume that the ultimate deal will look a lot more like the GOP plan. The two sides will be able to hammer out a compromise for the following reasons: Given the reconciliation rules in the Senate, the Democrats cannot filibuster tax-cutting legislation. Both the Reagan and Bush administrations passed tax cuts in their first year in office - Reagan signed them into law in August, Bush in June. Trump, like Bush, has the advantage of GOP control of both houses of Congress. He and his party would have to fumble the ball very badly to fail on comprehensive tax reform in 2017. Republicans have been demanding tax reform since 2010 and have several "off-the-shelf" plans to draw from, including Ryan's plan. Staffers know the issues. Trump has also already reduced his original ambitions to meet them halfway. Since Trump's campaign did not focus on tax reform, he can afford to let the GOP take the lead on it - he will still get credit for the resulting deal and will expect GOP support on infrastructure, immigration, and trade in turn. The first constraint that does exist is complexity. Comprehensive tax reform has not occurred since 1986, under Reagan, because it is fiendishly tricky. This means the timing could be delayed - perhaps as late as the third quarter of 2017, despite the eagerness of both Congress and the White House for reform. The second constraint is one of priorities. Trump and the GOP have a busy agenda for the first half of 2017, with taxes, Obamacare, and Trump's infrastructure plan. Rumors suggest that Congress will use its first reconciliation bill to repeal Obamacare. But since they do not know what will replace the current law yet, it would make more sense to reverse the order and do tax reform first. This will be easier, again, because tax reform has been a major issue for Republicans for a decade. Third is the problem of permanence. Assuming the Republicans use reconciliation to pass their tax reform, they will not be allowed to increase the federal budget deficit beyond the ten-year time frame of the budget resolution. They will have to include a "sunset" clause on the tax cuts, as occurred with the Bush tax cuts in 2001, leaving them vulnerable to expiration under the next administration.10 The Impact What will a sweeping tax reform plan mean? Headline U.S. corporate taxes are higher than every other country in the OECD, so the U.S. corporate sector will ostensibly gain competitiveness (Chart 5). This factor, combined with repatriation and threats of protectionism against outsourcing multi-national corporates (MNCs), should lift corporate investment in the U.S. Chart 5U.S. Companies Will Get Competitive Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Reducing loopholes would broaden the corporate tax base, the key value of the reform from the perspective of revenues and the country's economic structure. Multinational corporations already pay a lower effective tax rate than the official 35% corporate rate, so the impact will depend on their current effective rate as well as the new rate. Trump's plan would only increase effective taxes for firms in the utilities sector, while the GOP plan could increase effective taxes for firms in finance, electronics, transportation, and leasing. In both cases, companies in construction, retail, agriculture, refining, and non-durable manufacturing stand to benefit the most (Chart 6). Chart 6Tax Cuts Benefit Some Sectors More Than Others Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency A key question is how flow-through businesses are treated: whether they get Trump's 15% or the GOP's 25%. In the latter case they would see a tax hike (from an average rate of 19%) and thereafter be punished relative to more capital-heavy "C" corporations. Trump is a "populist" insofar as his plan would support flow-through businesses. Bottom Line: The quickest and biggest impact of Trump's fiscal policies on GDP growth will come from his tax cuts. With the Republicans long preparing for tax reform, and fully controlling Congress, tax reform is all but a done deal - and probably by Q3 2017 at latest. The outstanding question is whether Trump's infrastructure spending will be included in tax reform and thus compound the positive fiscal impact in 2017, or be pushed off into 2018. Fiscal Spending Trump's proposed $550 billion in new infrastructure investment is as nebulous as many of his other promises. However, as outlined above, we believe that Trump's victory partly depended on this issue and investors should not ignore Trump's commitment to it. Constraints are overstated. The Plan Trump's first clear infrastructure proposal came from two of his special advisers, Wilbur Ross and Peter Navarro.11 They propose government tax credits for private entities who invest in infrastructure projects. They argue that $1 trillion in new infrastructure investment - the same number cited on Trump's campaign website as the country's estimated needs over the next decade - would require $167 billion in equity investment, which could then be leveraged. To raise these sums, they propose the government offer a tax credit equal to 82% of the equity amount. They contend that the plan would be deficit-neutral because payments for the government tax credit would be matched with tax revenues from the labor involved in construction and the corporate profits flowing from the projects, charged at Trump's 15% corporate rate. The other component of the Ross-Navarro plan consists in combining infrastructure financing with the tax repatriation plan - a common proposal in Washington. Companies that are repatriating their earnings at the lower 10% rate could thus invest in infrastructure projects and use the 82% tax credit on that investment to cover the cost of their repatriation taxes. If the Trump administration sticks with this proposal, it will require the GOP to include the infrastructure plan in the tax reform bill. Or, given the bipartisan support for both a new repatriation tax and building infrastructure, Trump could turn to the Democrats for a separate bill covering these two policies. However, the specifics of the Ross-Navarro plan can be chucked out the window at will. They were designed to win the election, not to bind the administration's hands. Already, Trump has reversed his stance on the possibility of a state-run infrastructure bank (one of Clinton's proposals) as a way of financing new projects. What matters is that Trump and his top advisors are enthralled by the idea of a populist or "big government"-style conservatism that takes advantage of historically low interest rates - the post-financial crisis "Keynesian" moment - to stimulate the economy and improve U.S. productivity in the long run.12 Trump's emphasis on this issue in his November 8 victory speech says it all. Thus Trump's infrastructure ambitions are likely to be prioritized and will certainly not be abandoned. Unless Trump drastically alters his handling of the issue on January 20 - which we consider highly unlikely - it should be considered a top priority. The Constraints What are the constraints? President Obama's stimulus plan passed in February 2009, immediately after taking office, but that was in the midst of a financial crisis. Now conditions are different. Infrastructure is popular, but the timing with the economic cycle is not perfect, and the fiscal hawks in the GOP will try to water down Trump's proposals. Our clients are particularly concerned that the Tea Party-linked Republicans in Congress will be a major political hurdle. We disagree. On the issue of funding, what is important for legislative passage is not whether the plan ends up being "deficit neutral" as promised, but whether it can be marketed as such. Key Republicans like Kevin Brady, chair of the House Ways and Means Committee, have already admitted that some of the revenues from repatriated earnings will go toward infrastructure. Public-private partnerships will give Republicans a way of presenting the project as deficit-friendly. And it is true that interest rates are low for borrowers (at least for now), including state and local authorities - which account for the clear majority of infrastructure spending in the U.S. Political constraints are few. Public support for infrastructure is a no-brainer, opinion polls show that the public wants better infrastructure (Chart 7). It is also one of the least polarizing issues of all the issues in a recent Pew survey (Chart 8). Chart 7The 'Right' Kind Of ##br##Government Spending: Infrastructure Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 8Infrastructure Is Not##br## A Partisan Issue Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Moreover, there is no reason to believe that modern Republican presidents are particularly fiscally austere - Nixon, Reagan, and the Bushes were not (Chart 9). And Republican voters are not so fearful of big government when their party is at the helm as when they are in opposition (Chart 10). Election results show that voters consistently approve of about 70% of local transportation funding initiatives, which means they vote in favor of higher taxes to receive better infrastructure (Chart 11). Chart 9Fact: Republicans Run Bigger Budget Deficits bca.gps_sr_2016_11_30_c9 bca.gps_sr_2016_11_30_c9 Chart 10No Ruling Party Fears Big Government bca.gps_sr_2016_11_30_c10 bca.gps_sr_2016_11_30_c10 What about the Tea Party? It is true that fiscal conservatives in the GOP are skeptical of Trump's infrastructure ambitions. The Tea Party and Freedom Caucus make up about 60 combined votes. However, Trump's combination of Eisenhower big-spending Republicanism and populism won the election and has therefore written austerity's obituary. Furthermore, voters identifying with the Tea Party voted for Trump in the Republican primaries, according to exit polls (Chart 12). Hesitancy to support Trump on ideological grounds even caused the former Chairman of the Tea Party Caucus, Tim Huelskamp (R-KS), to lose his primary election to a more Trump-friendly challenger. Given that all members of the House of Representatives must run for re-election in 2018 - with campaigning starting in merely 18 months - they will dare not oppose Trump for fear of being Huelskamped themselves. Chart 11The 'Right' Kind Of Tax Hike: Paying For Roads Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Chart 12Trump Won The Tea Party Vote Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency The political winds against austerity were shifting even before Trump. In January 2015, the GOP-controlled Congress approved of "dynamic scoring," an accounting method that considers the holistic impact of budget measures - spending and/or tax cuts - on revenue and thus deficits.13 The GOP has also recently come close to readmitting "earmarks," legislative tags that direct funding to special interests in representatives' home districts. Earmarks were done away with in 2011, but they have crept back in different guises (Chart 13). Republican members of Congress can hear the gravy train and are scrambling to ensure they get on board. They want to be able to ride the new wave of spending all the way back to re-election in their home districts. Chart 13Pork-Barrel Prohibition Is Ending Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Finally, if Congress takes up an infrastructure-repatriation tax bill separately from the more partisan tax cuts, Trump may be able to offset any holdout fiscal hawks with support from Democrats. In late 2015, Democrats and Republicans voted together on the first highway funding bill in ten years, with large margins in both houses, easily overwhelming dissent from the Tea Party and Freedom Caucus. Vulnerable Democrats in the now "Trump Blue" states of Michigan, Wisconsin, Pennsylvania, and Ohio will be particularly interested in crossing the aisle on any infrastructure spending legislation. The Impact What will be the size and impact of Trump's infrastructure spending? Currently his transition team says he will oversee $550 billion in new investments, albeit offering no details or timeframe. This would be 72% of Obama's 2009 five-year stimulus at a time when there is little or no output or unemployment gap. In other words, the plan is pro-cyclical stimulus that will likely end up generating "too much" growth at a time when inflation expectations are already rising and the output gap is closing. The downside could be a rate-hike induced recession in 12-18 months. In terms of its impact on debt levels, infrastructure spending is less of a concern. The federal share of that $550 billion - i.e. the size of the tax credit for private participants - is going to be much smaller. During the campaign Trump implied $1 trillion in new investments over ten years, but the federal tax credit would have been a "deficit neutral" $137 billion. Applying the same ratio, back of envelope, Trump now aims for a $75 billion tax credit for the $550 billion worth of projects. But there will also likely be other components to the plan, such as federal support for state and local debt-financed infrastructure. Thus the headline size of Trump's infrastructure plan is far bigger than the federal commitment. Still, investors should appreciate that despite its modest size, the plan marks a break from the austerity-focused past. Bottom Line: Trump's election signals an anti-austerity turn in U.S. politics from which the fiscal hawks in the GOP cannot hide. Trump will ultimately receive congressional support on infrastructure spending, possibly bipartisan, and this "Return of G" will mark an important inflection point in U.S. economic policy.14 Immigration Globalization is, broadly defined, the free movement of goods, services, capital, and people. Trump began his campaign in June 2015 with a blistering speech opposing illegal immigration. His anti-immigrant rhetoric ratcheted up from that point, but while the media focused on the alleged xenophobia of his comments, Trump's message was consistently focused on the economic downside of an "open borders" policy. Since the election, Trump's rhetoric on immigration has dramatically softened. The Plan There are two components of Trump's immigration plan as far as we can tell: deportation and border enforcement. On the first, Trump's primary goal is to terminate Obama's "two illegal executive amnesties," i.e. Deferred Action for Childhood Arrivals (DACA) and Deferred Action for Parents of Americans (DAPA).15 This means he opposes two programs that are already frozen. In addition, he has pledged to deport 2-3 million undocumented immigrants, emphasizing criminals and drug offenders. This is comparable to Obama's 2.5 million deportations from 2009-15, the highest clip on record. We expect Trump to accelerate the pace of deportations, but it is by no means clear that he will do so, or do so dramatically. There is as yet no clear plan to deal with high-skilled immigrants, especially those arriving on H-1B non-immigrant visas authorizing temporary employment. Trump has made conflicting statements regarding the H-1B program, saying he wanted to keep attracting highly skilled workers to the U.S. but also criticizing the program specifically during a debate. Trump's pick for the attorney general, Alabama Senator Jeff Sessions, is a big opponent of the program. There is considerable evidence that the H-1B program hurts the wages of domestic workers, particularly in the tech sector.16 As for Trump's notorious "border wall," it is shaping up to be a change in degree, not kind. The Clinton administration's "deterrence through prevention" policy, beginning in 1994, and the Secure Fence Act of 2006, have led to extensive fencing and wall construction along the border over the past two decades. Trump will seek to fill gaps, reinforce border barriers, and probably erect better fences near population centers as more visible signs of his achievements. But he will not be building a Great Wall of Trump. The Constraints There are no major constitutional constraints on any of the proposals, since Trump is reversing the Obama administration's illegal non-enforcement of existing immigration law.17 The chief constraint Trump faces when it comes to increasing the pace of deportations and building enhanced walling and fencing is the cost. The threat to make Mexico provide all the funds is going to be watered down in negotiations.18 Trump could increase the Department of Homeland Security's budget, which slowed from 12% annual growth under Bush to 2.7% under Obama. Presumably congressional opposition would not be too virulent given the purpose. But spending on immigration enforcement already outpaces that of all other federal law enforcement agencies combined. A bigger constraint is whether, after the border is "normalized," Trump will follow through on his promise to make a "determination" on what to do with the non-criminal illegal immigrants. This language implies that he is ultimately amenable to comprehensive immigration reform and even a path to citizenship - a proposal that has already passed the Senate in an earlier form. To pass such a comprehensive reform bill, however, Trump will need to work with the Democrats in the Senate as they can and will filibuster any immigration reform bill that does not have a path towards some form of amnesty for the immigrants in the country. What of the timing? Deportations can begin promptly upon taking office - the agencies are already capable. Increasing border enforcement and structures will likely go into his first fiscal 2018 budget request - we expect the GOP Congress to be receptive. As for broader immigration reform, these will be the slowest to materialize, if ever. Previous GOP immigration reform laws passed after the midterm elections in 1986 and 1990, so 2018 may be a useful marker. The Impact On the margin, less immigration into the U.S. should raise domestic wages, particularly for the two sectors where low-skilled immigrants are most likely to be employed: agriculture and construction. Bottom Line: Trump's immigration policy is hardly revolutionary, despite his campaign focus on the issue. He has few constraints to his announced policies, but they are likely to be unimpressive in scope. There are three potential risks to our sanguine view. First, Trump decides to deport all the 11 million illegal migrants in the country, causing considerable political and social unrest. Second, he actually means what he says about Mexico paying for the wall. Third, he tries to end the H-B1 high-skilled temporary workers program. Reforming the overall immigration process - including a possible pathway to citizenship - is constrained by Democrats' control of the Senate and will therefore likely proceed on a longer timeframe (perhaps even after 2020). Trade Trump's trade protectionism is the main risk to markets and global risk assets. His victory represents a true break with the past seventy years of ever-greater globalization (Chart 14). We have expected the trend of de-globalization since, at least, 2014. However, we are surprised how quickly the issue became the electoral issue. Chart 14Globalization Peaked Before Trump Globalization Peaked Before Trump Globalization Peaked Before Trump Investors now have to re-price numerous assets for the de-globalization premium. The Plan Trump has threatened to name China a currency manipulator on day one in office, impose a 45% across-the-board tariff on Chinese goods, and a 35% tariff on Mexican goods. He has committed to canceling the U.S.'s biggest trade initiative in the twenty-first century, the Trans-Pacific Partnership (TPP), and he has threatened to renegotiate NAFTA and withdraw from the WTO, leaving U.S. tariffs with nothing but Smoot-Hawley to keep them tethered to earth. Thus Trump's victory threatens to become not only the chief symptom of "peak globalization"19 but also a great aggravator of it and cause of further de-globalization going forward (Chart 15). Chart 15De-Globalization To Continue bca.gps_sr_2016_11_30_c15 bca.gps_sr_2016_11_30_c15 There are signs that Trump may act on his rhetoric and enact a radical change in U.S. trade policy. Two of his top advisers, Dan DiMicco and Robert Lighthizer, are outspoken economic nationalists and "China bashers." DiMicco has dedicated his life to fighting Chinese mercantilism and believes that the U.S. and China are "already in a trade war; we [the U.S.] just haven't shown up yet."20 Yet there are also signs that Trump intends only to drive a hard bargain, not start a trade war. For instance, he says his first action will be to rip up the TPP, but this deal has not been ratified and was internationally controversial because it excluded China (as well as U.S. allies Korea, Thailand, and the Philippines). Moreover, while Trump says he will deem China a currency manipulator on day one in office, this is largely a symbolic act that entails no automatic, concrete punitive measures.21 Therefore Trump could take these two actions alone, or other symbolic ones, to prove that he is an economic patriot, and then settle down to "renegotiate" key trade relationships along the lines of the status quo. It is too soon to draw conclusions, but we do not think things will turn out as peachy as the best-case scenario. This is in large part due to the fact that the U.S. president has tremendous leeway on trade. The Constraints The U.S. president has few constraints when it comes to trade policy, for the following reasons:22 Delegated powers from Congress: Congress is the constitutional power that governs trade with foreign states. However, Congress passes laws that delegate authority to the executive branch to administer and enforce trade agreements and to exercise prerogative amid exigencies. Even when Congress approves a trade deal like NAFTA, it is the president who is empowered to lower tariffs - and therefore the president can issue a new proclamation raising them. The past century has produced a series of laws that give Trump considerable latitude - not only the right to impose a 15% tariff for up to 150 days, as in the Trade Act of 1974, but also unrestricted tariff and import quota powers during wartime or national emergencies, as in the Trading With The Enemy Act of 1917 (Table 1).23 A president's legal advisors are only too happy to use their imaginations. Nixon invoked the Korean War, which ended in 1952, as a justification for a 10% surcharge tariff on all dutiable goods in 1971, simply because the Korean state of emergency had never officially ended! Table 1Trump Faces Few Constraints On Trade Constraints & Preferences Of The Trump Presidency Constraints & Preferences Of The Trump Presidency Executive power over foreign policy: The executive branch is the constitutional power that governs foreign relations. Since international economics are inseparable from foreign relations and national security, the president has prerogative over matters even remotely touching trade. Both Congress and the judicial branch will tend to defer to a president in exercising these powers as well - at least until a gross subversion of national interest occurs. And even then, it is not clear how the constitutional struggle would play out - the courts always bow to the executive on matters of national security. Wars do not have to be declared for wartime trade powers, so all the U.S.'s various military operations across the world provide fodder for Trump to invoke the Trading With The Enemy Act, giving him power to regulate all forms of trade and seize foreign assets. Time is on the executive's side: Even assuming that Congress or the Supreme Court move to oppose the executive, it will likely be too late to avoid serious ramifications and retaliation from abroad. Congress is unlikely to vote to overrule the president until the damage has already been done - especially given Trump's powers delegated from Congress.24 As for the courts, the executive could swamp them with justifications for its actions; the courts would have to deem the executive likely to lose every single one of these cases in order to issue a preliminary injunction against each of them and halt the president's orders. Any final Supreme Court ruling would take at least a year. International law would be neither speedy nor binding. The Impact Trump is deeply committed to a tougher trade stance, has few constraints, and his protectionism deeply resonated with key swing voters. We doubt he will settle for cosmetic changes and the establishment Republican "business as usual." This means China relations are a major risk, especially in the long run. We will expand on these tensions, which will become geopolitical, in an upcoming report. What happens if Trump pursues protectionism wholeheartedly? First, the good. On the margin, some trade protections could attract foreign companies to relocate to the U.S. and discourage American companies from outsourcing - boosting investment and wages. It could also help slow the decline of American manufacturing employment. A simple comparison with Europe and Japan shows that the decrease of manufacturing jobs has been more dramatic in the U.S., so policy may be able to conserve what is left (Chart 16). Second, the bad. All the developed countries have seen manufacturing jobs decrease, and not only because of globalization. Technological advancement has played a major role as well. You can block off foreign goods, but you cannot roll back the march of the automatons (Chart 17), as our colleagues at U.S. Investment Strategy recently pointed out.25 Trump's blue collar workers may realize, after four years of protectionism that jobs are not coming back while the WalMart bills are getting pricier. Who will they vote for after that realization sets in? Chart 16U.S. Manufacturing Decline##br## Sharper Than In Other DM U.S. Manufacturing Decline Sharper Than In Other DM U.S. Manufacturing Decline Sharper Than In Other DM Chart 17Reasons For Robots##br## To Replace Workers Reasons For Robots To Replace Workers Reasons For Robots To Replace Workers Third, the ugly. If the U.S. goes protectionist, it will pull the rug out from neoliberalism globally and provide cover for similar protectionist realignments around the world - retaliatory as well as copy-cat. A falling tide lowers all boats. Worse than that, the decline in trade, insofar as it forces countries to rely on domestic markets, pursue spheres of influence, and protect access to vital commodities, could spark military conflict. Germany and Japan both started World War II precisely because their autarkic fantasies required expansion and pre-emptive warfare. This would be the mercantilist future that we warned clients of earlier this year.26 None of this is a foregone conclusion. There is simply too little information to judge which way the Trump administration will go - and how fast. But the fact remains that on trade, more so than anything else, Trump will be unconstrained. Bottom Line: De-globalization is the major risk of the Trump presidency.27 How Trump handles relations with China in 2017 will be the key indicator of whether he aims to revolutionize U.S. trade policy to the detriment of global exports and growth. If he blows past the rule of law and imposes steep "retribution" tariffs or quotas right away, then fasten your seat belt. Investment Conclusions For several years we have warned clients that austerity is kaput.28 It was never politically sustainable in the post-Debt Supercycle, low -growth environment that followed the 2008 Great Recession. The pendulum is swinging hard the opposite way, with Trump's heavy-handed, somewhat haphazard approach, adding momentum. Once the U.S. moves against austerity, we expect policymakers in other countries to follow. In the near term, the carnage in long-dated Treasury markets may pause as investors overthink the constraints to "G." Bond yields have already moved quite a bit. Structurally, however, the 35-year bond bull market is over.29 We continue to recommend that clients play the 2-year/30-year Treasury curve steepener, a position that is in the black by 11.2 basis points since November 1. In the long term, Trump's anti-globalization policies will impact investors the most. More protectionism, less immigration, and dollar-bullish fiscal policies will all be negative for America's MNCs. Meanwhile, fiscal spending, a stronger USD, and corporate tax reform that benefits small and medium enterprises (SMEs) paying the high marginal tax rate will benefit Main Street. As such, the way to play de-globalization in the U.S. is to go long SMEs / short MNCs, a view that we will expand upon in an upcoming collaborative report with BCA's Global Alpha Sector Strategy. Beyond the U.S., de-globalization will favor domestic consumer-oriented sectors and countries and will imperil international export-oriented sectors and countries. We particularly fear for export-heavy emerging markets, which depend on globalization for both capital and market access. Developed markets should have an easier time transitioning into a more protectionist world. As such, we continue to recommend a structural overweight in DM versus EM. For the time being, we are booking gains on our long S&P 500 / short gold trade, for a gain of 11.53% since November 8, due to our concern that equities may have already priced-in the lifting of animal spirits but not the negatives of de-globalization. Near term risk also abounds for our high-beta positions such as our long Japanese equities trade (gain of 3.99% since initiation on September 26) and long USD/JPY (gain of 3.57%, same initiation day). We will book gains and look to reinitiate both at a later date, given that our positive view on Japan remains the same. We will also close our long European versus global equities view, for a small loss of 1.34%. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 3 In physics, the Heisenberg's uncertainty principle - fundamental to quantum mechanics - supposes that the more precisely the position of a particle is determined, the less precisely its momentum can be known. Trump does not merely "flip flop" on policy issues - as his opponent Secretary Hillary Clinton was often accused of doing - but literally embodies two opposing policy views at the same time. 4 #TrumpisnotLucifer. 5 Reconciliation is a legislative process in the U.S. Senate that limits debate on a budget bill to twenty hours, thus preventing the minority from using the filibuster to veto the process. The procedure has also been used to enact tax cuts. In both 2001 and 2003, the Republican-held Senate used the procedure to pass President George W. Bush's tax cuts. 6 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. For analysis, please see Jim Nunns et al, "An Analysis of the House GOP Tax Plan," Tax Policy Center, September 16, 2016, available at www.taxpolicycenter.org. 7 A "flow-through" entity passes income on to the owners and/or investors. As such, the business can avoid double taxation, where both investors and the business are taxed. Only the investors and owners of a flow-through business are taxed on revenues. 8 Several groups would see no substantial tax cuts under the plan. Those making $15,000-$19,000 would see their tax rate increase from 10% to 12%. Those making $52,500-101,500 would see their rate stay the same at 25%, while those making $127,500-$200,500 would see their rate rise from 28% to 33%. Please see Jim Nunns et al, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016, available at www.taxpolicycenter.org. 9 A favorable rate of 10% (4% for non-cash assets) will be applied to accumulated earnings prior to 2017, while future overseas earnings will be subject to the corporate tax rate of 15%. The Tax Policy Center projects that $148 billion worth of unpaid tax revenue can be collected through the "deemed" (mandatory) repatriation. 10 The Bush tax cuts were extended in the American Taxpayer Relief Act of 2012, with some exceptions, like for the highest income groups. 11 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. The Trump campaign initially implied a decade-long total investment of $1 trillion "Trump Infrastructure Plan," with the government contributing a seed amount. The $1 trillion infrastructure-gap estimate comes from the National Association of Manufacturers, "Build to Win," dated 2016, available at www.donaldjtrump.com. The Trump team has reduced its total infrastructure investment goal to $550 billion, a number reaffirmed on Trump's White House transition website, www.greatagain.gov. 12 Please see Daniella Diaz, "Steve Bannon: 'Darkness is good,'" CNN, November 19, 2016, available at edition.cnn.com. Bannon, Trump's chief strategist, said: "Like (Andrew) Jackson's populism, we're going to build an entirely new political movement ... It's everything related to jobs. The conservatives are going to go crazy. I'm the guy pushing a trillion-dollar infrastructure plan. With negative interest rates throughout the world, it's the greatest opportunity to rebuild everything. Shipyards, iron works, get them all jacked up. We're just going to throw it up against the wall and see if it sticks. It will be as exciting as the 1930s, greater than the Reagan revolution - conservatives, plus populists, in an economic nationalist movement." 13 Dynamic-scoring, also known as macroeconomic modeling, is a favorite tool of Republican legislators when passing tax cut legislation. It allows them to cut taxes and then score the impact on the budget deficit holistically, taking into consideration the supposed pro-growth impact of the legislation. However, there is no reason why Republicans, under Trump, could not use the methodology for infrastructure spending as well. 14 Please see BCA Geopolitical Strategy Monthly Report, "Nuthin' But A G Thang," dated August 12, 2015, available at gps.bcaresearch.com. 15 By these executive orders, the Obama administration sought to prioritize the deportation of "high-risk" illegal immigrants while delaying action on more sympathetic groups. However, only one program was actually implemented (DACA), and both ground to a halt when the Supreme Court ordered an injunction. The justices concurred with lower courts that halted the programs as a result of the burden they would place on state finances. 16 Please see BCA Geopolitical Strategy Special Report, "Immigration Wars: The Coming Battle For Skilled Migrants," dated March 13, 2013, available at gps.bcaresearch.com. 17 The courts have already done the heavy lifting. Moreover the nullification of DACA only makes illegal immigrant children eligible for deportation, it does not necessitate that Trump actually deport them - that would require increasing the budget and capacity of Immigration and Customs Enforcement to cope with an additional four million deportees, all "low risk" and politically sympathetic. We doubt Trump will do this. 18 If Trump acts on his promise to make Mexico pay for the wall - a claim notably missing from his transition website greatagain.gov - then he may need to precipitate a foreign policy crisis (not to mention court opposition) through his own series of controversial executive orders. Alternatively, he could try to get Congress to amend the Patriot Act to allow the U.S. to extract payments from remittances from the U.S. to Mexico, but he would be at risk of a Senate filibuster. Both pose significant constraints. 19 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization: All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 20 Please see Lisa Reisman, "Nucor Provides Testimony To US House Ways And Means Committee On China Exchange Rate Policy," Metal Miner, September 16, 2010, available at www.agmetalminer.com. 21 Please see BCA China Investment Strategy, "China As A Currency Manipulator?" dated November 24, 2016, available at cis.bcaresearch.com. 22 In what follows we are indebted to an excellent paper by Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 23 See in particular the Trade Expansion Act of 1962 (Section 232b), the Trade Act of 1974 (Sections 122, 301), the Trading With The Enemy Act of 1917 (Section 5b), and the International Emergency Economic Powers Act of 1977. 24 A Federal District Court and the Supreme Court ruled against Harry Truman's executive orders to seize steel mills during the Korean War, but Truman's lawyers did not provide a statutory basis for his actions - they simply argued that the constitution did not limit the president's powers! 25 Please see BCA U.S. Investment Strategy Weekly Report, "Easier Fiscal, Tighter Money?," dated November 14, 2016, available at gps.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Monthly Report, "Austerity Is Kaput," dated May 8, 2013, available at gps.bcaresearch.com. 29 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.

Highlights The pace of globalization is slowing, reflecting the culmination of a decades-long process of integrating China and other emerging economies into the international trading system. Most commentators overstate the benefits of globalization, while glossing over the increasingly large distributional effects. A modest retreat from globalization would not irrevocably harm global growth, but a full-fledged trade war certainly would. Investors are underestimating the likelihood of disruptive trade measures from a Trump administration. Tactically underweight global equities. U.S. large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H-1B visa issuance under Trump's immigration plan. EM stocks could also come under pressure. Treasurys are oversold, but the structural trend for bond yields remains to the upside. The trade-weighted dollar could rally another 5% from current levels. And Take Your Damn Trump Hat With You If there is one sure way to get thrown out of a Davos party, it is by telling the assembled guests that globalization is not all that it is cracked up to be. After all, don't all cultured people know that globalization has made the world vastly richer? Well, maybe it has, but the evidence is not nearly as clear-cut as most people might imagine. Twenty years ago, the consensus among economists and policymakers was that international capital mobility should be strongly encouraged. Poor countries had a myriad of profitable investment opportunities, but lacked the savings to finance them, so the argument went. The solution, they were told, was to borrow from wealthier countries, which had a surfeit of savings. In the early 1990s, everything seemed to be going to plan. Emerging markets were running large current account deficits, using the proceeds from capital inflows to finance all sorts of investment projects. And then the Peso Crisis struck. And then the Asian Crisis. And just as quickly as the money came in, it came straight out. The result was mass defaults and depressed economies. Since then, most emerging economies have been trying to maintain current account surpluses - exactly the opposite of what theory would predict. Not to worry, the experts reassured us. What happened in emerging markets could not happen to developed economies with their strong institutions and sophisticated methods for allocating capital. The global financial crisis and later, the European sovereign debt crisis, put these claims to shame. Faced with this reality, the IMF published an official report in 2012 acknowledging that "rapid capital inflow surges or disruptive outflows can create policy challenges." It concluded that "there is ... no presumption that full liberalization is an appropriate goal for all countries at all times."1 This was a stunning about-face for an institution that, among other things, had sharply criticized Malaysia for imposing capital controls in 1998. Diminishing Returns To Globalization In contrast to capital account liberalization, the case for free trade in goods and services stands on sturdier ground. That said, proponents of free trade tend to overstate the benefits. As Paul Krugman has noted, the widely-used Eaton-Kortum model suggests that only about 5% of the increase in global GDP since 1990 can be attributed to higher trade flows.2 Moreover, it appears that the benefits to middle class workers in advanced economies from globalization have fallen over time. This is partly because trade liberalization, like most aspects of economic life, is subject to diminishing returns. Chart 1 shows that each succeeding round of trade liberalization has resulted in ever-smaller declines in average tariff rates. With tariffs on most tradeable goods now close to zero in the U.S. and most other advanced economies, there is less scope to liberalize trade further. As a result, proposed trade deals such as the Trans-Pacific Partnership (TPP) have focused on harmonizing business regulations and expanding patent and copyright protections. To call these deals "free trade agreements" is a stretch. Chart 1Tariffs Have Little Room To Decline Further bca.gis_wr_2016_11_25_c1 bca.gis_wr_2016_11_25_c1 Granted, many "invisible" barriers continue to stymie trade. John Helliwell has documented that a typical firm in Toronto generates roughly ten times as much sales from customers in Vancouver as it does from a similarly-sized, equidistant city in the U.S. such as Seattle.3 As it turns out, differences in legal systems and labor market institutions across countries, as well as differing social networks, can be as important an obstacle to trade flows as tariffs and quotas. But think about what this implies: If globalization were the key to economic development, then Canada, as a small economy situated next to a much larger neighbour, could prosper by dismantling these massive invisible trade barriers. However, we know that this proposition cannot be true: Canada is already a very rich economy, so any further trade liberalization would only boost incomes at the margin. What's Behind The Trade Slowdown? The analysis above helps put the much-discussed slowdown in global trade into context (Chart 2). As the IMF concluded in its most recent World Economic Outlook, while much of the deceleration in trade growth is attributable to cyclical factors, structural considerations also loom large.4 In particular, the boost to global trade over the past few decades stemming from the collapse of communism, the progressive elimination of most trade barriers, and the decision by most developing economies to abandon import-substitution policies appears to have run its course (Chart 3). In addition, the regional disaggregation of the global supply chain is slowing. These days, motor vehicle parts are shipped across national borders many times over before the final product rolls off the assembly line. The manufacturing process can only be broken down so much before diminishing returns set in. Chart 2Global Trade ##br##Growth Is Slowing Global Trade Growth Is Slowing Global Trade Growth Is Slowing Chart 3The Low-Hanging Fruits Of ##br##Globalization Have Been Picked bca.gis_wr_2016_11_25_c3 bca.gis_wr_2016_11_25_c3 Productivity gains in the global shipping industry are also moderating. As Marc Levinson argued in his book "The Box," the widespread adoption of containerization in the 1970s completely revolutionized the logistics and transportation industry. As a consequence, the days when thousands of longshoremen toiled in the great ports of Baltimore and Long Beach are long gone. Nowadays, huge cranes move containers off ships and place them into waiting trucks or trains. To the extent that there are still technological advances on the horizon - think self-driving trucks - these are likely to reduce intranational transport costs more than international costs. This could result in even slower trade growth by encouraging onshoring. Trade And Income Distribution Chart 4China's Rise Came Partly At ##br##The Expense Of U.S. Rust Belt Workers bca.gis_wr_2016_11_25_c4 bca.gis_wr_2016_11_25_c4 As every first-year economics student learns, David Ricardo's Theory of Comparative Advantage predicts that real wages will rise when countries specialize in the production of goods that they can manufacture relatively well. Students who stick around (and manage to stay awake) for second-year economics might learn about the Heckscher-Ohlin model. This model qualifies Ricardo's findings. Yes, free trade raises average real wages, but there can be large distributional effects. In particular, low-skilled workers could actually suffer a decline in real wages when rich countries increase trade with poorer countries. As trade ties between advanced and developing countries have grown, these distributional issues have become more important. David Autor has documented that increasing Chinese imports have had a sizable negative effect on manufacturing employment in the U.S. (Chart 4).5 It is thus not surprising that voters in Rust Belt states were especially receptive to Donald Trump's protectionist rhetoric. A Tale Of Two Globalizations: China Versus Mexico Most economists agree that trade liberalization has disproportionately benefited developing economies. Nevertheless, there too the benefits are often overstated. China, of course, is frequently cited as an example of a country that has prospered by integrating itself into the global economy. But what about Mexico? It also made a massive push to liberalize trade starting in the mid-1980s, which culminated in NAFTA in 1994. As a consequence, the ratio of Mexican exports-to-GDP rose from 13% in 1994 to 35% at present. Yet, as Chart 5 shows, GDP-per-hour worked has actually declined relative to the U.S. over this period. One key reason why China benefited more from globalization than Mexico is that China had a much better educated workforce. This allowed it to quickly absorb technological know-how from the rest of the world, setting the stage for the spectacular growth of its own domestic industries. Sadly, when it comes to human capital, China is more the exception than the rule across developing economies (Chart 6). Chart 5Trade Liberalization Has Not ##br##Improved Mexico's Relative Productivity bca.gis_wr_2016_11_25_c5 bca.gis_wr_2016_11_25_c5 Chart 6Educational Achievement ##br##In Emerging Economies: China Stands Out The Elusive Gains From Globalization The Elusive Gains From Globalization Noble... And Not So Noble Lies To be clear, the discussion above should not be interpreted as arguing that globalization is bad for growth. Trade openness does matter for economic development. However, other things, such as the level of human capital and the quality of domestic economic institutions, matter even more. How can one reconcile this view with the near-apocalyptic terms in which many commentators discuss the anti-globalization sentiment sweeping across many developed economies? Let me suggest two explanations: one noble, one less so. The noble explanation goes beyond economics. Proponents of trade liberalization often argue that the 1930 Smoot-Hawley Tariff Act was a leading cause of the Great Depression. On purely economic grounds, this argument makes little sense. Exports accounted for less than 6% of U.S. GDP in 1929. While trade volumes did fall rapidly between 1929 and 1932, this was mainly the result of the economic slump, rather than the cause of it. In fact, trade volumes actually fell more in the immediate aftermath of the 2008 financial crisis (Chart 7). Yet, from a political perspective, the importance of Smoot-Hawley is hard to deny. At a time when Nazi Germany was on the rise, the U.S. and its allies were squabbling over trade issues. As such, the main problem with Smooth-Hawley was not that it pushed the U.S. into a Depression, but that it sabotaged diplomatic coordination at a time when it was most needed. One suspects that something similar underlies much of the angst over Trump's trade policies. The Global Trade Alert, currently the most comprehensive database for all types of trade-related measures imposed since the global financial crisis, shows an increase in protectionist measures over the last few years (Chart 8). The risk is that this trend will accelerate after Donald Trump is sworn in as President. Chart 7Global Trade Fell More ##br##During The Great Recession The Elusive Gains From Globalization The Elusive Gains From Globalization Chart 8Protectionist Measures ##br##Are On The Rise The Elusive Gains From Globalization The Elusive Gains From Globalization Considering that globalization ran into diminishing returns some time ago, a modest unwinding of globalization would probably not have the calamitous impact that many fear. However, just like a plane that fails to fly sufficiently fast will fall to the ground, a "modest unwind" may prove difficult to achieve in practice. Globalization, in other words, may be approaching stall speed. And given the large number of issues that require global cooperation - terrorism, migration, climate change - that is a risk which requires attention. Money Talks If that were all to the story, it would be easy to forgive those who overstate the economic benefits from globalization in order to preserve the political ones. One suspects, however, that there may also be a self-serving motive at work. The integration of millions of workers from China and other developing economies into the global labor market has put downward pressure on wages, boosting profit margins in the process. Not surprisingly, CEOs, hedge fund managers, and other titans of industry have benefited greatly from this development. Chart 9 shows that most of the increase in income equality since 1980 has occurred not at the 99th percentile, but at the 99.99th percentile and higher. It would be naïve to think that the colossal gains that some have enjoyed from globalization would not color what they say on the subject. Chart 9The (Really) Rich Got Richer The Elusive Gains From Globalization The Elusive Gains From Globalization Investment Conclusions U.S. equities have been in rally mode since the election. Many aspects of Trump's agenda are good for stocks - corporate tax cuts, deregulation, and fiscal stimulus, just to name a few. These factors make us somewhat constructive on equities over a long-term horizon. Chart 10Tech Stocks Are Heavily ##br##Exposed To Globalism The Elusive Gains From Globalization The Elusive Gains From Globalization Nevertheless, it cannot be denied that Trump's anti-globalization rhetoric represents a direct threat to corporate earnings. While some of Trump's protectionist proposals will undoubtedly be watered down, investors are underestimating the likelihood of disruptive trade measures. Unlike on most issues where he has flip-flopped repeatedly, Trump has consistently espoused a mercantilist view on trade since the 1980s. He is also the sort of person that strives to reward his supporters while disparaging those who slight him. Rust Belt voters awarded Trump the presidency. Their loyalty will not be forgotten. This means the stock market's honeymoon with Donald Trump may not last much longer. We remain tactically cautious global equities and are expressing that view by shorting the NASDAQ 100 futures. Globally-exposed large cap tech stocks will suffer the most from a turn towards trade protectionism and from the curtailment of H1-B visa issuance under Trump's immigration plan (Chart 10). Emerging market equities are also likely to feel the heat from rising protectionist sentiment in developed economies. A stronger dollar will only add to EM woes by putting downward pressure on commodity prices and making it more expensive for EM borrowers to service dollar-denominated loans. As we discussed in "A Trump Victory Would Be Bullish For The Dollar" and "Three Controversial Calls: Trump Will Win, And The Dollar Will Rally," the three key elements of Trump's policy agenda - fiscal stimulus, tighter immigration controls, and higher tariffs - are all inflationary, and hence are likely to prompt the Fed to raise rates more than it otherwise would.6 Higher U.S. rates, in turn, will keep the greenback well bid. We expect the real trade-weighted dollar to strengthen another 5% from current levels. The flipside of a stronger dollar is increasing monetary policy divergence between the U.S. and the rest of the world. U.S. bond yields have risen significantly since the election. Tactically, we would not be adding to short duration positions at current levels. Structurally, however, the 35-year bond bull market is over. As we discussed in our latest Strategy Outlook,7 weak potential GDP growth is eroding excess capacity around the world, which is bad news for bonds. Population aging could also shift from being bullish to bearish for bonds, as more people retire and begin to draw down their savings. Meanwhile, central banks are looking for ever more creative ways to boost inflation, while the populist wave is forcing governments to abandon austerity measures. Lastly, and most relevant to this week's discussion, globalization - an inherently deflationary force - is in retreat. This, too, suggests that the longer-term risks to inflation are to the upside. Peter Berezin, Senior Vice President Global Investment Strategy peterb@bcaresearch.com 1 Please see "The Liberalization And Management Of Capital Flows: An Institutional View," IMF Executive Summary, November 14, 2012. 2 Paul Krugman, "The Gains From Hyperglobalization (Wonkish)," The New York Times, October 1, 2013. 3 John F. Helliwell and Lawrence L. Schembri, "Borders, Common Currencies, Trade And Welfare: What Can We Learn From The Evidence?" Bank of Canada Review, Spring 2005. 4 Please see "Global Trade: What's behind the Slowdown?" in "Subdued Demand: Symptoms and Remedies," IMF World Economic Outlook (October 2016). 5 David Autor, David Dorn, and Gordon Hanson, "The China Syndrome: Local Labor Market Effects Of Import Competition In The United States," The American Economic Review, Vol. 103, No. 6, (2013): pp. 2121-2168. 6 Please see Global Investment Strategy Weekly Report, "A Trump Victory Would Be Bullish For The Dollar," dated June 3, 2016, and Special Report, "Three (New) Controversial Calls," dated September 30, 2016, available at gis.bcaresearch.com 7 Please see Global Investment Strategy, "Strategy Outlook Fourth Quarter 2016: Supply Constraints Resurface," dated October 7, 2016, available at gis.bcaresearch.com Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights The basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. Even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. Trade friction between the U.S. and China may increase with product-specific tariffs, but that a broader escalation in protectionism is unlikely, at least in the near term. The changing correlation between the RMB and Chinese stocks suggests that investors may be becoming less worried about the RMB and China's foreign exchange policy. Over the long run, the "normal" negative correlation between the performance of exchange rate and that of the stock market should also emerge with regards to the RMB and Chinese stocks. Feature Financial markets will continue to grapple with what U.S. President-elect Donald Trump will bring to the global economy as we head into the final trading weeks of 2016. His signature policy proposals - fiscal stimulus, a more restrictive immigration policy, and trade protectionism - have already led to a significant repricing of risk asset, and will continue to unsettle investors. As far as China is concerned, the upshot is that more fiscal stimulus under President Trump will generate stronger American demand, which could spill over to China. The downside risk is undoubtedly protectionism, which will cast a long shadow on an economy that is still heavily dependent on overseas markets.1 President-elect Trump declared on the campaign trail that he would name China a currency manipulator on his first day in office, accompanied by punitive tariffs on Chinese imports that could reach 45%. This adds a major uncertainty to the growth outlook for China next year. Conditions And Remedies For A Currency Manipulator For now, it is impossible to predict what President Trump will do. He has become notably more pragmatic since his election victory. In his first policy statement, he declared his intentions to withdraw the U.S. from the Trans-Pacific Partnership (TPP) negotiations as his top priority on trade, while avoiding further China-bashing. However, the true color of his trade policy remains unclear. What is more certain is that the basic conditions that the U.S. Treasury utilizes to evaluate its major trade partners do not justify labeling China as a currency manipulator. The existing Treasury review process of foreign exchange practices is a formal process laid out in statutory law that governs the reporting process, the need for negotiations in cases of manipulation, and the recommended trade remedies if negotiations fail. Specifically, there are three conditions a nation must meet to be labeled a currency manipulator: It runs a significant bilateral trade surplus with the U.S.; It has a material current account surplus; and It has engaged in persistent one-sided intervention in the foreign exchange market. In China's case, the country does run a significant bilateral trade surplus with the U.S., but its current account surplus as a share of GDP has declined from a peak of 10% in 2007 to 2.5% currently (Chart 1). More importantly, while China's foreign exchange market intervention has indeed been one-sided since 2014, the effort has been to prop up the RMB against the dollar. Without the PBoC's intervention, the RMB would have fallen further, potentially substantially. The RMB may have met all three criteria for currency manipulation before the global financial crisis, but the case is a lot harder to make at the moment. Chart 1Conditions For A Currency Manipulator Conditions For A Currency Manipulator Conditions For A Currency Manipulator Moreover, even if China were officially declared as a manipulator, the remedial measures that the Treasury must follow under the existing legal framework are materially insignificant for a country like China. The U.S. Treasury is required to negotiate with alleged currency manipulators, utilizing several "sticks" if negotiations fail: Prohibit the Overseas Private Investment Corporation from financing (including providing insurance to) new projects in that country; Prohibit the federal government from procuring from that country; Seek additional surveillance of the macroeconomic and exchange rate policies of that country through the International Monetary Fund; Take into account the currency practices in negotiating new bilateral or regional trade agreements with that country. While these "sticks" may be intimidating enough for small open economies, for a country like China, they are largely irrelevant. There is no ongoing negotiation for bilateral trade agreement between the two countries, and on a federal level the U.S. government rarely procures in China, if at all. Therefore, labeling China a currency manipulator may be a highly symbolic move aimed at satisfying Trump supporters, but the real economic consequences are rather small. To be sure, the U.S. president has enough administrative authority to bypass existing legal constraints and take unilateral action on trade issues. However, that would require extraordinary political capital. Barring this rather "extreme" scenario, we expect trade frictions between the U.S. and China to increase in the form of product-specific tariffs. A broader escalation in protectionism is unlikely, at least in the near term. The Impact On Investment Flows From a balance-of-payment point of view, a country running a trade deficit should not be viewed as a sign that it is losing in bilateral trade. Rather, it reflects capital flows from a surplus country to a deficit country in the form of exported domestic savings. In this vein, China running a chronic current account surplus with the U.S. implies that the country as a whole has been accumulating U.S. assets. By the same token, so long as China runs a current account surplus, it means it is still a net creditor to the rest of the world, and the nation's foreign asset holdings, official and private sector combined, continue to increase. In previous years, it was the Chinese central bank that had increased its holdings of foreign assets, primarily in the form of U.S. Treasurys and other low-risk liquid assets. More recently, as the RMB has been depreciating against the dollar, the Chinese domestic private sector been accumulating foreign assets, particularly denominated in U.S. dollars. In fact, the private sector has taken over as the main source of demand for foreign assets, primarily in risker asset classes such as corporate equities, bonds and real estate. The official sector, on the other hand, has been selling foreign asset holdings, as reflected in China's declining official reserves. In other words, rather than experiencing an exodus of capital, there has been a gigantic "swap" of foreign assets between private and public sector in China. Indeed, Chart 2 shows China's official reserves have dropped significantly in the past two years. Chinese official holdings of Treasurys currently stand at USD 1157 billion, down from USD 1315 billion in 2011. Meanwhile, anecdotal evidence suggests that buoyant demand among Chinese households for foreign assets, particularly real estate. For the corporate sector, there has been a dramatic increase in overseas mergers and acquisitions (M&A) and other investment activity by Chinese companies, particularly in the U.S. (Chart 3). So far this year, total announced M&A deals by Chinese firms in the U.S. have already tripled compared to last year, however, most are still in progress and pending. Chart 2The Official Sector Is##br## Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... The Official Sector Is Shedding Foreign Assets... Chart 3... While The Private ##br##Sector Accumulates China As A Currency Manipulator? China As A Currency Manipulator? Looking forward, if the business environment in the U.S. under President Trump becomes less foreign-friendly, it may impact Chinese enterprises' confidence in acquiring U.S. assets, and complicate Chinese companies' M&A deals. At a minimum, the massive increase in Chinese M&A interest in the U.S. will pause until policy visibility improves, while the outlook for many already announced pending deals will remain murky. This may deter further capital flows to the U.S. by the Chinese private sector. Changing Correlation Between The RMB And Stocks? The RMB has continued to drift lower against the dollar in the past week in both the onshore and offshore markets. Interestingly, Chinese stocks have appeared to have largely ignored the RMB's slide and have continued to move higher. This is in stark contrast to last year's panic selloffs that happened whenever RMB appreciation against the dollar appeared to quicken (Chart 4). In August 2015 and January 2016, the RMB's outsized moves against the dollar caused major disruptions in both A shares and H shares, sending shockwaves across the globe. It is too soon to draw definitive conclusions from very short-term moves. However, the changing correlation between the RMB and Chinese stocks suggests that investors may have become less worried about the RMB and China's foreign exchange policy. First, investors may be getting more accustomed to the RMB's rising volatility. The trade-weighted RMB in recent days has been stable, a sign that the RMB's weakness against the dollar is mainly a reflection of the strong dollar. The People's Bank of China and other relevant authorities have also been paying more attention when communicating to market participants, which may also help anchor investors' expectations. Second, in previous episodes of "sharper" RMB depreciation, the Chinese economy was clearly decelerating, and the RMB weakness further amplified investors' anxiety on China's macro conditions. Currently the Chinese economy is showing notable signs of improvement, particularly in the industrial sector, which also lessens investors' concerns. Chart 4The RMB Is Less Troubling ##br##To Market bca.cis_wr_2016_11_24_c4 bca.cis_wr_2016_11_24_c4 Chart 5The Mirror Image Between Yen ##br##And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks The Mirror Image Between Yen And Japanese Stocks Finally, the market may be starting to reflect the reflationary impact of a weaker currency rather than the negative consequences of RMB depreciation. China's growth improvement is in no small part attributable to the falling exchange rate. This in and of itself limits the RMB's downside, rather than leading to an endless downward spiral. It remains to be seen whether Chinese stocks will stay calm as the RMB continues to depreciate against a surging dollar. Our hunch is that global equity markets, particularly in the U.S., have become complacent with a strong dollar and rising U.S. interest rates, both of which tighten global liquidity conditions. Therefore, global equities are vulnerable to downside risk, which could spill over to the Chinese market. For now, we are staying on the sidelines and do not suggest investors chase the rally in Chinese equities. However, over the long run, we expect investors will eventually come to terms with the "new normal" for the RMB as it becomes an important macro factor for the economy and stock market. Chart 5 shows that the performance of Japanese stocks has almost been a mirror image of the yen/dollar exchange rate, in which a weaker yen boosts Japan's growth profile as well as stock prices, and vice versa. Barring a crisis scenario, such a correlation will also emerge between the RMB and Chinese stocks over the long run. Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "China-U.S. Trade Relations: The Big Picture", dated November 17, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Investors are betting that Trump's expansionary agenda will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. We doubt that Trump's fiscal and regulatory plan will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place. We expect that Trump will find most common ground with Congress on the fiscal side. It will be difficult, politically, for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform. We expect a meaningful fiscal stimulus package to be passed in the U.S. that will boost growth temporarily. We cannot rule out a trade war that more than offsets the fiscal impulse. Nonetheless, Trump's desire for growth means that he may tread carefully on protectionism. A window may open next year that will favor risk assets for a period of time. A temporary U.S. growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Our bias is to upgrade risk assets to overweight, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new Administration's policy intentions. In the meantime, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. The bond selloff is likely to pause until there is more concrete evidence that Congress will accept tax cuts and infrastructure spending, but global yields eventually have more upside potential. Value and relative monetary policies favor the Japanese and European stock markets versus the U.S., at least in local currencies. We are less bearish on high-yield bonds in relative terms, although we are still slightly below-benchmark. Feature Initial fears that a Trump victory would be apocalyptic for the economy and financial markets quickly morphed into an equity celebration on hopes that the Republican sweep would usher in policies that will shift American growth into high gear. Major U.S. stock indexes have broken above recent trading ranges, despite the surge in the dollar and the devastation in bond markets. Investors are betting that Trump's expansionary policies will not be torpedoed by his less market-friendly policies such as trade protectionism. We have some sympathy for this view, but believe that investors should remain cautious on risk assets until we receive more clarity on the sequencing of Trump's wish list and how aggressively he will pursue fiscal expansionism relative to trade and immigration reform. In the meantime, investors should remain long the dollar and short duration within bond portfolios, although a near-term correction of recent market action appears likely. Our geopolitical strategists argued through the entire campaign that Trump had a better chance of winning than the consensus believed because he was riding a voter preference wave that is moving left. Trump campaigned as an unorthodox Republican, appealing to white, blue collar voters by blaming globalization for their job losses and low wages, and by refusing to accept Republican (GOP) orthodoxy on fiscal austerity or entitlement spending. Chart I-1Big Government Is Only ##br##A Problem For The Opposition bca.bca_mp_2016_12_01_s1_c1 bca.bca_mp_2016_12_01_s1_c1 The polarization of U.S. voters and comparisons with the U.K. Brexit vote are well trodden themes that we won't rehash here. The important point is that the GOP now holds both the White House and Congress. The investment implications hinge critically on how friendly Congress is to Trump's policy prescriptions. Many pundits argue that House and Senate Republican's will block Trump's ambitious tax cut and infrastructure spending plan because it would blow out the budget deficit. The reality is more complex. It will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Our post-election Special Report pointed out that, over the past 28 years, each new president has generally succeeded in passing their signature items.1 Moreover, the GOP is less fiscally conservative than is widely believed. Fiscal trends under the Bush and Reagan administrations highlighted that Republicans do not always keep spending in check (Chart I-1). The key pillars of Trump's campaign were renegotiating trade deals, immigration reform, increased infrastructure and defense spending, tax cuts, protecting entitlements, repealing Obamacare and reducing regulations. However, there is a big difference between election promises and what can actually be delivered. It is early going, but our first Special Report, beginning on page 19, presents a Q&A from our geopolitical team on what we know in terms of political constraints and possible outcomes in the coming year. Common Ground On Fiscal Policy We expect that Trump will find most common ground with Congress on the fiscal side. Infrastructure spending has bipartisan support, as highlighted by last year's highway funding bill. Democratic senators and House Republicans have promised to work with the new President on infrastructure spending. Trump is likely to offer tax reform in exchange for his infrastructure plan. Trump wants to cut the top marginal corporate tax rate (from 39.6% to 33%), repeal the Alternative Minimum Tax, and slash the corporate tax rate (from 35% to 15%). His plan also includes increased standard deduction limits and a full expensing of business capital spending. The Tax Policy Center estimates that Trump's tax plan alone would increase federal debt by $6.2 trillion over the next ten years (excluding additional interest).2 An extra $1 trillion in infrastructure outlays over the next decade, together with a growing defense budget, could add another $100-$200 billion to total federal spending per year. The problem, of course, is that few sources of new revenue have been suggested to cover the costs of these policy changes. The Tax Policy Center's scoring of the Trump plan implies a jump in the U.S. debt/GDP ratio from 77% today to 106% in 2026. Other studies claim that the budget damage will be far less than this because government revenues will boom along with the economy. We doubt that will be the case. The outlook for U.S. trade policy is even more nebulous. Trump has threatened to kill the Trans-Pacific Partnership (TPP), renegotiate the North American Free Trade Agreement (NAFTA) and potentially place tariffs of 35% and 45%, respectively, on imports from Mexico and China (among other protectionist measures). He has even threatened to take the U.S. out of the WTO.3 These threats are no more than posturing ahead of negotiations, but Trump needs to show his base of support that he is working to "make America great again". Protectionism will probably generate more pushback from Republicans in the House and Senate than Trump's fiscal measures. The Economic Implications Of Trumponomics Table I-1Ranges For U.S. Fiscal Multipliers December 2016 December 2016 In terms of the overall economic impact, there are many moving parts and it is unclear how much the Trump Administration will push fiscal stimulus versus trade protectionism. As discussed in the Special Report, it is possible that the tax cuts will be implemented as quickly as the second quarter of 2017, while infrastructure spending could begin ramping up in the second half of the year. However, we cannot rule out a lengthy bargaining process that would delay the economic stimulus into 2018. We doubt that Trump will get everything on his wish list. Moreover, the multiplier effects of tax cuts, which will benefit the upper-income classes the most, are smaller than for direct government spending (Table I-1). Nevertheless, even if he gets one quarter of what he is seeking, it could be enough to boost aggregate demand growth by up to 1% per year over a two year period. In terms of trade, Trump will undoubtedly kill the TPP immediately following his inauguration to show he means business. The President also has the power to implement tariffs without Congressional consent. It is unclear whether he can also cancel NAFTA unilaterally, but at a minimum he can impose higher tariffs and trade restrictions on Canada and Mexico. Nonetheless, comments from his advisors suggest that president-elect Trump wants stronger growth above all else. This means that he may tread carefully to avoid the negative growth effects of a trade war. Some high-profile studies of the impact of the Trump economic plan paint a grim picture. The Peterson Institute points out that "withdrawal from the WTO would lead to the unraveling of all tariff negotiations and the reversion of rates to the MFN level of a preexisting agreement, conceivably all the way back to the Smoot-Hawley rates that were in effect in 1934." Another Peterson study reported the results of a simulation of the impact of returning to the Smoot-Hawley tariff levels, using a large general equilibrium global model.4 They find that U.S. real GDP would contract by about 7½%, or roughly $1 trillion. Thus, a "doomsday trade scenario" is possible, but it seems inconceivable that Trump would withdraw from the WTO given his desire for growth. More likely, he will settle for higher tariffs placed on Mexico and China. Such tariffs would undermine U.S. growth on their own, but we believe that some recent studies discussed in the press overstate the negative impact of these tariffs. Back-of-the-envelope estimates suggest that the tariff increases would reduce U.S. real GDP by roughly 1.2%, including retaliation by Mexico and China in the form of higher tariffs on U.S. exports (see Box I-1 for more details). The negative shock would likely be stretched over a couple of years.5 Box 1 Importantly, not all of any tariff increase would be "passed-through" to U.S. businesses and households. Studies show that, historically, the pass-through of tariff increases into U.S. prices was actually quite low, at about 0.5. A large portion of previous tariff hikes have been absorbed by foreign producers as they endeavored to protect market share. This means that a 35% tariff on Mexican imports would result in a roughly 17½% rise in import prices from Mexico. A 45% tariff on Chinese goods would result in a 22½% rise in import prices from China. Moreover, the import price elasticity of U.S. demand, or the sensitivity of U.S. demand to a change in the price of imported goods, is estimated to be about 1. That is, a 22½% rise in import prices from China leads to a 22½% drop in import volumes from that country. Roughly one-half of the drop in imports is replaced by purchases from other countries and one-half from U.S. sources. This so-called "expenditure switching" effect actually boosts U.S. real GDP on its own. Of course, this lift is more than offset by the fact that households and businesses suffer a loss of purchasing power due to higher import prices. Chinese and Mexican imports represent 2.7% and 1.7%, respectively, of U.S. GDP. With these figures and the elasticities discussed above, we can calculate a back-of-the-envelope estimate of the impact of the Trump tariffs. The expenditure switching effect would boost U.S. real GDP by about 0.4%. This is offset by the purchasing power effect of -0.7% (including a multiplier of 1.5), leaving a net loss of only 0.3%. Of course, China and Mexico will retaliate by imposing higher tariffs on U.S. exports. This has a larger negative impact on the U.S. because American export volumes decline and there is no offsetting expenditure-switching effect. We estimate that retaliation with equal tariffs on U.S. exports would reduce U.S. GDP by about 1% using reasonable elasticities. Adding it all up, the proposed Trump tariffs on China and Mexico would result in a roughly 1.2% hit to U.S. real GDP. This could overstate the negative shock to the extent that the tariff revenues are spent by the U.S. government.6 Moreover, some studies of the Trump agenda assume that business spending would wither under a stronger dollar, waning business confidence and higher interest rates. We are not so pessimistic. The threat of punitive measures is likely to dissuade some U.S. companies from moving production abroad. Ford announced that it had abandoned plans to shift production of its luxury Lincoln SUV from Kentucky to Mexico. On the flipside, the fear of losing access to the U.S. market might persuade some foreign companies to relocate production to the United States. Such worries were a key reason why Japanese automobile companies began to invest in new U.S. production capacity starting in the 1980s. Moreover, U.S. corporate capital spending has been lackluster since the Great Recession due to "offshoring". Higher tariffs would promote "onshoring", helping to lift capital spending within the U.S. economy. We are not arguing that trade protectionism will be good for the U.S. economy. We are merely pointing out that there are positive offsets to the negative aspects of protectionism, and that many studies are overly pessimistic on the impact on growth. That said, all bets are off if Trump does the unthinkable and cancels NAFTA outright and/or takes the U.S. out of the WTO. The Fed's Reaction The economic and financial market dynamics over the next couple of years depend importantly on how the Fed responds to the Trump policy mix. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked the Fed Chair and current monetary policy settings. A review of the Fed may happen at some point, but we assert that an investigation will not be a priority early in Trump's mandate. Some have raised concerns that Trump could stack the FOMC with hawks when he fills the openings next year. More likely, he will opt for doves because he will not want a hawkish Fed prematurely shutting down the expansion. The studies that warn of a major U.S. recession under Trump's policies assume that the Fed tightens aggressively as fiscal stimulus lifts the economy's growth rate. For example, the Moodys' report assumes that the fed funds rate rises to 6½% by 2018!7 No wonder Moodys' foresees a downturn that is longer than the Great Recession. No doubt, it would have been better if fiscal stimulus arrived years ago when there was a substantial amount of economic slack. With the economy close to full employment today, aggressive government pump-priming could set the U.S. up for a typical end to the business cycle; overheating followed by a Fed-induced recession. Indeed, many investors are wondering if the U.S. is overdue for a recession anyway. The current expansion phase is indeed looking long-in-the-tooth by historical standards. However, the old adage is apt: "expansions don't die of old age, they are murdered by the Fed". In Charts I-2A, Chart I-2B and Chart I-2C, we split the U.S. post-1950 economic cycles into three sets based on the length of the expansion phase: short (about 2 years), medium (4-6 years) and long (8-10 years). What distinguishes short from the medium and long expansions is the speed by which the most cyclical parts of the economy accelerate, and the time it takes for the unemployment rate to reach a full employment level. Long expansion phases were characterized by a drawn-out rise in the cyclical parts of the economy and a slow return to full employment in the labor market, similar to what has occurred since the Great Recession (Chart I-2C). Chart I-2ALong bca.bca_mp_2016_12_01_s1_c2a bca.bca_mp_2016_12_01_s1_c2a Chart I-2BMedium Expansions bca.bca_mp_2016_12_01_s1_c2b bca.bca_mp_2016_12_01_s1_c2b Chart I-2CA Short Expansion bca.bca_mp_2016_12_01_s1_c2c bca.bca_mp_2016_12_01_s1_c2c Of course, the Fed did not begin to tighten policy immediately upon reaching full employment in the past. The Fed began hiking rates an average of 13 months after reaching full employment in the short cycles, 30 months for medium cycles, and more than 60 months in the "slow burn" expansions (Table I-2). Even if we exclude the 1960s expansion, when the Fed delayed for too long and fell behind the inflation curve, the Fed has waited an average of 45 months before lifting rates in the other long expansions (beginning in 1982 and 1991). The longer delay compared to the shorter expansions reflected the slow pace at which inflationary pressures accumulated. During these periods, inflation-adjusted earnings-per-share (EPS) expanded by an average of 25% and the real value of the S&P 500 index increased by 28%. Table I-1U.S. Expansions Can Last Long After Full Employment Is Reached December 2016 December 2016 The lesson is that risk assets can still perform well for a long time after the economy reaches full employment. Admittedly, however, equity valuation is more stretched today than was the case at similar points in past long cycles. Before the U.S. election, the current expansion appeared to be heading for a similar long, drawn-out conclusion. Inflationary pressures are beginning to emerge, but only slowly, and from a low starting point. Moreover, evidence suggests that the Phillips curve8 is quite flat at low levels of inflation. This implies that the Fed has plenty of time to normalize interest rates because inflation is unlikely to surge. However, a sea change in trade and fiscal policy could change the calculus. To the extent that fiscal stimulus is front-loaded relative to trade protection, and that any trade restrictions add to inflation, Trump's policy agenda could force the Fed to normalize rates more quickly. The FOMC Will Wait And See Chart I-3Inflation Expectations Moving To Target Inflation Expectations Moving To Target Inflation Expectations Moving To Target Yellen's congressional testimony in November revealed that the Fed is not yet preparing for a more aggressive tightening cycle. There was nothing to suggest that the Fed is revising its economic forecasts following the election. Similarly, the Fed is not making any upward revisions to its estimate of the long-run neutral rate, which remains "quite low by historical standards." The implication is that the Fed will raise rates in December, but it will keep its "dot" forecast unchanged. The FOMC is prudently awaiting the details of the fiscal package before changing its economic and interest rate projections. We doubt that the Fed will be aggressive in offsetting the fiscal stimulus. We have argued in the past that the consensus on the FOMC would not follow the Bank of Japan and officially target a temporary overshoot of the 2% inflation target. Nonetheless, most Fed officials would not be upset if, with hindsight, they tighten too slowly and inflation overshoots modestly. The inflation target is supposed to be symmetric, which means that 2% is not meant to be a hard ceiling. Moreover, the Fed will be extremely cautious about tightening monetary policy until TIPS breakevens are more firmly anchored around pre-crisis levels. Market-based measures of inflation compensation have surged in the past few weeks, but remain below levels that are consistent with the Fed hitting its 2% PCE inflation target (Chart I-3).9 Investors should continue to hold inflation protection in the bond market. A window may open sometime in 2017 in which improving economic growth is met with a cautious Fed. In this environment, we would expect the Treasury curve to bear-steepen and risk assets to outperform. The window will likely close once inflation moves up and inflation expectations converge at a level consistent with the 2% target. Bond Strategy The implications of Trump's policy agenda are clearly bond bearish, although yields have shifted a long way in a short time. The gap between market rate expectations and the Fed's median expected path has narrowed considerably, both at the long-end and short-end of the curve (Chart I-4). The 5-year/5-year forward overnight index swap rate is now 2.1%, only 82 bps below the Fed's median estimate of the equilibrium fed funds rate. The U.S. 10-year yield has already converged with two measures of fair value, although yields remain well below fair value in the other major countries according to estimates of nominal potential output growth (Charts I-5 and I-6). The fact that the gap between the Fed's dots and market expectations has almost closed, means that a lot of bond-bearish news has been discounted in the U.S. We would not be surprised to see a partial retracement of the recent bond selloff. Investors will want to see concrete plans for substantial fiscal stimulus before the next leg of the bond bear market takes place. Speculators may wish to take profits on short bond plays, but investors with a 6-12 month horizon should remain short of duration benchmarks. Chart I-4Market Expectations Converging With Dots Market Expectations Converging With Dots Market Expectations Converging With Dots Chart I-5Bond Fair Value Method (I) Bond Fair Value Method (I) Bond Fair Value Method (I) Chart I-6Bond Fair Value Method (II) bca.bca_mp_2016_12_01_s1_c6 bca.bca_mp_2016_12_01_s1_c6 On a long-term horizon, the Trump agenda reinforces our view that the secular bull market in bonds is over. Larry Summers' Secular Stagnation thesis will be challenged and investors will come to question the need for ultra-low real interest rates in the U.S. well into the next decade. A blowout in the U.S. budget deficit will temper the excess global savings story to some extent. Tax cuts, infrastructure spending, full expensing of capital goods and reduced regulation may also boost the long-run potential growth rate in the U.S. All of this suggests that equilibrium interest rates and bond yields will shift higher. Nonetheless, poor demographic trends and other impediments to both the supply- and demand-sides of the U.S. and global economies have not disappeared. The ECB is likely to extend its bond purchase program beyond next March, while the Bank of Japan has capped the 10-year JGB yield at close to zero, both of which should limit the amount by which yields in the other developed markets can rise. We could even see global yields fall back to near previous lows if the Fed winds up tightening too aggressively and sparks the next recession. Is Trump Bullish For Stocks? Chart I-7Equity Market Breakouts Equity Market Breakouts Equity Market Breakouts Developed country stock markets cheered the U.S. election outcome, presumably betting that the positives will outweigh the negatives. The main indexes in the U.S. and Japan have broken out of their trading ranges (Chart I-7). Bourses in Europe have also moved higher, but have not yet broken out. On the plus side, deregulation and stronger growth are bullish for U.S. corporate profits. Trump's proposal for a major corporate tax cut is another positive for equities, although the effective corporate tax rate in the U.S. is already at multi-decade lows. Cutting the marginal rate will thus not affect the effective rate much for large corporations. Any lowering of the marginal rate will benefit small and medium enterprises, as well as domestically-oriented S&P 500 corporations. On the negative side, dollar strength will be a headwind given that about a third of S&P 500 earnings are sourced from abroad. This raises the question of which factor will dominate profit growth over the next year; better economic growth or dollar strength? Table I-3 presents a matrix of different scenarios for the dollar and economic growth applied to our U.S. EPS model. Our base-case assumptions, implemented before the election, generated 5-6% earnings growth in 2017. We assumed that real and nominal GDP growth would be on par with the conservative IMF forecast. The bullish case assumes that real GDP growth is about a percentage point stronger, with modestly higher inflation. The opposite is assumed in the bear case. These three cases are combined with various scenarios for the dollar. The key point of Table I-3 is that the growth assumptions dominate the dollar effects. If growth is significantly stronger than the base case, then it would require a massive dollar adjustment to offset the positive impact on earnings. For example, our EPS estimate rises from 5-6% in the base case to almost 13% in the strong growth scenario, even if the dollar appreciates by 5%.10 The elephant in the room is the prospect of a trade war. Anti-globalization polices are negative for equities generally, although the boost for domestically-oriented firms provides some offset. As we argued above, higher tariffs on Mexico and China alone would not fully counteract a major fiscal push next year, especially if the trade impediments are implemented with a lag. Nonetheless, a broader anti-trade initiative that draws retaliation from many of America's trading partners cannot be ruled out. This is the main reason why we remain tactically cautious on equities. Table I-3U.S. Earnings Scenarios December 2016 December 2016 Country Equity Allocation In common currency terms, the U.S. equity market has a lot going for it relative to Japan and Europe. There will be spillovers from stronger U.S. growth to other countries, but the U.S. will benefit the most from Trump's fiscal stimulus plan. Continuing policy divergence will prop up the dollar, boosting returns in common-currency terms. The dollar has appreciated by about 4% in trade-weighted terms since we first predicted a 10% rise, suggesting that there is another 6% to go. Chart I-8Eurozone Still Has Lots Of Slack bca.bca_mp_2016_12_01_s1_c8 bca.bca_mp_2016_12_01_s1_c8 However, it is a tougher call in local currency terms. Monetary policy will remain highly accommodative in both Japan and Europe. As we highlighted in last month's Overview, we still expect Japan to implement a major fiscal stimulus plan. In the context of the Bank of Japan's fixing of the 10-year yield, government spending will amount to a helicopter drop policy that could generate a substantial yen depreciation. The central bank will continue to hold the yield curve down even when growth picks up, to drive real yields lower via rising inflation expectations. In the Eurozone, the ECB is likely to extend its asset purchase program beyond next March because it cannot credibly argue that inflation is on track to meet the target on any reasonable timetable. While the Eurozone economy has been growing well above trend this year, the fact that wage growth is languishing highlights that significant labor market slack persists (Chart I-8). Easy-money policies in Europe and Japan will be bullish for stocks in both markets in absolute terms and relative to the U.S. Stocks are also cheaper in Japan and the Eurozone. Earlier this year, we presented a methodology for valuing Eurozone stocks relative to the U.S. from a top-down perspective. The methodology accounted for different sector weightings and the fact that European stocks generally trade at a discount to the U.S. This month's second Special Report, beginning on page 27, applies the same methodology to Japanese/U.S. relative valuation. Combining seven relative valuation measures into a single composite metric, we find that both the Eurozone and Japanese equity markets are about one standard deviation cheap relative to the U.S. (Chart I-9). History shows that investors would have made substantial (currency hedged) excess returns if they had favored Eurozone and Japanese stocks to the U.S. on a six-month or longer investment horizon whenever our composite valuation index reached one standard deviation on the cheap side. Our recommended (hedged) overweight in Europe and Japan has not worked out yet, as tepid global growth has instead flattered the lower-beta U.S. market. That tide should turn, however, if the rise in global bond yields reflects a credibly reflationary growth pulse in the U.S. A stronger dollar would redistribute some of that growth to other countries. Chart I-10 shows that higher beta markets like Europe and Japan can outperform the U.S. when bond yields rise. The financial sectors in both Europe and Japan, so punished relative to the broad market as a result of deleveraging and negative interest rates, would then be poised to outperform as well. Chart I-9Equity Valuation Equity Valuation Equity Valuation Chart I-10U.S. Equities ##br##Underperform When Yields Rise U.S. Equities Underperform When Yields Rise U.S. Equities Underperform When Yields Rise Investment Conclusions: Hopes are running high that fiscal stimulus and a more business-friendly regulatory framework will stir animal spirits, rekindle business investment and lift the U.S. economy out of its growth funk. The violent reaction in financial markets to the election has probably gone too far in discounting a transformative policy change. We doubt that Trump's fiscal and regulatory agenda will place the U.S. economy on a permanently higher growth plane. Many of the growth headwinds that existed in the U.S. before the election remain in place, such as: the end of the Debt Supercycle; deteriorating demographics; elevated corporate leverage; and nose-bleed levels of government debt. A lot of good (policy) news is already discounted in equity prices, implying that the market is vulnerable to policy or economic disappointments. That said, a window may open next year that would favor risk assets for a period of time. A temporary growth acceleration in late-2017/early 2018 would lift the equity and corporate bond boats. Markets will front-run the growth pulse (some of it is admittedly already discounted). Our bias is therefore to upgrade these asset classes, but poor value means that the risk/reward tradeoff is underwhelming until we get more visibility on the new administration's policy intentions. Until there is more clarity, remain at benchmark in equities, overweight the dollar and below-benchmark duration in fixed-income portfolios. EM assets appear to us like a lose-lose proposition. A trade war would obviously be disastrous for this asset class. But EM also loses if U.S. protectionism takes a back seat to growth initiatives to the extent that this results in a stronger dollar. EM risk assets have never escaped periods of dollar strength unscathed. The possibility of RMB depreciation versus the U.S. dollar adds to EM vulnerability. Our other investment recommendations include the following: avoid peripheral European government bonds within European bond portfolios due to Italian referendum risk; avoid U.S. municipal bonds, as tax cuts would devalue the tax advantage of muni debt; remain overweight inflation-linked bonds versus conventional issues within government bond portfolios, as inflation expectations have more upside potential; we are marginally less bearish on high-yield bonds since better growth will temper defaults. We also see less near-term risk of a Fed-driven volatility event. Nonetheless, concerns about corporate health still justify a slight underweight relative to Treasurys in the U.S. Overweight investment-grade corporates in Europe versus European governments due to ongoing ECB support; overweight European and Japanese equities versus the U.S. in currency-hedged terms. within the U.S. equity market, remain overweight small caps since Trump's corporate tax reform will benefit small firms disproportionately. Dollar strength also favors small versus large caps. Mark McClellan Senior Vice President The Bank Credit Analyst November 24, 2016 Next Report: December 20, 2016 1 Please see BCA Geopolitical Strategy, "U.S. Election: Outcomes and Investment Implications," November 9, 2016, available at gps.bcaresearch.com 2 Please see Jim Nunns, Len Burman, Ben Page, Jeff Rohaly, and Joe Rosenberg, "An Analysis Of Donald Trump's Revised Tax Plan," Tax Policy Center, October 18, 2016. 3 World Trade Organization. 4 Scott Bradford, Paul Grieco and Gary Clyde Hufbauer, "The Payoff to America from Global Integration," Peterson Institute for International Economics. 5 These calculations capture the demand-side effects of the tariffs. There will also be supply-side effects, in terms of reduced productivity, but this will be relatively small and affect the economy largely over the medium term. 6 The elasticities and methodology for these calculations are based on the report; "Trump's Tariffs: A Dissent," J.W. Mason, November 2016. 7 "The Macroeconomic Consequences of Mr.Trump's Economic Policies," Moody's Analytics, June 2016. 8 The short-term tradeoff between unemployment and inflation. 9 Inflation breakeven rates have historically exceeded 2% because of the presence of risk premia. 10 The impact of dollar appreciation on profits shown in Table 3 may seem too low to some readers given that S&P 500 companies derive a third of their earnings from abroad. However, some of these earnings are hedged, while dollar strength will benefit the earnings of domestically-oriented U.S. companies. II. A Q&A On Political Dynamics In Washington In this Special Report, BCA's Geopolitical Strategy service answers some key questions posed by clients surrounding the incoming Trump administration. The situation could evolve quickly in the coming months, but these answers convey our preliminary thoughts. What support will President-elect Trump's infrastructure plans have from Republicans in Congress? The support for infrastructure spending can be gauged by popular opinion and the bipartisan highway funding bill passed by Congress late last year. The $305 billion bill to fund roads, bridges and rail lines received support from both parties (83-16 vote in the Senate and 359-65 vote in the House). The dissenting votes included fiscal conservatives and Tea Party/Freedom Caucus members. And yet many of their voters supported Trump, whose victory shows the political winds shifting against "austerity." Moreover, new presidents normally receive support from their party on major initiatives early in their term. Democratic Senators and House Representatives have suggested they may work with Trump on infrastructure spending, most notably Bernie Sanders, Elizabeth Warren, Chuck Schumer and even Nancy Pelosi. This could mark an instance of bipartisanship in the context of still-growing polarization. The 2018 mid-term elections will be difficult for the Democrats, with 10 Democratic senators facing elections in states which Donald Trump won, including key "Rust Belt" swing states where the infrastructure argument is appealing (Michigan, Wisconsin, Pennsylvania, Ohio). Thus, there are political incentives for Democrats to cooperate with the White House on infrastructure. Trump owes his victory to swing voters who favor infrastructure. As we discuss below, he may give the GOP Congress some concessions (for instance, on tax reform) in exchange for cooperation on infrastructure spending. How many votes would he need to get an infrastructure bill passed in Congress? Trump will likely get the votes. He needs 218 votes in the House and 51 votes in the Senate, assuming his infrastructure plan is not so partisan (or so entwined with partisan measures like his tax cuts) as to draw a Senate filibuster. The GOP has 239 seats in the House and at least 51 in the Senate (Louisiana could make it 52). One way of overcoming any Democratic filibuster in the Senate is by "Reconciliation," a process for speeding up bills affecting revenues and expenditures. Under this process, which requires the prior passage of a budget resolution, a simple majority in the Senate is enough to allow a reconciliation bill to pass. The process can be used for passing tax cuts as well, after procedural changes in 2011 and 2015. If passed, what is the earliest we could expect more spending? Congress passed President Obama's $763 billion stimulus package, the American Recovery and Reinvestment Act (ARRA), in February 2009, the month after he was sworn in. About 20% of the investment outlays went out the door by the end of fiscal 2009 and 40% by the end of fiscal 2010.1 Today, infrastructure outlays are less urgent, as the country is not in the mouth of a financial crisis, but the roll-out could be expedited by the administration. Trump's plan calls for building infrastructure through public-private partnerships, which could involve longer negotiation periods but also faster completion once started. Trump's team claims they can accelerate the spending process by cutting red tape. What is a 'best guess' on the final amount of deficit-financed infrastructure spending? Trump is currently committed to $550 billion in new infrastructure investment, down from initial suggestions of $1 trillion over a decade. A detailed plan has not been released, however. Trump's campaign promised to induce infrastructure spending via public-private partnerships, with tax credits for private investors. The plan was said to be "deficit neutral" based on assumptions about revenue recuperated from taxing the labor that works on the projects and the profits of companies involved, taxed at Trump's proposed 15% corporate tax rate.2 The government tax credit would have amounted to 13.7% of the total investment. Earlier proposals can easily be revised or scrapped. Already, Trump has reversed his earlier opposition to Hillary Clinton's proposal of setting up an infrastructure bank, potentially financed by repatriated earnings of U.S. corporations. His potential Treasury Secretary, Steven Mnuchin, raised the possibility on November 16. Who are key players in this process and what are their backgrounds? The aforementioned leading Democrats could become key players, if they prove willing to work with Trump on infrastructure. Comments by Paul Ryan and the Congressional GOP should be monitored, as infrastructure spending was not a major part of their policy platform, called "A Better Way," released in June of this year.3 The only infrastructure that Ryan mentioned in the GOP policy paper was energy infrastructure. Not the "roads, bridges, railways, tunnels, sea ports, and airports" that President-elect Trump has promised repeatedly, in addition to energy. Asked during the Washington Ideas Forum in September whether he supports infrastructure spending, Ryan said it is not part of the GOP's proposal. Other notable personalities to watch: Wilbur Ross, an American investor and potential Commerce Secretary pick, was one of the authors of Trump's original, public-private infrastructure plan. Peter Navarro, UC-Irvine business professor and another economic advisor, co-authored that proposal. Also watch: Steven Mnuchin, Finance Chairman of the Trump campaign and former Goldman Sachs partner, and potential Treasury Secretary pick. Stephen Moore, a member of Trump's economic advisory team and the chief economist for the Heritage Foundation. John Paulson, President of Paulson & Co. Also watch fiscal hawks such as House Majority Leader Kevin McCarthy of California, who has recently softened on infrastructure spending, saying it could be "a priority" and "a bipartisan issue." Representative David Brat of Virginia, another ultra-conservative Freedom Caucus member, who has softened on infrastructure. House Appropriations Chairman Hal Rogers, and Representative Bill Flores, Chairman of the conservative Republican Study Committee, could also send signals. Chairman of the House Committee on ways and Means, Kevin Brady, has already admitted that some tax receipts from repatriated corporate earnings may go to infrastructure. Would deficit spending on infrastructure revive problems with the debt ceiling? The debt ceiling legislation is technically separate from the budget process. It is the statuary threshold on the level of government debt. It currently stands at $20.1 trillion. Congress voted last fall to "suspend" the debt ceiling until March of 2017. This means it will come due right around the time that negotiations over the fiscal 2018 budget resolution take place. But debt ceiling negotiating tactics are unlikely to recur in Trump's first year with his own party in control of Congress. Trump and the GOP could vote to "suspend" the debt ceiling indefinitely. Or, the GOP could set the debt ceiling limit so high that it no longer matters in the near term. Where do the GOP and Trump disagree on tax reform? Tax reform is a major GOP demand in recent years; it was also a focus, albeit less central, in Trump's campaign. Both want to flatten the personal income tax structure from 7 brackets to 3 brackets, with 12%, 25%, and 33% tax rates. Trump revised his initial tax plan, which called for 10%, 20%, and 25% rates, late in his campaign to be more compatible with the GOP. In terms of corporate taxes, President-elect Trump proposes a 15% rate for all businesses, with partnerships eligible to pay the 15% rate instead of being taxed under a higher personal income tax rate. By contrast, the GOP has called for a 20% corporate tax rate and a 25% rate for partnerships. How difficult is it to simplify the tax code? It is certainly not easy, but it can be done in 2017 given that the GOP controls both the White House and Congress. GOP leaders claim that a proposal will go public early in the year and a vote will occur within 2017. GOP leaders want a comprehensive law, including income and corporate tax reform, but there are rumors of splitting the two. Income tax reform may take longer to pass because it is more complex. There has not been comprehensive tax reform in the U.S. since Ronald Reagan signed the Tax Reform Act of 1986. The Republicans obtained lower tax rates in exchange for a broadening of the base that the Democrats favored. It would be difficult to strike a similar deal next year, given that Republicans seek to slash taxes on corporations and top earners, and Democrats are staunchly opposed. There is likely to be some horse trading between Trump and the GOP. The GOP may use tax reform as the price of their support for Trump's infrastructure investment. Alternatively, Trump could hold out his Supreme Court appointments in exchange for GOP acquiescence on taxes and infrastructure. He could, for example, threaten to appoint centrist justices if the GOP does not play ball on other matters. What are the obstacles and timeline to a repatriation tax on overseas corporate earnings? An estimated $2.5-$3 trillion in corporate earnings are currently held "offshore," which means that taxes on this income is deferred until it is repatriated to the U.S. There is growing bipartisan support for a deemed repatriation tax. This means a one-off tax imposed on all overseas income not previously taxed. Obama, Hillary Clinton, Trump, and GOP representatives have all presented proposals to tap this source of tax revenue. For that reason there are various avenues through which it could be legislated. Trump put forth a plan to tax un-repatriated earnings at a 10% rate for cash (4% for non-cash earnings), with the liability payable over a 10-year period. As mentioned, this could be combined with his infrastructure plan as a way to finance an infrastructure bank or encourage the same corporations to invest in infrastructure development via tax breaks. According to the Tax Policy Center, Trump's repatriation plan would raise $147.8 billion in revenue over 2016-2026. Overall, this is a paltry sum of $14 billion per year. In a similar vein, President Obama's plan called for a 14% rate on repatriated earnings and was projected to raise $240 billion. The GOP offers a different plan from Trump. The party supports a repatriation tax at an 8.75% rate, payable over eight years. The GOP's plan would raise an estimated $138.3 billion during the same period. The GOP proposes to overhaul the entire U.S. corporate taxation system, while Trump does not. The GOP would change it from the worldwide system (i.e. the same corporate tax rate for U.S. corporations on profits everywhere), to a more typical destination-based system, in which U.S. corporations would be exempt from U.S. taxes on profits earned overseas. The latter would reduce the incentive for offshoring and tax inversions, that is, moving head offices outside of the U.S. to take advantage of lower tax rates. The 2004 tax holiday was a disappointment. Findings from the Center on Budget and Policy Priorities, NBER, Congressional Research Service, and others, indicate that the repatriated earnings did not significantly improve long-term fiscal deficits, boost employment, or increase domestic investment. Will Trump accuse China of "currency manipulation" on his first day in office as promised? It seems likely that Trump will follow through with his pledge of naming China a "currency manipulator." The question is whether he does so through the existing, formal Treasury Department review process or whether he would bypass that system and take independent action as the executive. Adhering to the formal process would show that Trump wants to keep tensions contained even as he draws a tougher line on economic relations with China. The "currency manipulation" charge is a mostly symbolic act that does not automatically initiate punitive measures. The move will not be unprecedented, as the U.S. labeled China a manipulator from 1992-1994. The label requires bilateral negotiations and could lead to Treasury recommending that Congress, or Trump, take punitive measures. The 2015 update to the law specifies what trade remedies Treasury might suggest, but the remedies are not particularly frightful. The options might prevent the U.S. government from supporting some private investment in China, cut China out of U.S. government procurement contracts, or cut China out of trade deals. The latter point, however, will be overshadowed by Trump's withdrawing the U.S. from the Trans-Pacific Partnership, a net gain for China since that strategic trade initiative had excluded China from the beginning. The real risk - higher than ever before, but still low probability - is that Trump could act unilaterally to impose tariffs or import quotas under a host of existing trade laws (1917, 1962, 1974, 1977) which give him extensive leeway. Some of these would be temporary, but others allow him to do virtually whatever he wants, especially if he declares a state of emergency or invokes wartime necessity (his lawyers could use any existing overseas conflict for this purpose).4 Presidents have been unscrupulous about such rationalizations in the past. Congress and the courts would not be able to stop Trump for the first year or two if he proceeded independently by executive decree. WTO rulings would take 18 months. China would not wait to retaliate, leading to a trade conflict of some sort. Would Congressional Republicans support punitive measures against China? How would China respond? There are two possibilities. First, Trump is free to set his own executive timeline if his administration makes a special case and he acts through executive directives. Second, Trump could proceed under the Treasury Department's existing timeline. An investigation would be launched in the April Treasury report, leading to negotiations with China. If there is no satisfactory outcome of the negotiations, then the October Treasury Report could label China as a currency manipulator. Under the 2015 law, there would be a necessary one-year waiting period before punitive measures are implemented. But again, Trump could override that. China would cause a diplomatic uproar; it would level similar accusations at the U.S. of distortionary trade policies. China would likely respond unilaterally as well as go to the WTO to claim that the U.S. has abrogated the purpose of the agreement, giving it an additional path to retaliate within international law. China's unilateral sanctions could target U.S. high-quality imports, services, or production chains. Or China could sell U.S. government debt in an attempt to retaliate, though it is not clear what the net effect of that would be. However, China would suffer worse in an all-out trade war. Xi Jinping has been very pragmatic about maintaining stability, like previous Chinese presidents since Deng. He is tougher than usual, but as long as Trump proposes credible negotiations, rather than staging a full frontal assault, Xi would likely attempt to strike a deal, perhaps cutting pro-export policies while promising faster structural rebalancing, to avoid a full-blown confrontation. We have seen with Russia that authoritarian leaders can use external threats and economic sanctions as a way to rally the population "around the flag." Trump's campaign threats, combined with other macro-economic trends, pose the risk that over the next four years China could face intensified American economic pressure and internal economic instability simultaneously. That would be a volatile mix for U.S.-China relations and global stability. But, once in office, it remains to be seen how Trump will conduct relations with China. Most likely, the currency manipulation accusation will cause a period of harsh words and gestures that dies down relatively quickly. The two powers will proceed to negotiations over a "new" economic relationship, highlighting the time-tried ability of the U.S. and China to remain engaged and "manage" their differences. Nevertheless, any shot across the bow will point to Sino-American distrust that is already growing over the long run. That distrust is signaled by Trump's success in key swing states by pitching protectionism, specifically against China. Will Trump's border enforcement policies add to fiscal stimulus? Yes, it would add marginally to the fiscal thrust that we expect from other infrastructure and defense spending. How will Trump approach the deportation of illegal immigrants? Trump will probably maintain Obama's stance on illegal immigration and deportation. Obama has deported around 2.5 million illegals between 2009 and 2015, the most of any president. These are mostly deportable illegals and non-citizens with criminal convictions. Trump stated in an interview on 60 Minutes that he plans to deport 2 to 3 million undocumented immigrants. The execution of this order will be swift as the Department of Homeland Security (DHS) has already exhibited this capacity under Obama. It is difficult to gage the economic impact of deportation. A study done by the University of Southern California found that undocumented immigrants are paid 10% lower than natives with similar skills in California.5 About half of farm workers and a quarter of construction workers are undocumented immigrants. If this source of cheap labor is removed, the cost for business in these sectors will increase. Are there other policy areas where you see a significant divergence between Congressional Republicans and Trump? Trump and the GOP establishment obviously have an awkward relationship that is only beginning to heal. Both sides are making progress in bridging the gap, but on trade protectionism, infrastructure, immigration, entitlement spending, and foreign policy Trump will continue to sit uneasily with Republican orthodoxy. This will give rise to a range of disagreements, separate from those listed above, of which we note only two here that have caught our attention during the post-election transition. How to deal with Putin: Trump has received renewed criticism from Sen. John McCain over a possible thaw in relations with Russia. This could affect the sanctions on Russia imposed by the U.S. and EU after the intervention in Ukraine in 2014, as well as broader Russia-NATO relations. H1B Visa: Trump is in favor of expanding H1B1 visas and allowing the "best" immigrants to stay in the U.S. once they complete their university education. But his White House chief strategist Steve Bannon has vilified the GOP for doing this. Thus there could be disagreement between the GOP and Trump's team on the issue of highly skilled immigrants. The BCA Geopolitical Team 1 Please see the White House, "The Economic Impact Of The American Recovery And Reinvestment Act Five Years Later," in the "2014 Economic Report of the President," available at www.whitehouse.gov. 2 Please see "Trump Versus Clinton On Infrastructure," October 27, 2016, available at peternavarro.com. 3 Please see Paul Ryan, "A Better Way For Tax Reform," available at abetterway.speaker.gov. 4 Please see Marcus Noland et al, "Assessing Trade Agendas In The US Presidential Campaign," Peterson Institute for International Economics, PIIE Briefing 16-6, dated September 2016, available at piie.com. 5 Please see Manuel Pastor et al, "The Economic Benefits Of Immigrant Authorization In California," Center for the Study of Immigrant Integration, dated January 2010, available at dornsife.usc.edu. III. Japanese Equities: Good Value Or Value Trap? Japanese stocks have experienced a long stretch of underperformance versus the U.S. since the early 90's. The deflationary macro backdrop and poor corporate profitability are the main underlying factors, although there are many others. More recently, some corporate fundamentals have shifted in favor of Japanese stocks relative to the U.S., but investors remain skeptical, sending Japanese valuations to near all time lows in absolute terms and relative to the U.S. In this Special Report, we take a top-down approach to determine whether Japanese stocks are cheap versus the U.S. after adjusting for persistent differences in underlying profit fundamentals. Our mechanical and fundamental valuation indicators provide an impressive historical track record of "buy" and "sell" signals when the metrics reach extreme levels. The story is corroborated at the sector level. The implication is that there is plenty of "kindling" to drive a reversal in Japanese stock relative performance, but it needs a spark. We believe the catalyst could be a major fiscal push that would be like a "helicopter drop" under the current monetary regime. Unfortunately, the timing is uncertain. A major fiscal package may not occur until the spring. Japanese equities have been a perennial underperformer versus the U.S. for almost three decades, in both local- and common-currency terms (Chart III-1). There was a ray of light in the early years of Abenomics, when the aggressive three-arrow approach appeared to be finally lifting the Japanese economy out of Secular Stagnation. Yen weakness contributed to a surge in earnings-per-share (EPS) in absolute terms and relative to both the U.S. and world. Equity multiples also rose between 2012 and 2015. Unfortunately, Abe's honeymoon with equity markets has since faded. Yen strength, collapsing inflation expectations and weakening business confidence have caused investors to question the upside potential for Japanese corporate top-line growth (Chart III-2). EPS have fallen by 11% percent this year in absolute local currency terms, and are down by 10.7% versus the U.S. In turn, Japanese equities have dropped from the mid-2015 peak (Chart III-3). The decline in Japanese multiples this year is in marked contrast to a rise in the U.S. Chart III-1Japanese Equities ##br##Have Underperformed Japanese Equities Have Underperformed Japanese Equities Have Underperformed Chart III-2A Challenging ##br##Macro Backdrop bca.bca_mp_2016_12_01_s3_c2 bca.bca_mp_2016_12_01_s3_c2 Chart III-3Japanese EPS Growth ##br##Has Been Strong Until 2016 bca.bca_mp_2016_12_01_s3_c3 bca.bca_mp_2016_12_01_s3_c3 Japanese equities currently appear very cheap to the U.S. market based on standard valuation measures (Chart III-4). However, these ratios are always lower in Japan, except for price-to-forward earnings. Japanese companies generally have a much higher interest coverage ratio compared to Corporate America. Nonetheless, they tend come up short in terms of profitability. Operating margins in the U.S. have typically been double that of Japan (Chart III-5A). Japan's return-on-equity (RoE) has been dismal because of low levels of corporate leverage and loads of low-yielding cash sitting on balance sheets (Chart III-6). Table III-1 shows that Japan has a much larger sector weighting in consumer discretionary and a much lower weighting intechnology. Still, the story does not change much when we adjust financial ratios for differences in sector weights between the two markets (Chart III-5B). Chart III-4Japan Is Always Cheaper Japan Is Always Cheaper Japan Is Always Cheaper Chart III-5A...Adjusted For Common Sector Weights Japanese Vs. U.S. Fundamentals... Japanese Vs. U.S. Fundamentals... Chart III-5BJapanese Vs. U.S. Fundamentals... ...Adjusted For Common Sector Weights ...Adjusted For Common Sector Weights Chart III-6RoE Is Consistently Lower In Japan bca.bca_mp_2016_12_01_s3_c6 bca.bca_mp_2016_12_01_s3_c6 Table III-1Japanese Vs. U.S. Sector Weights December 2016 December 2016 The lower level of RoE by itself justifies a price discount on Japanese equities. But by how much? Are Japanese stocks still cheap once they are adjusted for structurally depressed profitability relative to the U.S.? This report assesses relative valuation, employing the same methodology used in our previous work on Eurozone equity valuation.1 While many cultural nuances make direct comparison of the Japanese market difficult, investment decisions are made within the scope of the available set of alternatives. With Japanese equity valuations at the lowest levels in recent history, the key question is whether this represents an opportunity to load up, or an example of a "value trap". We conclude that valuation justifies an overweight in Japanese equities (currency hedged), although the fiscal stimulus required to unlock the value may not arrive until February. Mechanical Approach We excluded the financial sector from our market valuation work since analysts use different fundamental statistics to judge profitability and value compared to non-financial companies. We also recalculated all of the Japanese aggregates using U.S. weights in order to avoid the problem that differing sector weights could bias measures of relative value for the overall market. The mechanical approach adjusts the valuation measures by subtracting the 5-year moving average (m.a.) from both markets. For example, the calculation for the price-to-sales ratio (P/S) is: VG = (US P/S - 5-year m.a.) - (EMU P/S - 5-year m.a.) Then we divided the Valuation Gap (VG) by the 5-year moving standard deviation of the VG. This provides a valuation indicator that is mean-reverting and fluctuates roughly between -2 and +2 standard deviations: Valuation Indicator = VG/(5-year moving standard deviation of VG) The same methodology is applied to the other valuation measures shown in Charts III-7A, 7B, 7C, 7D and III-8A, 8B, 8C. This approach suggests that the U.S. market is trading expensive to Japan in all seven cases except for the Shiller P/E. Japan is around 1-sigma cheap on most of the other valuation measures, with forward P/E the highest at almost 2 standard deviations. Chart III-7AMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7a bca.bca_mp_2016_12_01_s3_c7a Chart III-7BMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7b bca.bca_mp_2016_12_01_s3_c7b Chart III-7CMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7c bca.bca_mp_2016_12_01_s3_c7c Chart III-7DMechanical Valuation Indicators (I) bca.bca_mp_2016_12_01_s3_c7d bca.bca_mp_2016_12_01_s3_c7d Chart III-8AMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8a bca.bca_mp_2016_12_01_s3_c8a Chart III-8BMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8b bca.bca_mp_2016_12_01_s3_c8b Chart III-8CMechanical Valuation Indicators (II) bca.bca_mp_2016_12_01_s3_c8c bca.bca_mp_2016_12_01_s3_c8c The underlying logic is that using a longer-term moving average should remove the structurally lower bias in Japanese valuations. Standardizing relative valuations in such a way should provide extreme valuation signals that can be used to gauge major trading opportunities. One potential pitfall of using a 5-year moving average to discount the structurally lower valuation of Japanese equities versus U.S. is that it fails to capture an extended period of either over- or under-valuation. For example, the U.S. may enter a bubble phase that does not occur in Japan. The 5-year moving average would move higher over time, eventually giving the false signal that the U.S. is back to fair value if the bubble persists. This is a fair criticism, although the track record of these valuation metrics shows that extended bubbles have not been a large source of false signals. Valuation By Sector We applied the same methodology at the sector level. Due to space constraints, we cannot present the 70 charts covering the seven relative valuation metrics across the 10 sectors. However, we present the latest reading for the 70 indicators in Table III-2, which reveals whether the U.S. is expensive (e) or cheap (c) versus Europe. A blank entry means that relative valuation is in the range of fair value. Table III-2Story Holds At The Sector Level December 2016 December 2016 The sector valuation indicators corroborate the message from the aggregate valuation analysis; over 60% of valuation metrics suggest that the U.S. is at least modestly expensive versus Japanese stocks. The U.S. is cheap in only 13% of the cases, with 26% at fair value. Value measures that most consistently place U.S. sectors in expensive territory are P/CF, P/B and EV/EBITDA. The U.S. sectors that are most consistently identified as expensive are financials, consumer discretionary, industrials, utilities, tech and basic materials. U.S. healthcare received a fairly consistent "cheap" rating while U.S. telecoms were consistently "cheap" or "fair" across all valuation measures. Predictive Value? Having a standardized tool of relative valuation is well and good but multiple divergence between regions is only useful if it translates into excess returns. Valuation is generally a poor timing tool but proves to be useful in predicting returns over a longer investment horizon. Theoretically, forward relative returns between Japanese and U.S. equities should be positively correlated with the size of the gap in their relative valuation metrics. In order to test the efficacy of the mechanical valuation indicator we calculated forward relative returns at points of extreme valuation divergences (in local currency). The trading rule is set such that, when the mechanical indicator reaches positive one or two standard deviations, we short the more expensive U.S. market and go long Japanese equities. Conversely, the opposite investment stance is taken for value readings of negative one and two standard deviations. Forward returns are calculated on 3, 6, 12, and 24 month horizons. Overall, the indicators performed well when the valuation gap between U.S. and Japanese multiples reached (+/-) 1 and 2 standard deviations from the long-term mean. Valuation measures exhibiting the highest returns were P/CF and forward P/E. For brevity, we present only these two measures in Table III-3. At two standard deviation extremes, the mechanical indicator produced a two-year forward return of 84% and 44% for P/CF and forward P/E, respectively. Table III-3 also presents the indicator's batting average. That is, the number of positive excess returns generated by the trading rule as a percent of the total number of signals. For P/CF, the batting average is between 50-60% for a 1 standard deviation valuation reading and mostly 100% for 2 standard deviations. The batting average for the forward P/E ranges from 53-92% for 1 standard deviation, and 83-100% for 2 standard deviations. Table III-3Select Mechanical Indictor Returns And Batting Averages December 2016 December 2016 Presently, all of the indicators are at or above the zero line signaling that the U.S. market is overvalued versus Japan. The valuation metric sending the strongest signal of U.S. overvaluation has interestingly been one of the better predictors of positive excess returns; the forward P/E mechanical indicator has just recently touched the +2 standard deviation level. Given the information provided by our back tested results above, investors are poised to enjoy strong positive returns by overweighting Japanese equities versus their U.S. peers. Fundamental Approach Chart III-9Japan Has A Lower Cost Of Debt bca.bca_mp_2016_12_01_s3_c9 bca.bca_mp_2016_12_01_s3_c9 Japanese companies trade at a discount relative to their U.S. peers due to more volatile Japanese profit fundamentals and a structurally depressed RoE. To compensate for structural differences in fundamentals we regressed U.S./Japanese value gaps on spreads in underlying financial statistics such as earnings-per-share growth, the interest coverage ratio, free-cash-flow growth, operating margins, and forward earnings-per-share growth. A dummy variable was used to exclude the "tech bubble" years in the late 90's to early 00's since the surge in tech stocks had an outsized effect on overall relative valuations, distorting the true underlying trend. The fundamental approach used in our previous Special Report comparing the U.S. and Eurozone did not work as well as hoped and we had an inkling that an analysis of Japan versus the U.S. might yield similar results. Once again we were underwhelmed by the results, although some valuation measures did produce decent outcomes. These included P/S, P/B, and P/CF. Unfortunately, fundamental models for EV/EBITDA, P/E and forward P/E either had low explanatory power or had coefficients with the wrong sign. The financial variable that appears most frequently as being significant in our fundamental models is the interest coverage ratio. Japanese firms have experienced a massive reduction in net debt post-GFC, while those in the U.S. have been taking advantage of lower rates to issue debt and perform share buybacks. Weak aggregate demand has dissuaded Japanese corporations from performing any sort of intensive capital expenditure programs and they have therefore been using free cash flow to build up cash reserves on their balance sheet and pay down debt. Not to mention, the more dramatic decrease in borrowing rates for Japanese firms has reduced their interest burden vis-à-vis U.S. corporates (Chart III-9). Chart III-10 presents the modeled fair values along with the corresponding valuation indicator. The U.S. market is expensive compared to Japan for all three models, with the most extreme cases being P/S and P/CF. Chart III-10AFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators Chart III-10BFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators Chart III-10CFundamental Valuation Indicators Fundamental Valuation Indicators Fundamental Valuation Indicators While the fundamental approach gave results that are less than spectacular, they still corroborate the message given by the mechanical approach. Japanese equities are undervalued compared to their U.S. peers and are reaching extreme levels, even after adjusting for structural trends in the underlying financials. Chart III-11Combined Fundamental Indicator Returns December 2016 December 2016 The next step is to verify the predictive power of our fundamental models. We analyzed forward returns implementing the same methodology used for the mechanical indicators. A (+/-) 1 standard deviation threshold was used as an investment signal to either overweight Japanese equities versus the U.S., if positive, or take the opposite stance if negative. Chart III-11 shows the returns categorized by time horizon and the number of valuation measures flashing a positive investment signal. The results were mixed; strong positive returns occurred when only one or two measures displayed valuation extremes, but excess returns were less than spectacular during periods when all three metrics provided the same signal. This is counter-intuitive, but when analyzing Chart III-10 it becomes apparent that the periods where all three indicators simultaneously entered extreme territory are concentrated in the last two years of history when U.S. market returns have trounced Japan. For periods during which our indicator flashed one or two positive signals, mostly before the past two years, returns were in line with those achieved by the mechanical indicators. Table III-4 shows the probability of success for the combined fundamental approach. Overall it has a batting average lower than that of the mechanical approach, with 60-89% for one signal and 70-86% for two signals. The batting average was generally poor when there were three signals for the reason discussed above.2 Since the beginning of 2015, all three indicators have been signaling that Japanese stocks are extremely cheap versus the U.S. Indeed, relative valuation continues to stretch as U.S. equity prices rise versus Japan, bucking the recent relative shifts in balance sheet fundamentals that favor the Japanese market. Table III-4Combined Fundamental Indicator Batting Averages December 2016 December 2016 Conclusion We are pleased with the results of the mechanical approach. The majority of valuation measures show that investors will make positive returns by overweighting and underweighting Japanese equities versus the U.S. when relative valuation reaches extreme levels. The consistency of these excess returns highlights that the indicators add value to global equity investors. We had hoped that a fundamentals based approach to valuation would have worked better. Conceptually, it would be more intellectually gratifying for company financials to better explain excess returns compared to technical measures. In a liquidity-driven world, this may be too much to ask. Although our fundamental models did not pan out perfectly, they still provided support for our underlying thesis that Japanese equities offer excellent value relative to the U.S. market. These models highlight that Japanese balance sheet and income statement trends favor this equity market versus the U.S. at the moment. Investors have been ignoring the fundamentals, frowning on Japanese equities in absolute terms and, especially, relative to the U.S. The sour view on Japan likely reflects disappointment in Abenomics. This includes not only fears that Abenomics is failing to lift the economy out of the liquidity trap, but also fading hopes for changes in corporate governance that would force firms to make better use of their cash hoards to the benefit of shareholders. All the valuation metrics presented above say that it is a good time to overweight Japan versus the U.S. in local currency terms. Of course, so much depends on policy these days. Our valuation metrics highlight that there is plenty of "kindling" in place for a reversal in relative performance given the right spark. As discussed in the Overview section, the catalyst could be a major fiscal stimulus package. When combined with a yield curve that is fixed by the Bank of Japan, it would amount to a "helicopter drop". Such a policy would drive up inflation expectations, push down real borrowing rates and dampen the yen. This self-reinforcing virtuous circle would be quite positive for growth in real and nominal terms, lifting the outlook for corporate profit growth and sparking a substantial re-rating of Japanese stocks. The timing is admittedly uncertain. A smaller fiscal package could be implemented as part of a third supplementary budget before year-end. A major fiscal push is most likely to occur only in February, when the next full budget is announced. Still, rock-bottom valuations make Japan an attractive market for longer-term investors, although the currency risk must be hedged. Michael Commisso Research Analyst 1 Please see The Bank Credit Analyst, "Are Eurozone Stocks Really Cheap?" July 2016, available at bca.bcaresearch.com 2 Except for the 24-month column, which shows a 100% batting average. However, this can be ignored. There was only a single episode of three positive signals that occurred more than 24 months ago, allowing a 24-month return calculation.

Highlights The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. However, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. in China's total trade peaked in the late 1990s. The case of China U.S. steel trade dispute suggests that unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. Feature Global financial markets have gradually been coming to terms with the concept of President Donald Trump. Interestingly, U.S. equity market participants appear to be cheering on a potentially sizable fiscal spending package under the new administration, which has boosted industrial sector stocks over the past week. Markets in Asia, particularly Chinese H shares, however, have been less upbeat and have focused more on a possible protectionism backlash emanating from the U.S. under the new leadership. Tough talk on China has featured in every U.S. presidential campaign going back to Nixon reaching out to China in the early 1970s - from Jimmy Carter's strong condemnation of Nixon-Kissinger's "immoral" secret diplomacy of "ass kissing" the Chinese, to Bill Clinton's harsh warnings to the "butchers of Beijing", to repeated pledges by Obama in the 2008 campaign to label China as a "currency manipulator" - all of which signaled an immediate confrontation. Once in office, however, all candidates significantly softened their rhetoric, as government policies require much more realistic and thoughtful discussion, negotiation and compromise. Furthermore, given the huge importance of trade for both economies, a full-fledged trade war between the U.S. and China would risk the growth recession and enormous financial volatility around the globe, a lose-lose outcome hardly conceivable to anyone, no matter how much chest-thumping and aggrandizing is involved. To be sure, the threat of protectionism should not be downplayed. It appears clear that president-elect Trump will be less accommodative to free trade than his predecessors, which is confirmed by his choice of Mr. Dan Dimicco, a former CEO of an American steelmaker and an outspoken critic of U.S. trade policy, particularly with China, to head his trade transition team. However, it is unpredictable at the moment what specific measures he would take to be able to assess potential consequences. It is therefore more useful to take a step back and look at the big picture of trade relations between the two countries. China-U.S. Bilateral Trade Chinese sales to the U.S. far outnumber its purchases, leading to an ever-growing trade surplus in China's favor (Chart 1). In fact, the U.S. accounts for over half of China's total trade surplus - a key piece of evidence supporting some American politicians' accusation of China's purported currency manipulation and unfair trade practices. The U.S. accounts for 18% of Chinese exports, while China accounts for only 8% of American overseas sales, which puts China at a disadvantage in a full-blown trade war. Underneath, however, China has become an increasingly important export destination of American companies in recent years, while the significance of the U.S. as part of China's total trade peaked in the late 1990s (Chart 2). The share of U.S.-bound Chinese exports has remained roughly unchanged since the global financial crisis, and down significantly from pre-crisis levels. Chinese sales to the U.S. in recent years have been largely in line with overall export growth. On the contrary, American shipments to China have increased sharply as a share of total exports. Over the past five years, China has accounted for almost 20% of the net increase in U.S. exports, far outpacing any other American trade partner. Chart 1U.S.-China##br## Bilateral Trade U.S.-China Bilateral Trade U.S.-China Bilateral Trade Chart 2China Depends More ##br##On The U.S. Than Vice Versa China Depends More On The U.S. Than Vice Versa China Depends More On The U.S. Than Vice Versa Conventional wisdom holds that protectionist policies will be of more benefit to those countries running deficits in bilateral trade. However, a trade war with China would also remove the biggest source of marginal demand for American goods, which would be met with strong domestic resistance. Anti-Dumping And China's Trade Performance China is no stranger to anti-dumping measures in global trade. The country accounts for 30% of all anti-dumping actions initiated by World Trade Organization (WTO) members in recent years, even though Chinese products account for only about 14% of total global goods exports. China has not been regarded as a "market economy" by major developed countries, making it an easier target for punitive tariffs and other barriers under WTO rules. A case in point is steel products, which remain center stage in the ongoing trade dispute between China and the U.S. President George W. Bush in 2002 imposed tariffs of up to 30% on a broad range of Chinese steel products, while the Obama administration further upped the ante with various product-specific punitive measures during his tenor. These measures have dramatically changed steel trade for both countries: From the U.S. side, total American steel imports have remained largely range-bound in the past 20 years, but Chinese steel products have had a dramatic rollercoaster ride (Chart 3). Punitive tariffs led to a collapse of Chinese steel in the U.S. market, accounting for a mere 3% of total U.S. steel imports, down from a peak of almost 20% in 2008. However, the losses to Chinese steelmakers have simply been filled by other exporting countries. For example, U.S. steel imports from Brazil have roared back to historical high levels as Chinese products plummeted (Chart 3, bottom panel). On the Chinese side, Chinese steel products suffered huge market share losses in the U.S., but the country's total steel exports have continued to make new record highs, as it has dramatically expanded sales to other markets, particularly developing countries (Chart 4). The U.S. currently accounts for about 1% of total Chinese steel exports, down from about 10% at the peak, while Vietnam has rapidly replaced the U.S. as a key market for Chinese steelmakers to expand overseas sales. Chart 3China In U.S. Steel Imports China In U.S. Steel Imports China In U.S. Steel Imports Chart 4U.S. In Chinese Steel Exports U.S. In Chinese Steel Exports U.S. In Chinese Steel Exports Moreover, the punitive measures imposed by the U.S. have pushed Chinese steelmakers into higher value-added products. The top panel of Chart 5 shows the average price of American steel imports from China was roughly comparable to U.S. steel purchases from other developing countries in the late 1990s, while Germany and Japanese steelmakers traditionally occupied the higher-priced segments. The situation has shifted quickly in the past two decades: The unit price of Chinese steel sales in the U.S. has risen rapidly relatively to their peers, increasingly challenging producers in more advanced countries. Other emerging countries have filled the space left by China and remained at the lower end of the spectrum. Similarly, on the Chinese side, the average price of Chinese steel exports to the U.S. has increased sharply in recent years relative to other major markets, particularly developing countries (Chart 5, bottom panel). Currently, the average price of China's steel products exported to the U.S. is far higher than to other countries - almost triple that to other emerging countries. This confirms that Chinese steelmakers have been moving up the value-added ladder in the U.S. market, but have been "dumping" cheaper products to other developing countries. The important point here is that the punitive tariffs have indeed significantly reduced Chinese sales to the U.S., but other steel-producing countries have simply "stolen" China's lunch. By the same token, unless the U.S. imposes punitive tariffs on imports from all countries, picking on China will only shift American demand to other more expensive alternatives, while the benefits to American domestic producers will be questionable, let alone American consumers. Moreover, President Trump may still target Chinese steel products as a highly symbolic gesture to show his toughened stance on China and to keep his campaign trail promises of reviving rust-belt states - the relevance of which, however, has diminished dramatically, as steel products now account for only a tiny fraction of total trade between these two countries (Chart 6). Chart 5Chinese Steelmakers##br## Are Moving Up The Value Chain Chinese Steelmakers Are Moving Up The Value Chain Chinese Steelmakers Are Moving Up The Value Chain Chart 6Steel Is No Longer ##br##Relevant For China-U.S. Trade China-U.S. Trade Relations: The Big Picture China-U.S. Trade Relations: The Big Picture U.S. And China In Global Trade A more inward-looking U.S. administration certainly bodes poorly for international trade and globalization. However, the role of China should not be underestimated. For tradable goods, it is well known that China has long surpassed the U.S. as the world top exporter. For imports of goods, the U.S. is still bigger, but the gap has narrowed dramatically (Chart 7). China has already become a bigger market than the U.S. for a growing list of countries, particularly commodities producers and China's Asian neighbors. What is much less known is that Chinese imports of services just this year also surpassed that of the U.S., marking an important milestone in China's global reach and influence (Chart 8). Moreover, China's exports of services are much smaller, leaving a deficit almost as large as U.S. service surpluses with the rest of the world. Chart 7U.S. And China##br## In Global Trade Of Goods U.S. And China In Global Trade Of Goods U.S. And China In Global Trade Of Goods Chart 8China Surpassed##br##The U.S. In Service Imports China Surpassed The U.S. In Service Imports China Surpassed The U.S. In Service Imports In a world starving for growth, China remains a bright spot. Potential protectionist threats from the U.S. will likely generate a mutual desire among China and other economies to work more closely. China will inevitably continue to explore bilateral and multilateral free-trade agreements (FTA) with its main trade partners. China currently has 19 FTAs under construction, among which 14 agreements have been signed and implemented. Together, FTAs cover an increasingly bigger share of Chinese exports, higher than Chinese sales to the U.S. (Chart 9). Chart 9China Sells More To FTA##br## Countries Than To The U.S. China Sells More To FTA Countries Than To The U.S. China Sells More To FTA Countries Than To The U.S. Meanwhile, China will likely take a more active role in negotiating the "Regional Comprehensive Economic Partnership (RCEP)" - an ambitious multilateral agreement on trade and investments that covers almost half of the world population and output. On the other hand, the outlook of the Trans-Pacific Partnership (TPP) under President Trump has become more uncertain, which may also push other emerging countries to participate in China-initiated trade deals. If President Trump indeed turns more inward, the center of global trade will further shift toward China. A Word On The RMB And Industrial Stocks The RMB has continued to drift lower against the greenback in recent days, which still reflects the dollar's broad strength rather than RMB weakness. In fact, the trade-weighted RMB has strengthened notably (Chart 10). Conspiracy theories abound that China may engineer a flash-crash of the RMB before President Trump takes office to "preempt" any protectionist pressures. This scenario certainly cannot be ruled out, but it is highly unlikely in our view, as it may further intensify trade tensions between the two countries, making Trump's trade policy on China even less predictable. In short, we maintain the view that the near-term RMB outlook is entirely dictated by the movement of the dollar, and that the Chinese authorities should be able to maintain exchange rate stability, as discussed in recent reports.1 Turning to the stock market, Chinese industrial stocks have not joined the sharp post-Trump rally of their U.S. counterparts, likely a reflection of investors' conviction that protectionism in the U.S. may benefit domestic firms at the expense of foreign entities, particularly Chinese firms. (Chart 11). However, similar to almost all other major sectors, the profitability of Chinese industrial names is almost identical to their American peers, but they are trading at hefty discounts based on conventional valuation indicators, reflecting a much larger risk premium in Chinese stocks. For now, we remain on the sidelines with respect to Chinese stocks due to developing global uncertainty, as discussed in detail last week.2 Beyond near-term tactical consideration, we expect Chinese shares to resume their uptrend both in absolute terms and against EM and global benchmarks. Chart 10The RMB Remains Stable##br## In Trade-Weighted Terms The RMB Remains Stable In Trade-Weighted Terms The RMB Remains Stable In Trade-Weighted Terms Chart 11Industrial Stocks:##br## Spot The Differences Industrial Stocks: Spot The Differences Industrial Stocks: Spot The Differences Yan Wang, Senior Vice President China Investment Strategy yanw@bcaresearch.com 1 Please see China Investment Strategy Weekly Report, "The RMB's Near-Term Dilemma And Long-Term Ambition", dated October 20, 2016, and "Greater China Currencies: An Overview", dated November 3, 2016, available at cis.bcaresearch.com 2 Please see China Investment Strategy Weekly Report, "Chinese Stocks: Between Domestic Improvement And External Uncertainty", dated November 10, 2016, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Trump's election victory means that there is potential for policy settings to flip from "easy money, tight fiscal" to "tight money, easy fiscal" The market implications of that shift are dollar bullish, bond bearish and equity mixed. The major risk is that violent currency and bond market moves rekindle emerging market stress and/or choke off the recovery before fiscal spending kicks in. Trump's trade reform risks being a tax on growth. Businesses may opt to automate instead of hire. A variety of factors now make small caps appealing relative to large caps. Feature Contrary to the pre-election consensus, Donald Trump's election victory has prompted a risk-on rally, based on the notion that Trump's vision of fiscal largesse will be realized (Chart 1). Ultimately, it will only become clear what policy changes are on the table once Trump takes office in January. The consensus at BCA is that Trump will be "unbound" in his first two years as President. Thus, if Trump lives up to his campaign promises, fiscal stimulus and trade restriction will be tabled early in 2017. Chart 1Trump Moves Trump Moves Trump Moves As we argue below, trade restrictions should be viewed as a tax on growth. We have doubts about the link between job creation and tariffs. If anything, imposing tariffs on imports could incite a more intense wave of automation. After all, the cost of capital is still attractive relative to labor costs. Meanwhile, fiscal spending - if delivered even close to the size and scope that Trump has hinted at in his pre-election speeches - will boost GDP growth well above trend in 2017. If that occurs, the dynamic that has existed since 2010, i.e. "tight fiscal, exceptionally easy money policy" will rapidly flip to "easy fiscal, tight money". For the bond market and the U.S. dollar, the investment implications are clear: Treasuries are likely to head higher, and the pressure will be for the U.S. dollar to rise. Implications for equities are less certain. If the U.S. dollar rises, it might rekindle emerging world financial stress and undermine U.S. corporate profits. The rapid rise in yields may not easily be digested by the equity market and it is notable that corporate spreads have not rallied along with other risk assets in recent days. We are comfortable maintaining a defensive stance. Donald Trump said a lot of things to a lot of people during the campaign process. He can't possibly deliver on all of his promises, but earlier this week, BCA sent out a Special Report to all clients, outlining the implications of the election results and what we expect he can accomplish.1 We believe there are three that are especially important for investors to monitor: the potential for trade restrictions, gauging fiscal stimulus and monetary policy settings in this possibly new environment. Stagflation? Trump has repeatedly signaled his intention to restrict American openness to international trade and the U.S. president can revoke international treaties solely on their own authority. Trump can also impose tariffs. All of this is of course inflationary, and it's the nasty kind. We have repeatedly written in this publication that, historically, the U.S. economy only falls into recessions for two reasons. The first is growth-restrictive monetary policy and the second is an adverse supply shock that acts like a tax on growth, e.g. an oil price spike. Tariffs are akin to the latter. Chart 2 shows that as import penetration rose over the past 30 years, tradeable goods price inflation steadily fell. A simple read of the chart suggests that with barriers in place and as import penetration recedes, the process of the past 30 years will reverse and consumer goods prices will rise. This can easily be absorbed if it is accompanied by rising wages via the "onshoring" of jobs. But that is not a foregone conclusion. Instead of bringing manufacturing jobs back to the U.S., a more logical decision might be for businesses to further automate production. After all, earlier studies have already concluded that nearly half of all existing jobs are at high risk of being automated over the next decade or so.2 As Chart 3 shows, with the price of capital equipment and software still falling and the cost of capital so low relative to the cost of labor, the incentive to automate instead of hire is high. Chart 2Trade And Inflation Trade And Inflation Trade And Inflation Chart 3Tariffs May Lead To Robots, Not Jobs Tariffs May Lead To Robots, Not Jobs Tariffs May Lead To Robots, Not Jobs The bottom line is that increased tariffs will increase prices in the near term. But it is hardly clear that this will improve the lives of voters or create a more virtuous economic recovery. Opening The Fiscal Taps... In last week's report, we explored the potential for fiscal spending to turbocharge the U.S. economy. We warned that fiscal multipliers are probably not overly high in the current environment and the effectiveness of fiscal spending is highly dependent on the type of fiscal stimulus. Trump has called for significantly lowering both income and corporate taxes, although his main pitch has been infrastructure spending. The latter tends to have the highest multiplier effects, but can often take a long time to get underway. However, one important point is that Trump will face little political restraint, at least in his first two years in office. Gridlock will not be a problem given that all three Houses are now in GOP hands. And it will be difficult politically for Republicans in the Senate and House to stand in Trump's way given that he has just been elected on a populist platform; it would be seen as thwarting the will of the people. Over the past 28 years, each new president has generally succeeded in passing their signature items. Moreover, the GOP has historically not been that fiscally conservative. Overall, a Trump government will more than make up for the drag from weak state and local spending that we wrote about last week. Exactly how big of an impulse will only become clear once Trump takes office. ...And Tightening The Money Supply? Forecasts about the impact of fiscal spending on 2017 GDP growth are premature, since it is impossible to decipher an action plan from campaign rhetoric. And the severity of stagflation due to trade restrictions will be highly dependent on the form and scope of trade reform. Ergo, it is too early to make bold new assumptions about the path of Fed rate hikes. An aggressive fiscal plan that boosts GDP well above trend growth would force policymakers to revise their expected path of rate hikes higher. That would be a sea change from the past four years, when policymakers have consistently revised the neutral rate down. We are not worried about central bank independence or Janet Yellen's future. Donald Trump has, at various times, both praised and attacked Janet Yellen and current monetary policy settings. A review of the Fed may happen at some point, but we assert that investigating the Fed will not be a priority early in Trump's mandate. Market Action The bond market has already priced in more inflation and more growth for 2017 since Trump's victory. 10-year Treasury yields have surged to 2.15% and momentum selling could lift the 10-year Treasury yield even further into oversold territory. But that is not a case to become aggressively underweight duration. Dollar strength and rising bond yields have already tightened financial conditions significantly over the past several weeks. The risk is that these trends go too far in the near term, inflicting economic damage before fiscal spending kicks in. Given the easy monetary stance of central banks around the world, lack of significant fiscal stimulus elsewhere, economic growth outperformance in the U.S. and rising interest rates, the dollar should rise in the medium term. We remain dollar bulls. We have been surprised by the equity market action since November 8. Although we repeatedly wrote that a Trump victory was unlikely to have meaningful negative consequences for risk asset prices, we did not anticipate a rally. As for equities, our cautiousness toward risk assets in 2016 has been primarily focused on the ongoing headwinds for profits in a demand-deficient economy, especially while margins are falling and valuations are elevated (Chart 4). Greater fiscal spending would surely help to alleviate our concern, although that conclusion seems premature given the lack of contour to Trump's plans so far. Perhaps the greatest downside risk is a reaction from China. After all, Trump's anti-trade rhetoric has been pointed (mostly) at China and Asia. Recall that in August, 2015, the RMB was devalued just weeks ahead of an expected rate hike from the Fed. That devaluation sent shock waves through financial markets and ultimately delayed the Fed rate hike until the end of the year (Chart 5). A similar proactive policy move from Chinese policymakers should be on investors' radars. Overall, we remain comfortable with our cautious equity stance, albeit recent market action has created an entry point in favor of small relative to large cap stocks. Chart 4Equity Fundamentals Still Poor Equity Fundamentals Still Poor Equity Fundamentals Still Poor Chart 5China: Global Stability Risk? China: Global Stability Risk? China: Global Stability Risk? Enter Small Cap Bias We upgraded small caps relative to large caps to neutral in August. We now recommend investors make the full switch to a small cap bias relative to large caps. Small cap stocks were hit harder than large caps in the weeks leading up to the election, as investors shed riskier assets; we believe this provides a good entry point to a cyclical uptrend in small cap performance (Chart 6). True, at first glance, advocating for small cap exposure appears inconsistent with our overall defensive equity strategy. After all, small cap outperformance tends to be associated with risk-on phases. However, small cap stocks have a variety of other characteristics that currently make them appealing relative to larger caps. Chart 6(Part I) Favor Small/Large Caps (Part I) Favor Small/Large Caps (Part I) Favor Small/Large Caps Chart 7(Part II) Favor Small/Large Caps (Part II) Favor Small/Large Caps (Part II) Favor Small/Large Caps Small cap companies tend to be more domestically focused. We expect that U.S. growth will continue to outpace growth overseas. And particularly important, small cap companies, with their domestic focus, are better insulated from dollar strength (Chart 7). Small cap weightings are no longer geared toward cyclical sectors. As part of our cautious strategy, we remain focused on defensive vs. cyclical sectors. There are no major differences between large and small cap defensive and cyclical sector weightings (Table 1). Trump corporate tax reform, if implemented, will favor small, domestic firms. Because major corporations already have low effective tax rates, any lowering of the marginal rate will benefit small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then this would diminish their current tax advantage vis-à-vis smaller companies. Table 1Similar Weightings For Small And Large Cap Cyclicals And Defensives Easier Fiscal, Tighter Money? Easier Fiscal, Tighter Money? Bottom Line: Small cap outperformance is typically associated with risk-on equity phases. However, valuations now favor small caps. Importantly, small caps are better insulated from dollar strength and are one way to play the domestic vs. global theme. Additionally, smaller firms will be the relative winners from corporate tax reform. Small caps are set to outperform large caps. Lenka Martinek, Vice President U.S. Investment Strategy lenka@bcaresearch.com 1 Please see Geopolitical Strategy Special Report "U.S. Election: Outcomes & Investment Implications," dated November 9, 2016, available at gps.bcaresearch.com 2 "The Future Of Employment: How Susceptible Are Jobs To Computerisation?" Carl Frey and Michael Osborne, September 2013. Appendix Monthly Asset Allocation Model Update Our Asset Allocation (AA) model provides an objective assessment of the outlook for relative returns across equities, Treasuries and cash. It combines valuation, cyclical, monetary and technical indicators. The model was constructed as a capital preservation tool, and has historically outperformed the benchmark in large part by avoiding major equity bear markets. Please note that our official cyclical asset allocation recommendations deviate at times from the model's recommendation. The model is just one input to our decision process Chart 8. The model's recommended weightings for the major asset classes remained unchanged this month: neutral equity exposure at 60% (benchmark 60%), slightly overweight Treasury allocation at 40% (benchmark 30%) and underweight cash at 0% (benchmark 10%). The neutral portfolio recommendation for equities is in line with our qualitative defensive stance, in place since August 2015. Although the technical component of the equity model still has a "buy" signal, the breadth indicator has moved into less favorable territory relative to the momentum indicator. The monetary component has also slightly weakened but retains its positive bias for equities. The earnings-driven component continues to warrant caution as expectations for the outlook of corporate profits would need to be bolstered through stronger economic stronger growth over the medium term. Our qualitative stance for the allocation of Treasuries in balanced portfolios is neutral (since November 7, 2016) in contrast to the slightly overweight recommendation from our quantitative model. Even so, despite that the "buy signals" of the cyclical and technical components of the bond model still persist, the preference for Treasuries has diminished to some extent. Nevertheless, the valuation component continues trending towards expensive territory and a "buy signal" remains in place Chart 9. Chart 8Portfolio Total Returns Portfolio Total Returns Portfolio Total Returns Chart 9Current Model Recommendations Current Model Recommendations Current Model Recommendations Note: The asset allocation model is not necessarily consistent with the weighting recommendations of the Cyclical Investment Stance. For further information, please see our Special Report "Presenting Our U.S. Asset Allocation Model", February 6, 2009.

BCA will be holding the Dubai session of the BCA Academy seminar on November 28 & 29. This two-day course teaches investment professionals how to examine the economy, policy, and markets; and also makes links between these important factors. Moreover, it represents a great networking opportunity for all attendees. I look forward to seeing you there. Best regards, Mathieu Savary Highlights Donald Trump's victory represents a sea-change for U.S. politics as well as the economy. His expansionary fiscal policy, to be implemented as the labor market's slack evaporates, will boost demand, wages, and will prove inflationary. The Fed will respond with higher rates, boosting the dollar. EM Asian currencies will bear the brunt of the pain. Commodity currencies, especially the AUD, will also be significant casualties. EUR/USD will weaken in the face of a strong greenback, but should outperform most currencies. Key risks involve gauging whether the Fed genuinely wants to create a "high-pressure", economy as well as the potential for Chinese fiscal stimulus. Feature Trump's electoral victory only re-enforces our bullish stance on the dollar. A Trump presidency implies much more fiscal stimulus than originally anticipated. Therefore, the Fed will not be the only game in town to support growth. This strengthens our view that, on a cyclical basis, the OIS curve still underprices the potential for higher U.S. interest rates. In a Mundell-Fleming world, this suggests a much higher exchange rate for the greenback. Additionally, Trump's protectionist views are likely to hit EM economies - China in particular - harder than DM economies. We continue to prefer expressing our bullish dollar view by shorting EM and commodity currencies. Is Trump Handcuffed? Trump's victory reflects a tidal wave of anger and dissatisfaction with the current state of the U.S. economy. Most profoundly, his candidacy was a rallying cry against an increasingly unequal distribution of economic opportunities and outcomes for the U.S. population. As we highlighted last week, since 1981, the top 1% of households have seen their share of income grow by 11%. In fact, while 90% of households have seen their real income contract by 1% since 1980, the top 0.01% of households have seen their real income increase more than five-fold (Chart I-1). Chart I-1The (Really) Rich Got Richer Reaganomics 2.0? Reaganomics 2.0? In this context, Trump's appeal, more than his often-distasteful racial or gender rhetoric, has been his talk of protecting the middle class. But, by losing the popular vote, are his hands tied? Marko Papic, BCA's Chief Geopolitical Strategist, surmises in a Special Report1 sent to all BCA's clients that it is not the case. First, Trump's victory speech emphasized infrastructure spending, indicating that this is likely to be his first priority. As Chart I-2 illustrates, there is a lot of room for the government to spend on this front. At 1.4% of GDP, government investment is at its lowest level since World War II. Furthermore, according to the Tax Policy Institute, Trump's current plan includes $6.2 trillion in tax cuts over the next 10 years. Second, the Republican Party now controls Congress as well as the White House. Not only has the GOP historically rallied around the president when all the levers of power are in the party's hands, but also, the Tea party has been one of Trump's most ardent supporters. Hence, Trump's program is unlikely to be completely squelched by Congress. Third, the GOP is most opposed to government spending when Democrats control the White House. When Republicans are in charge of the executive, the GOP is a much less ardent advocate of government stringency, having increased the deficit in the opening years of the Reagan, Bush I, and Bush II administrations (Chart I-3). Chart I-2Room To Increase##br## Infrastructure Spending Room To Increase Infrastructure Spending Room To Increase Infrastructure Spending Chart I-3Republicans Are Fiscally Responsible ##br##When It Suits them bca.fes_wr_2016_11_11_s1_c3 bca.fes_wr_2016_11_11_s1_c3 Finally, international relations are the president's prerogative. While there are legal hurdles to renegotiate treaties like NAFTA, Trump can slap tariffs easily, rendering previous arrangements quite impotent. Though protectionism has not been highlighted in Trump's victory speech, the topic's popularity with his core electorate highlights the risk that trade policies could be impacted. Bottom Line: Trump has a mandate to spend and got elected because of his policies that support the middle class. His surprise victory represents a sea-change, a move the rest of the Republican establishment will not ignore. Therefore, we expect Trump to be able to implement large-scale fiscal stimulus. Economic Implications To begin with, Trump is a populist politician. While populism ultimately ends badly, it can generate a growth dividend for many years. Nowhere was this clearer than in 1930s Germany, where Hitler's reign yielded a major economic outperformance of Germany relative to its regional competitors (Chart I-4).2 Government infrastructure spending played a large role in this phenomenon. Also, the Reagan era shows how fiscal stimulus can lead to a boost to growth. From the end of the 1981-82 recession to 1987, U.S. real GDP per capita outperformed that of Europe and Japan, despite the dollar's strength in the first half of the decade. Fascinatingly, the U.S. GDP per capita even outperformed that of the U.K., a country in the midst of the supply-side Thatcherite revolution (Chart I-5). This suggests that the U.S's economic outperformance was not just a reflection of Reagan's deregulatory instincts. Chart I-4Populism Can Boost Growth Populism Can Boost Growth Populism Can Boost Growth Chart I-5Reagan Deficits Boosted Growth Too bca.fes_wr_2016_11_11_s1_c5 bca.fes_wr_2016_11_11_s1_c5 Unemployment is close to its long-term equilibrium, and the hidden labor-market slack has greatly dissipated. Additionally, one of the biggest hurdles facing small businesses is finding qualified labor. In the context of a tight labor market, we anticipate that Trump's fiscal stimulus will not only boost aggregate demand directly, but will also exert significant pressures on already rising wages (Chart I-6). Compounding this effect, if Trump does indeed focus on infrastructure spending, work by BCA's U.S. Investment Strategy service shows that this type of stimulus offers the highest fiscal multiplier (Table I-1).3 Chart I-6Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Stimulating Now Will Feed Wage Growth Table I-1Ranges For U.S. Fiscal Multipliers Reaganomics 2.0? Reaganomics 2.0? Additionally, a retreat away from globalization, and a move toward slapping more tariffs and quotas on Asia and China would be inflationary. Historically, falling inflation has coincided with falling tariffs as competitive forces increase. This time, with the output gap closing, and the tightening labor market, decreasing the trade deficit could arithmetically push GDP above trend, accentuating wage and inflationary pressures. Finally, for households, a combination of rising wages, elevated consumer confidence, and low financial obligations relative to disposable income could prompt a period of re-leveraging (Chart I-7). Moreover, the median FICO score for new mortgages has fallen from more than 780 in 2013 to 756 today, an easing in lending standard for mortgages. All the factors above suggest that U.S. growth is likely to improve over the next two years, driven by the government and households. It also points towards rising inflationary pressures. As we have highlighted before, the more the economy can generate wage growth to support domestic consumption, the more it becomes resilient in the face of a stronger dollar. The tyranny of the feedback loop between the dollar and growth will loosen. This environment would be one propitious for the Fed to hike interest rates as the economy becomes less dependent on lower rates for support. In the long-run, the Trump growth dividend is likely to require a payback, but this discussion is for another day. Bottom Line: Trump is likely to boost U.S. economic activity through fiscal stimulus, especially infrastructure spending. Since the slack in the economy is now small, especially in the labor market, this increases the likelihood that the Fed will finally be able to durably push up interest rates (Chart I-8). Chart I-7Household Debt Load Can Grow Again Household Debt Load Can Grow Again Household Debt Load Can Grow Again Chart I-8Vanishing Slack = Higher Rates bca.fes_wr_2016_11_11_s1_c8 bca.fes_wr_2016_11_11_s1_c8 Currency Market Implications The one obvious effect from a Trump victory is that it re-enforces our core theme that the dollar will strengthen on a 12 to 18-months basis as the market reprices the Fed's path. However, we expect Asian currencies to be viciously hit by this new round of dollar strength. For one, compared to the drubbing LatAm currencies received, KRW, TWD, and SGD are only trading 13%, 9%, and 15% below their post 2010 highs. Most importantly though, EM Asia has been the main beneficiary of 35 years of expanding globalization. Countries like China or the Asian tigers have registered world-beating growth rates thanks to a growth strategy largely driven by exports (Chart I-9). Chart I-9Former Winners Become Losers Under Trump Reaganomics 2.0? Reaganomics 2.0? We expect these economies and currencies to suffer the most from Trump's retribution and from a continued structural underperformance of global trade. China, Korea, and co. are likely to be hit by tariffs under a Trump administration. Also, under a Trump administration, the likelihood of implementation of new international trade treaties is near zero. Therefore, the continuous expansion of globalization of the previous decades is over, and may even somewhat reverse. Furthermore, a move toward a more multipolar world, like the interwar period, tends to be associated with falling trade engagement. Trump's desire to diminish the global deployment of U.S. troops would only add to such worries. Regarding the RMB, the picture is murky. On the one hand, the RMB is trading 4% below fair value and does not need much devaluation from a competitiveness perspective. However, Chinese internal deflationary pressures, courtesy of much overcapacity, remain strong (Chart I-10). Easing these pressures requires a lower RMB. Moreover, the offshore yuan weakened substantially in the wake of Trump's victory, yet the onshore one did not, suggesting that the PBoC is depleting its reserves to support the currency. This tightens domestic liquidity conditions, exacerbating the deflationary forces in the country. Chart I-10Plenty Of Excess Capacity In China Reaganomics 2.0? Reaganomics 2.0? This means that China is in a bind as a depreciating currency will elicit the wrath of president Trump. The risk is currently growing that China will let the RMB fall substantially between now and January 20. Such a move would magnify any devaluating pressures on other Asian exchange rates. While it is difficult to be bullish MXN outright on a cyclical basis when expecting a broad dollar rally, the recent weakness in MXN is overdone. Mexico has not benefited nearly as much from globalization as Asian nations. Also, after a 60% appreciation in USD/MXN since June 2014, even after the imposition of tariffs, Mexico will still be competitive. Even then, the likelihood and severity of any tariffs enacted on Mexico might be exaggerated by markets. In fact, President Nieto's invitation to Trump last summer may prove to have been a particularly uncanny political move. Investors interested in buying the peso may want to consider doing it against the won, potentially one of the biggest losers from a Trump presidency. Outside of EM, the AUD is at risk. Australia sits in the middle of the pack in terms of economic and export growth during the globalization era, but it is very exposed to Asian economic activity. Historically, the AUD has been tightly correlated with Asian currencies (Chart I-11). Adding insult to injury, Australia is a large metals producer, which means that Australia's terms of trade are highly levered to the Chinese investment cycle, the main source of demand for iron ore, copper, etc. (Chart I-12). With China already swimming in over capacity, unless the government enacts a new infrastructure package, Chinese imports of raw materials will remain weak. Chart I-11AUD Will Suffer If Asian Currencies Fall bca.fes_wr_2016_11_11_s1_c11 bca.fes_wr_2016_11_11_s1_c11 Chart I-12China Is The Giant In The Room Reaganomics 2.0? Reaganomics 2.0? The NZD is also likely to suffer against the USD. The currency's sensitivity to the dollar strength and EM spreads is very high. However, we expect AUD/NZD to remain depressed. The outlook for relative terms of trades supports the kiwi as ag-prices will be less impacted by a slowdown in Chinese capex than metals. Additionally, on most metrics, the New Zealand economy is outperforming that of Australia (Chart I-13). The CAD should beat both antipodean currencies. First, it is less sensitive to the U.S. dollar or EM spreads than both the AUD and the NZD, reflecting its tighter economic link with the U.S. We also expect some softer rhetoric and actions from Trump when it comes to implementing trade restrictions with Canada than with Asia. Finally, while we are very concerned for the outlook for metals, the outlook for energy is superior. Yes, a strong greenback is a headwind for oil prices, but a Trump presidency is likely to result in strong household consumption. Vehicle-miles-driven growth would remain elevated, suggesting healthy oil demand from the U.S. Meanwhile, our Commodity & Energy Strategy service expects the drawdown in global oil inventories to accelerate, particularly if Saudi Arabia and Russia can agree on a 1mm b/d production cut at the upcoming OPEC meeting at the end of the month, which is bullish for oil (Chart I-14). Chart I-13Stronger Kiwi Domestic Fundamentals bca.fes_wr_2016_11_11_s1_c13 bca.fes_wr_2016_11_11_s1_c13 Chart I-14Better Supply/Demand Backdrop For Oil bca.fes_wr_2016_11_11_s1_c14 bca.fes_wr_2016_11_11_s1_c14 We also remain yen bears. The isolationist stance of Trump is likely to incentivize Abe to double down on fiscal stimulus, especially on the military. Japan is currently massively outspent on that front by China (Chart I-15). With the BoJ pegging policy rates at 0% for the foreseeable future, the yen will swoon on the back of falling real yields. Moreover, if our bearish stance on Asian currencies materializes itself, this will put competitive pressures on the yen, creating an additional negative. For the euro, the picture is less clear. The euro remains the mirror image of the dollar, so a strong greenback and a weak euro are synonymous. Additionally, Trump stimulus, if enacted, will ultimately result in higher nominal and real yields in the U.S. relative to Europe, especially as the euro area does not display any signs of being at full employment (Chart I-16). That being said, the euro is currently very cheap, supported by a current account surplus, and the ECB might begin tapering asset purchases in the second half of 2017. Combining these factors together, while we remain cyclically bearish on EUR/USD - a move below parity over the next 12-18 months is a growing possibility - the euro will outperform EM currencies, commodity currencies, and even the yen. We are looking to buy EUR/JPY, especially considering the skew in positioning (Chart I-17). Chart I-15Japan Will Spend More On Its ##br##Military With Or Without Trump bca.fes_wr_2016_11_11_s1_c15 bca.fes_wr_2016_11_11_s1_c15 Chart I-16European Labor Market##br## Slack Is Evident European Labor Market Slack Is Evident European Labor Market Slack Is Evident Chart I-17EUR/JPY Has##br## Room To Rally bca.fes_wr_2016_11_11_s1_c17 bca.fes_wr_2016_11_11_s1_c17 Finally, the outlook for the pound remains clouded until we get a better sense of the High Court's decision on the government's appeal regarding the need for a Parliamentary vote on Brexit. We expect the court's decision to re-inforce the previous ruling, which means that the pound could strengthen as the probability of a "soft Brexit" grows. The resilience of the pound in the face of the recent dollar's strength points to such an outcome. Risk To Our View And Short-Term Dynamics The biggest risk to our view is obviously that Trump's fiscal plans never pan out. However, since our bullish stance on the dollar predates Trump's electoral victory, we would therefore remain dollar bulls, albeit less so. Nonetheless, limited fiscal stimulus would likely cause a temporary pullback in the dollar. Chart I-18A Mispricing Or A Signal? bca.fes_wr_2016_11_11_s1_c18 bca.fes_wr_2016_11_11_s1_c18 Another short-term risk is the Fed. Currently, inflation expectations in the U.S. have shot up. If the Fed does not increase rates in December - this publication currently thinks the FOMC will increase rates then - the dollar will fall as this move will put downward pressures on U.S. real rates. This is especially relevant as the 5-year/5-year forward Treasury yield stands at 2.8%, in line with the Fed's estimate of the long-term equilibrium Fed funds rates as per the "dots". A big risk for our EM / commodity currency view is China. China may not respond to Trump by aggressively bidding down the CNY before January 20. Instead, to counteract the negative effect of Trump on Chinese export growth, China might instigate more fiscal stimulus, plans that always have a large infrastructure component. The recent parabolic move in copper needs monitoring (Chart I-18). Bottom Line: A Trump victory is a massive boon for the dollar. However, because Trump represents a move away from globalization, the main casualties of the Trump-dollar rally will be Asian currencies and the AUD. The CAD and the NZD will also undergo downward pressures, but less so. Finally, while EUR/USD is likely to fall, the euro will outperform EM currencies, commodity currencies, and the yen. As a risk, in the short-term, an absence of Fed hike in December would represent the biggest source of weakness for the dollar. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Geopolitical Strategy Special Report, "U.S. Election: Outcomes And Investment Implications", dated November 9, available at gps.bcaresearch.com 2 To be clear, while we do find some of Trump comments over the past year highly distasteful, we are not suggesting that he is a re-incarnation of Hitler or that his presidency is doomed to end in a massive global conflict. It is only an economic parallel. 3 Please see U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability", dated November 7, available at usis.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 bca.fes_wr_2016_11_11_s2_c2 bca.fes_wr_2016_11_11_s2_c2 Policy Commentary: "We are going to fix our inner cities and rebuild our highways, bridges, tunnels, airports, schools, hospitals. We're going to rebuild our infrastructure, which will become, by the way, second to none. And we will put millions of our people to work as we rebuild it." - U.S. President Elect Donald Trump (November 9, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 Relative Pressures And Monetary Divergences - October 21, 2016 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 bca.fes_wr_2016_11_11_s2_c4 bca.fes_wr_2016_11_11_s2_c4 Policy Commentary: "I'm very skeptical as far as further interest rate cuts or additional expansionary monetary policy measures are concerned -- over time, the benefits of these measures decrease, while the risks increase" - ECB Executive Board Member Sabine Lautenschlaeger (November 7,2016) 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 bca.fes_wr_2016_11_11_s2_c5 bca.fes_wr_2016_11_11_s2_c5 Chart II-6JPY Technicals 2 bca.fes_wr_2016_11_11_s2_c6 bca.fes_wr_2016_11_11_s2_c6 Policy Commentary: "In order for long-term interest rate control to work effectively, it is important to maintain the credibility in the JGB market through the government's efforts toward establishing sustainable fiscal structures" - BoJ Minutes (November 10, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 British Pound Chart II-7GBP Technicals 1 bca.fes_wr_2016_11_11_s2_c7 bca.fes_wr_2016_11_11_s2_c7 Chart II-8GBP Technicals 2 bca.fes_wr_2016_11_11_s2_c8 bca.fes_wr_2016_11_11_s2_c8 Policy Commentary: "[The impact of a weak pound on inflation]... will ultimately prove temporary, and attempting to offset it fully with tighter monetary policy would be excessively costly in terms of foregone output and employment growth. However, there are limits to the extent to which above-target inflation can be tolerated" - BOE Monetary Policy Summary (November 3, 2016) 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 bca.fes_wr_2016_11_11_s2_c9 bca.fes_wr_2016_11_11_s2_c9 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Policy Commentary: "Inflation remains quite low...Subdued growth in labor costs and very low cost pressures elsewhere in the world mean that inflation is expected to remain low for some time" - RBA Monetary Policy Statement (October 31, 2016) Report Links: When You Come To A Fork In The Road, Take It - November 4, 2016 USD, JPY, AUD: Where Do We Stand - October 28, 2016 The Pound Falls To The Conquering Dollar - October 14, 2016 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Policy Commentary: "Weak global conditions and low interest rates relative to New Zealand are keeping upward pressure on the New Zealand dollar exchange rate. The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradables sector. A decline in the exchange rate is needed" - RBNZ Governor Graeme Wheeler (November 10, 2016) 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 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Policy Commentary: "We have studied the research and the theory behind frameworks such as price-level targeting and targeting the growth of nominal gross domestic product. But, to date, we have not seen convincing evidence that there is an approach that is better than our inflation targets" - BoC Governor Stephen Poloz (November 1, 2016) 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 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Policy Commentary: "We don't have a fixed limit for growing the balance sheet; it's a corollary of our foreign exchange market interventions - which we conduct to fulfill our price stability mandate" - SNB Vice-President Fritz Zurbruegg (October 25, 2016) 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 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Policy Commentary: "Banks' capital ratios have doubled since the financial crisis and liquidity has improved. At the same time, some aspects of the Norwegian economy make the financial system vulnerable. This primarily relates to high property price inflation combined with high household indebtedness" - Norges Bank Deputy Governor Jon Nicolaisen (November 2, 2016) 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 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 bca.fes_wr_2016_11_11_s2_c20 bca.fes_wr_2016_11_11_s2_c20 Policy Commentary: "...the weak inflation outcomes in recent months illustrate the uncertainty over how quickly inflation will rise. The Riksbank now assesses that it will take longer for inflation to reach 2 per cent. The upturn in inflation therefore needs continued strong support" - Riksbank Minutes (November 9, 2016) Report Links: The Pound Falls To The Conquering Dollar - October 14, 2016 Long-Term FX Valuation Models: Updates And New Coverages - September 30, 2016 Dazed And Confused - July 1, 2016 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlight Growth perked up in the major economies in October, and the manufacturing recession appears to have passed without event. The October employment report testified to the underlying health of the U.S. economy and clears the way for a rate hike at the FOMC's December meeting. Markets are skeptical that December's hike will be the first in a series, opening the door for a dollar rally while the Fed moves to meet its projected timetable. Unconvinced that global growth is about to accelerate in a meaningful way, and concerned about the ripple effects of a stronger dollar, we maintain the defensive bias in our model portfolios. Feature October was a good month for growth, as highlighted by broadly encouraging data across the major developed economies. U.S. GDP had its best print in two years in the third quarter, and European PMIs, firmly ensconced above 50, point to Eurozone growth around 1.5%. The plunge in sterling appears to have sheltered the U.K. from the worst effects of Brexit, even if it has triggered some unease about inflation. Japan remains hobbled, but our Global Investment Strategy service argues that reduced fiscal drag and a weaker yen will boost growth. The October employment data painted a portrait of a vibrant U.S. labor market. Job gains remained steady while the broad U-6 measure of unemployment, including discouraged job seekers and those working part time who would prefer to be working full time, fell by two ticks to a new post-crisis low (Chart 1). Consistent with the shrinking pool of idled workers, average hourly earnings surged, notching their biggest year-over-year gains of the expansion. The pickup in wages rekindled hopes of a virtuous circle linking hiring, wages, consumption, capex and more hiring. Chart 1The Supply Of Idled Workers Is Shrinking The Supply Of Idled Workers Is Shrinking The Supply Of Idled Workers Is Shrinking One GDP print does not make a trend, of course, and the hoped-for inflection point has remained out of reach throughout the post-crisis period (Chart 2 and Chart 3). Aggregate demand remains mushy even if it is improving. Forward-looking markets typically take their cues from direction rather than level, and punk post-crisis growth certainly hasn't hurt U.S. equities. The valuation backdrop has become much less hospitable, however, and the Fed appears less inclined to spike the punch bowl with its most potent fuel. The unsettled picture could make for a bumpy U.S. equity ride, especially if markets have become overly complacent about the pace of rate hikes. Chart 2The Post-Crisis Inflection: Ever In Sight... bca.bcasr_sr_2016_11_09_001_c2 bca.bcasr_sr_2016_11_09_001_c2 Chart 3...But Always Out Of Reach bca.bcasr_sr_2016_11_09_001_c3 bca.bcasr_sr_2016_11_09_001_c3 Economic Growth In The U.S. And Beyond What matters most to markets, a metric's current position (level), or its path (direction)? Favoring direction is generally a reliable stock market rule of thumb, though it's not always easy to recognize in real time. The key challenge for investors today is determining if the recent improvements are short-lived wiggles or a true inflection point. It would be helpful to know if extraordinary policy measures can boost organic growth or if they will simply redistribute it via exchange-rate adjustments. Measures of global trade are inconclusive. While things look much better in hubs like Korea and Taiwan (Chart 4), aggregate global trade volume is still mired in a one-step-forward, one-step-back pattern around the zero line (Chart 5). Isolated improvements in a handful of economies against a flat global backdrop highlight that a broad rebound has yet to take hold. Signs of life in individual countries should not be written off - it is promising that Korean and Taiwanese exports have staged their rebounds despite steady exchange-rate gains - but overall global export activity remains at a level more commonly associated with recessions than quickening expansions. Chart 4Some Exporters Are Stirring... Some Exporters Are Stirring... Some Exporters Are Stirring... Chart 5...But Aggregate Trade Is Stagnant ...But Aggregate Trade Is Stagnant ...But Aggregate Trade Is Stagnant Global PMI data are more broadly encouraging. Major-economy manufacturing PMIs are at levels consistent with decent growth and are sending a message, echoed by G7 industrial production (Chart 6), that the manufacturing recession is over. Although manufacturing typically accounts for less than a third of major-economy activity, its cyclicality helps it punch above its weight, and industrial slowdowns have the potential to trigger recessions. This time around, manufacturing failed to heat up enough to induce a broader slowdown and reliable recession signals are quiet (Chart 7). Chart 6The End Of The Manufacturing Recession The End Of The Manufacturing Recession The End Of The Manufacturing Recession Chart 7No Recession In Sight No Recession In Sight No Recession In Sight The October employment situation report was solidly encouraging. The U.S. labor market has found firm footing. Job gains have been remarkably steady, and our employment model projects they will persist, even if at a slightly slower pace (Chart 8). Both the average hourly earnings series and the Atlanta Fed's wage tracker show that rank-and-file workers are finally capturing some real income gains (Chart 9). Chart 8When The Economy Tests NAIRU... bca.bcasr_sr_2016_11_09_001_c8 bca.bcasr_sr_2016_11_09_001_c8 Chart 9...Wages Get A Boost bca.bcasr_sr_2016_11_09_001_c9 bca.bcasr_sr_2016_11_09_001_c9 Third Quarter Earnings Season S&P 500 operating earnings present another level/direction dichotomy. Per Standard & Poor's projections,1 trailing four-quarter operating earnings will finish the quarter 11% below their 3Q14 high-water mark (Chart 10, top). But the direction is as strong as the level is weak. Not only does this quarter mark the first year-over-year earnings gain since 3Q14, it is the second strongest since the pace of earnings growth normalized in 2012 (Chart 10, bottom). Chart 10Breaking Out Of The Earnings Recession Breaking Out Of The Earnings Recession Breaking Out Of The Earnings Recession Margins widened and earnings grew broadly across sectors without a clear cyclical or defensive theme. Rate sensitives achieved the strongest top-line growth, but endured margin contraction (Chart 11). Looking ahead, margins seem more likely to contract than expand in the coming quarters, given building wage pressures. On the other hand, an end to the sharp declines in Energy earnings will remove a drag that has weighed on S&P 500 results for several quarters. Chart 11Margins' Last Gasp? Spotlight On U.S. Equities Spotlight On U.S. Equities Margins' seeming inability to defy budding wage gains makes it unclear exactly how investors should position themselves, but the outlook for the dollar could provide some insight. Multinationals are prominent among the S&P 500's largest constituents, and since 2011, the broad trade-weighted dollar index has exhibited a robust negative correlation with S&P 500 earnings. Peak acceleration in the dollar has led earnings troughs by a quarter or two and earnings growth has quickened when the dollar has consolidated or retraced its gains (Chart 12). In a rising-dollar environment, U.S. firms competing globally face the unpalatable choice of protecting their margins and ceding share, or ceding share to defend their margins. Chart 12Strong Dollar, Weak Earnings Strong Dollar, Weak Earnings Strong Dollar, Weak Earnings Fed Policy: The Known Unknown Chart 13Markets Are Sleeping On The Fed Markets Are Sleeping On The Fed Markets Are Sleeping On The Fed The Fed has evinced a clear desire to hike rates, and investors know that it will be withdrawing accommodation at the edges. But the terminal fed funds rate for this cycle, and the pace at which the FOMC approaches it, are unknown. Market expectations, as implied by OIS2 contracts, reveal that investors have become complacent about the pace of hikes. While the consensus expects a quarter-point hike at the FOMC's December meeting, money markets are discounting just an 11% chance of a second 25-bps hike by the end of October 2017 (Chart 13, top panel), and a 75% chance of a second hike by the end of October 2018 (Chart 13, bottom panel). The Fed's dot-plot rate hike forecasts have been laughably off the mark, and to this point investors have tuned them out to their benefit. The preconditions for a progression of hikes seem to be coming together, however, as labor slack disappears, wage pressures emerge and the output gap steadily narrows. Every FOMC voter or regional Fed president who's stepped within range of an open microphone the last few weeks has gone out of his or her way to endorse the notion that two 2017 rate hikes are reasonable, and those with a more hawkish bent appear to be comfortable with three. Viewed beside the data and the guidance, markets seem to be in denial. Currency exchange rates are subject to multiple cross-currents, but policy rate differentials have taken a leading role since the dollar's surge began in the second half of 2014. Some Fed hikes are already baked into the EUR-USD and USD-JPY crosses, but the implied expectation that it could take two years for the FOMC to lift the fed funds rate by 50 bps suggests that the path of least resistance for the dollar is up. The implications for global equity positioning point to favoring Europe- and Japan-based multinationals (on a currency-hedged basis) over their U.S. counterparts. They also argue for caution around emerging market assets, as a stronger dollar is a drag on commodity prices, makes it more difficult for domestic borrowers to service dollar-denominated debt, and imperils the supply of external capital that helps fund fiscal deficits. Investment Implications Putting it all together, we continue to favor a defensive stance. Real rates haven't budged during the post-Brexit sovereign yield backup (Chart 14, top panel), which has entirely been a function of less depressed term premiums (Chart 14, middle panel) and varying increases in inflation expectations (Chart 14, bottom panel). We are not yet convinced that the quickening in growth measures is anything other than one more of the false dawns that have been a regular feature of the last several years. We also see the uncertainty accompanying the Fed's turn away from accommodation at the margin as carrying considerable potential for disruption. It seems overly optimistic to think that policy makers will be able to shift course without causing at least a hiccup or two. With the S&P 500 trading at an elevated forward multiple (Chart 15), U.S. equities have little if any cushion against disappointment. Chart 14Bonds Aren't Pricing In Better Growth Bonds Aren't Pricing In Better Growth Bonds Aren't Pricing In Better Growth Chart 15Little Cushion Against Disappointment Little Cushion Against Disappointment Little Cushion Against Disappointment Maintaining a defensive portfolio bias is consistent with our qualms about growth and the potential for policy hiccups. We attribute cyclical sectors' outperformance relative to defensive sectors to technical rather than fundamental factors. Cyclicals had become oversold relative to defensives, as had emerging markets, at a time when the dollar needed to take a break from its upward sprint. We view the whole commodity/cyclical/EM complex as participating in a countertrend rally. We are vigilant, however, and we are asking ourselves where we could be getting it wrong even more frequently than usual. Many of the defensive spaces we currently favor have been bid up to levels where they would not seem to have any cushion at all. It is not comforting to invest on the basis of overshoots that are expected to become even more extended, but that is life with TINA in the ZIRP/NIRP era. Our model portfolios have underperformed over their first four weeks thanks to our income hybrids' underperformance versus plain-vanilla fixed income and defensives' underperformance versus cyclicals, but we think they will enhance the overall portfolios' risk-adjusted return profiles over time. The lack of a credible recession threat argues for maintaining our underweight in plain-vanilla fixed income products, but uncomfortably tight high-yield spreads have us concentrating our spread product exposure in the investment-grade space. We maintain our (currency-hedged) equity tilts toward Europe and Japan, and away from the U.S., largely on our expectations for ongoing dollar strength. That view also informs our allocations to mid- and small-cap U.S. equities, which are more domestically focused than their large- and mega-cap counterparts. Our Fed view underpins our dollar expectations, and any change in our policy take would result in portfolio changes. We will undertake a comprehensive view of our model portfolios in December, once they have two months of performance under their belts. Postscript: Dewey Defeats Truman Global ETF Strategy has a cyclical, not a tactical, orientation. Our process is directed toward catching cyclical moves and we avoid the chasing-our-own-tail spiral of trying to handicap short-term wiggles. As a result, when this report went to press Tuesday afternoon, we looked through the election and rejected tweaking our portfolios to position for any particular outcome. While we were surprised by the results of the election, our U.S. portfolios' domestic orientation, and the generally defensive cast to all of our portfolios, should help insulate them from any incremental volatility that may ensue over the rest of the year. The immediate market reaction soundly rejected our stance on the course of Fed rate hikes, but we think investors may change their tune given more time to reflect. We think it is far from certain that the Fed will tear up its playbook. Upheaval in the financial markets could well stay the FOMC's hand in December, but the first half hour of New York trading suggests that the potential for upheaval was rather overhyped. We do not see why the election results would have any impact on the labor market and the creeping upward pressure on wages. Markets are said to hate uncertainty and the actions of a Trump administration are surely harder to predict than the actions of a Clinton administration. We are not going to become traders, but we will be more vigilant over the two-plus months before the Inauguration and the first weeks of the new administration. We will adopt a more tactical orientation if conditions warrant, but we are not acting hastily now. We expect that there will be a lot of head fakes before markets find their true course. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 With 84% of S&P 500 constituents having reported through November 3rd, Standard & Poor's projected year-over-year growth in operating earnings of nearly 14%. 2 Overnight index swaps (OIS) are our preferred vehicle for deriving rate hike expectations because they represent contracts between real-life market participants and are thus more reliable than survey measures.

Highlights De-globalization is accelerating. Europe is holding together, with populism in check. China power consolidation reflects extreme risks. Brexit is more likely, not less, after court ruling. Feature Chart I-1America Has Soured On Globalization De-Globalization De-Globalization The world woke up on Wednesday to President-elect Donald J. Trump. It will take time for the markets to digest the new regime in Washington D.C., but something tells us that it will not be business-as-usual over the next four years. We give our post-mortem assessment in the enclosed In Focus Special Report, starting on page 28. The divisive campaign reached epic lows in decorum and polarization, but both candidates did have one major thing in common: They shared a negative view of globalization, representing a paradigm shift in geopolitics and macroeconomics. Investors often take policymakers to be agents of political supply. Political rhetoric is taken seriously, analyzed, and its implications for various assets are discussed with confidence. But this approach gets the causality all wrong. Politicians are merely supplying what the political marketplace is demanding. In those terms, Donald Trump was not an agent of change. He was merely a product of his environment. So what is the American median voter demanding? Judging by the success of Donald Trump - and Senator Bernie Sanders in the Democratic primary race - the answer is less free trade, more government spending, and a promise to keep entitlement spending at current, largely unsustainable levels. Americans empirically support globalization at a lower level than the average of advanced, emerging, or developing economies (Chart I-1). What is the problem with globalization? In our 2014 report titled "The Apex Of Globalization - All Downhill From Here," we argued that globalization was under assault due to three dynamics:1 Deflation is politically pernicious: Globalization was one of the greatest supply-side shocks in recent history and thus exerted a strong deflationary force (Chart I-2). A persistently low growth environment that flirts with deflation is unacceptable for the majority of the population in advanced economies. Citizens have already experienced a combination of wage suppression and debt escalation. And while globalization produced disinflationary forces on the price of labor and tradeable goods, it has done little to check the rising costs of education, health care, child care, and housing (Chart I-3), which cannot be outsourced to China or Mexico. Chart I-2Globalization Was A Major Supply-Side Shock Globalization Was A Major Supply-Side Shock Globalization Was A Major Supply-Side Shock Chart I-3You Can't Ship Daycare To China bca.gps_mp_2016_11_09_s1_c3 bca.gps_mp_2016_11_09_s1_c3 The death of the Debt Supercycle: The 2008 Great Recession shifted the demand curve inward. BCA coined the "debt supercycle" framework in the 1970s to characterize the overarching trend of rising debt in a world where political leaders, with the Great Depression and Second World War in the back of their mind, continually resorted to reflationary policies to overcome each new recession. However, the 2008 economic shock permanently shifted household preferences in the West, reducing demand by turning consumers into savers (Chart I-4A and Chart I-4B). This contributes to the global savings glut and reinforces the deflationary environment. Chart I-4AGlobal Demand Engine ... bca.gps_mp_2016_11_09_s1_c4a bca.gps_mp_2016_11_09_s1_c4a Chart I-4B...Is Not Coming Back bca.gps_mp_2016_11_09_s1_c4b bca.gps_mp_2016_11_09_s1_c4b Multipolarity: Global leadership by a dominant superpower can overcome ideological challenges and demand deficiencies by providing a consumer of last resort. In game-theory terms, such a global hegemon acts as an exogenous coordinator, turning a non-cooperative game into a cooperative one. But in today's world, geopolitical and economic power is becoming more diffuse. We know from history that intense competition between a number of leading nations imperils globalization (Chart I-5). This is particularly the case in a low-growth environment. Geopolitical and economic multipolarity increase market risk premiums. Chart I-5Multipolarity Imperils Globalization Multipolarity Imperils Globalization Multipolarity Imperils Globalization These factors imperiled globalization well before Donald Trump, Bernie Sanders, Jeremy Corbyn, and Nigel Farage came to dominate the news flow in 2016. The macroeconomic and geopolitical context guaranteed that anti-globalization rhetoric would prove successful at the ballot box. Chart I-6Sino-American Macroeconomic Symbiosis Ended##br## In 2008 Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over Sino-American Symbiosis Is Over In addition to these structural challenges to globalization, the next U.S. administration will also have to handle the increasingly complex Sino-American relationship. The future of the post-Bretton Woods macroeconomic and geopolitical system will be decided by these two great powers. And we fear that both economic and geopolitical tensions will worsen.2 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 I-6). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. 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 to trade - to defend their domestic market from competition.3 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West. The problem with this choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into global trade (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open up 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.4 What should investors expect in a world that has less globalization, more populism, and rising Sino-American tensions? We think there are five structural investment themes afoot: Chart I-7Globalization And MNCs: A Tight Embrace bca.gps_mp_2016_11_09_s1_c7 bca.gps_mp_2016_11_09_s1_c7 Inflation is back: Globalization has been one of the most important pillars of a multi-decade deflationary era. If it is imperiled, political capital will swing from capitalists to the owners of labor. Sovereign bonds are not pricing in this paradigm shift, which is why investors should position themselves for the "End Of The 35-Year Bond Bull Market."5 We are long German 10-year CPI swaps as a strategic play on this theme. USD strength: The market got the USD wrong. Trump is not bad for the greenback. More government spending and higher inflation will allow U.S. monetary policy to be tighter than that of its global peers. Furthermore, U.S. policymakers will not look to arrest the dollar bull market. "Main street" loves a strong dollar, particularly U.S. households and consumers. King Dollar will be the righteous agent of plebeian retribution against the patrician corporations used to getting their way on Capitol Hill. And finally, more geopolitical risk will mean more safe haven demand. RMB weakness: China needs to depreciate its currency in order to ease domestic monetary policy and is therefore constrained by its slowing and over-leveraged economy. But in doing so, it will export deflation and ensure that a trade war with the U.S. ensues. In addition, China's EM peers will suffer as their competitiveness vis-à-vis their main export market - China - declines. We expect that China will hasten its ongoing turn towards protectionism itself. This means that if investors want to take advantage of China's rise, they should buy Chinese companies, not the foreign firms looking to grab a share of China's middle-class market. Long defense stocks: Global multipolarity is correlated with armed conflict. We have played this theme by being long U.S. defense / short aerospace equities. Our colleague Anastasios Avgeriou, Chief Strategist of BCA's Global Alpha Sector Strategy, recommends investors initiate a structural overweight in the global defense index.6 Long SMEs / Short MNCs: A world with marginally less free trade, and marginally more populism, will favor domestically oriented sectors. Small- and medium-sized enterprises (SMEs) in the U.S., for example. Multinational corporations (MNCs) have particularly benefited from free trade and laissez faire economics. The relationship between globalization and S&P 500 operating earnings has been tight for the past 50 years (Chart I-7). Not anymore. In the new environment, investors will want to be long domestically-oriented sectors and economies against externally-oriented ones. These are structural themes supported by structural trends. We would have recommended these five investment themes irrespective of who won the U.S. election. In this Monthly Report, we focus on leadership races around the world. Our In Focus section gives a post-mortem on the U.S. presidential election. The rest of this Global Overview focuses on upcoming elections in Europe (as well as the December 4 Italian constitutional referendum) and the impending Chinese leadership rotation in 2017. We also give our two cents on recent developments related to Brexit in the U.K. Europe: Election Fever Continues Chart I-8Italian Referendum: Likely A 'No' Italian Referendum: Likely A "No" Italian Referendum: Likely A "No" The Netherlands, France, Germany, and potentially, Italy could all hold elections over the next 12 months, a recipe for market volatility. These four countries are part of the EMU-5 and account for 71% of the currency union's GDP and 66% of its population. Should investors expect a paradigm shift? We think the answer is yes, but surprisingly, not towards more Euroskepticism. Our view is that continental Europe - unlike its Anglo-Saxon peers, the U.K. and the U.S. - is actually moving marginally towards the center.7 The median voter in Europe is not becoming more Euroskeptic and even appears to support modest, pro-business, structural reforms! Wait... what? Indeed. Read on. Italy The constitutional referendum being held on December 4 remains too close to call, although we suspect that it will fail (Chart I-8). However, we doubt very much that the defeat of the government's position will initiate a sequence of events that takes Italy out of the euro area. As we argued in a recent Special Report titled "Europe's Divine Comedy: Italian Inferno," Italian policymakers are using Euroskepticism to extract concessions from Europe. But Italy is structurally constrained from exiting European institutions because of its bifurcated economy.8 Moreover, a failed referendum outcome is not a strategic risk to Europe: Euro support: Italians continue to support euro area membership, albeit at a lower level than in the past (Chart I-9). As such, the Euroskeptic Five Star Movement (M5S) has political reasons to become less opposed to euro area membership, as its anti-establishment peers have done in Greece, Portugal, and Spain. Bicameralism: If the constitutional referendum fails, then the Senate will remain a fully empowered chamber in the Italian Parliament. Given Italy's complicated electoral laws, M5S will be unable to capture both houses in Italy's notoriously bicameral legislative body, unless it does very well in the next election. But M5S has consistently trailed the incumbent, pro-establishment Democratic Party (PD) in the polls (Chart I-10). Sequence: As Diagram I-1 shows, the contingent probability of the December constitutional referendum leading to an Italian exit from the euro area is 1.2%. Chart I-9Italy & Euro: OK (For Now) bca.gps_mp_2016_11_09_s1_c9 bca.gps_mp_2016_11_09_s1_c9 Chart I-10Italy: Euroskeptics Peaking? bca.gps_mp_2016_11_09_s1_c10 bca.gps_mp_2016_11_09_s1_c10 Diagram I-1From Referendum To Referendum: Contingent Probability Of Italy ##br##Leaving The Euro Area Following The Constitutional Referendum Vote De-Globalization De-Globalization Investors should not translate our sanguine view into a positive view of Italy. As we outlined in the above-cited Special Report, we remain skeptical that Italy can improve its potential growth rate by boosting productivity. But there is a big leap between more-of-the-same in Italy and a euro area collapse. The Netherlands The anti-establishment and Euroskeptic Party for Freedom (PVV) is set to perform poorly in the upcoming March 15 Dutch election. Polls suggest that it will roughly repeat its 10% performance from the 2012 election (Chart I-11). This is extremely disappointing given its polling earlier in the year. PVV's support has collapsed recently, most likely the result of the immigration crisis abating (Chart I-12) and the Brexit referendum in June. Many Dutch may be interested in casting a protest vote against the establishment, but a large majority still support euro area membership (Chart I-13). As such, they are put off by the vociferous Euroskepticism represented by the PVV. Chart I-11The Netherlands: Euroskeptics Collapsing bca.gps_mp_2016_11_09_s1_c11 bca.gps_mp_2016_11_09_s1_c11 Chart I-12Read Our Chart: Migration Crisis Is Over bca.gps_mp_2016_11_09_s1_c12 bca.gps_mp_2016_11_09_s1_c12 Chart I-13The Netherlands & Euro: Love Affair bca.gps_mp_2016_11_09_s1_c13 bca.gps_mp_2016_11_09_s1_c13 The Netherlands is a very important euro area member state. Its economy is large enough that its views matter, despite its small population. Euroskepticism in the Netherlands is notable, but it does not mean that the country's leadership will contemplate a referendum on membership. More likely, the establishment will seek to counter the populist PVV by becoming stricter on immigration and looser on budget discipline. Investors can live with both. France The French election is a two-round affair that will be held on April 23 and May 7. The key question is who will win the November 20 primary of the center-right party, Les Républicains, formerly known as the Union for a Popular Movement. According to the latest polls, former Prime Minister (1995-1997) Alain Juppé is set to win the primary over former President Nicolas Sarkozy (Chart I-14). Who is Alain Juppé? The 70-year old has been the mayor of Bordeaux since 2006, but he is better remembered for the failed social welfare reforms (the Juppé Plan) that caused epic strikes in France back in 1995. He is pro-euro, pro-EU, and pro-economic reforms. In other words, he is everything that Brexit and Trump/Sanders/Corbyn are not. According to the latest polls, Juppé is a heavy favorite against the anti-establishment candidate Marine Le Pen (Chart I-15). This is unsurprising as Le Pen's popularity peaked in 2013, as we have been stressing to clients for years (Chart I-16). Chart I-14Please Google Alain Juppe... bca.gps_mp_2016_11_09_s1_c14 bca.gps_mp_2016_11_09_s1_c14 Chart I-15...The Next President Of France De-Globalization De-Globalization Chart I-16Le Pen's Popularity In A Secular Decline bca.gps_mp_2016_11_09_s1_c16 bca.gps_mp_2016_11_09_s1_c16 Why has Le Pen struggled to gain traction in an era of terrorism, migration crises, and the success of anti-establishment peers such as Brexiters and Donald Trump? There are two major reasons. First, she continues to oppose France's membership in the euro area, despite very large support levels for the common currency in the country (Chart I-17). Second, she is holding together a coalition of northern and southern National Front (FN) members. This coalition pins together a diverse group. Northern right-wing FN members are more akin to their Dutch peers, or the "alt-right" movement in the U.S. They are anti-globalization, anti-political correctness (PC), and anti-immigration - specifically, further immigration of Muslims to France. However, this northern FN faction is ambivalent on social issues such as homosexuality (in fact, many of Le Pen's closest advisors from the north of France are openly gay), and they oppose Islam from a position that Muslim immigrants are incompatible with French liberal values. The southern FN faction is far more traditionally conservative, drawing their roots from the old anti-Gaullist, staunchly Catholic right wing. When Le Pen loses the 2017 presidential election, it will spell doom for the National Front. The only thing holding the two factions together is her leadership. Therefore, not only is France likely to elect a pro-reform president from the political establishment, but also its anti-establishment, Euroskeptic movement may be facing an internal struggle. Germany The German federal election is expected to be held sometime after August 2017. Chancellor Angela Merkel faces a decline in popularity (Chart I-18) and a challenge from the populist Alternative für Deutschland (AfD), which performed well in two Lander (state) elections this year. Nonetheless, the migration crisis that rocked Merkel's hold on power has abated. As Chart I-12 shows, migrant flows into Europe peaked at 220,000 last October and began to plummet well before the EU-Turkey deal that the press continues to erroneously cite as the reason for the reduction in migrant flows. As we controversially explained at the height of the crisis, every migration crisis ultimately abates as border enforcement strengthens, liberal attitudes towards refugees wane, and the civil wars prompting the flow exhaust themselves.9 Germany's centrist parties maintain a massive lead over the upstart AfD and Die Linke, the left-wing successor of East Germany's Communist establishment (Chart I-19). However, AfD's successes in Mecklenburg West Pomerania and Berlin have prompted investors to ask whether it will garner greater national support in the general election. Chart I-17France & Euro: Loveless Marriage,##br## But Together For The Kids bca.gps_mp_2016_11_09_s1_c17 bca.gps_mp_2016_11_09_s1_c17 Chart I-18Merkel's Popularity Has Suffered,##br## But Stabilized Merkel's Popularity Has Suffered, But Stabilized Merkel's Popularity Has Suffered, But Stabilized Chart I-19There Is A##br## Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... There Is A Lot Of Daylight... We doubt it. Both states are sort of oddballs in German politics. For example, Mecklenburg West Pomerania is known for a strong anti-establishment sentiment. AfD largely took votes away from the National Democratic Party (ultra-far-right, neo-Nazis) and Die Linke. These two parties won a combined 25% of the vote in 2011. In 2016, the combined anti-establishment vote, including AfD, was 33%. Clearly this is a notable gain for the non-centrist parties, but it is hardly a paradigm shift. In Berlin, the AfD gained a solid 14% of the vote, but the sensationalist media conveniently avoided mentioning that it came in fifth in the final count. By our "back-of-the-envelope" calculation, AfD managed to take only about 8% of the vote from establishment parties. The bulk of its success once again came from taking votes from other populist parties. For example, Berlin's Pirate Party - yes, "pirates" - took 8% of the vote in the last election and none in 2016. Nonetheless, we suspect that time may be running out for Angela Merkel. She has been in power since 2005 and many voters have lost confidence in her. Merkel may choose not to contest the election at the CDU party conference in early December, or she may step aside as the leader following the election. Why? Because polls suggest that Merkel's CDU will have to once again rely on a Grand Coalition with its center-left opponent, the SPD, to govern. Politically, this is a failure for Merkel as the Grand Coalition was always intended to be a one-term arrangement. If Merkel decides to retire, how will the ruling CDU choose its successor? The process is relatively closed off and dominated by the party elites. The Federal Executive Board of the CDU selects the candidates for chairperson and the party delegates must choose the leader with a majority. The outcome is largely preordained, and Merkel has typically won above 90% of the party congress delegate vote. The possibility of a chancellor from the CDU's Bavarian sister-party, the Christian Social Union (CSU), is also decided by the elites. Therefore, the likelihood of an anti-establishment candidate hijacking the CDU/CSU leadership is minimal. How will the markets react to Merkel's resignation? Investors are overstating Merkel's role as the "anchor" of euro area stability. She has, in fact, dithered multiple times throughout the crisis. In 2011, for example, Merkel delayed the decision on whether to set up a permanent euro area fiscal backstop mechanism due to upcoming Lander elections in Rhineland-Palatinate and Baden Württemberg. In addition, her likely successor will not mark a paradigm shift in terms of Germany's pro-euro outlook (Box I-1). Bottom Line: Investors may wake up in mid-2017 to find that the U.K. is firmly on its way out of the EU and that the U.S. is embroiled in deepening political polarization. Meanwhile, France and Spain will be led by reformist governments, Italy will remain in the euro area, and Germany will be mid-way through a rather boring electoral campaign featuring pro-euro establishment parties. What is keeping the European establishment in power? In early 2016, we argued that it was its large social welfare state. Unlike the laissez-faire economies of the U.S. and the U.K., European "socialism" has managed to redistribute the gains of globalization sufficiently to keep the populists at bay. As such, European voters are not flocking to populist alternatives, despite considerable challenges such as the migration crisis and terrorism. Populists are gaining votes in Europe nonetheless. To counter that trend, we should expect to see Europe's establishment parties turn more negative towards immigration, positive on fiscal activism, and more assertive towards security and defense policy. But on the key investment-relevant issue of euro area membership and European integration, we see the consensus remaining with the status quo. China: Xi Is A "Core" Leader... So What? Chinese President Xi Jinping's recent designation as the "core" of the Chinese leadership should be seen as a marginally market-positive event in an otherwise bleak outlook. Not because the president has a new title, but because of the underlying reality that he is consolidating power ahead of the 19th National Party Congress. Set for the fall of 2017, the Congress will feature a major rotation of top Communist Party leaders and mark the halfway point of his 10-year administration. The new title was not a surprise when it trickled out of the Chinese Communist Party's Sixth Plenary meeting on October 24-27. But the media took the opportunity once again to decry President Xi's "ever-expanding power."10 As our readers know, we do not think there has been a palace coup in China. That is, we do not think Xi has overthrown the "collective leadership" model, i.e. rule by the Politburo Standing Committee, established after the death of Chairman Mao.11 Instead, we think he is presiding over a major centralization phase in Chinese politics. Xi's status as the "core" feeds into the broader idea of re-centralization that we identified as a key theme for this administration when it began its term back in 2012.12 The Sixth Plenum reinforced this view in various ways:13 Xi is clearly in charge: A smattering of local party officials started calling him the core leader earlier this year, but now it has been endorsed in official documents at the highest level. Again, it is not the title itself that matters, but the fact that Xi compelled the whole party to give him the title. This distinguishes him from his two predecessors, Presidents Hu Jintao and Jiang Zemin, and in this way he resembles his mighty predecessor Deng Xiaoping. Xi already developed a strong track record for re-centralizing the political system prior to receiving the new title.14 Collective leadership persists: Deng invented the idea of the "core" leader specifically as a way to assert the need for a top leader or chief executive without reverting to Maoist absolutism. The core leader is the supreme leader within a collective leadership system. This interpretation was expressly reaffirmed by the communique issued at the Sixth Plenum, which denounced ruling by a single person and praised the current system.15 Corruption purge has not split the party: The focus of the plenum was the Communist Party's rules for disciplining its own members. This specifically highlighted Xi's harsh anti-corruption campaign, which has netted numerous party officials, and has not yet concluded (Chart I-20). The fact that this campaign has continued longer than expected without prompting significant resistance shows that centralization is acceptable to the party (and anti-corruption is positive for the party's public image). Policy coherence could improve: A rash of rumors suggest that Xi will not only promote his allies but also tweak party rules and norms in order to ensure he retains a factional majority on the Politburo Standing Committee after 2017. This should be positive for policymaking since the cohort of leaders ready to rise up the ranks is weighted against his faction as a result of the previous administration's appointments. These developments would be negative if Xi avoids appointing successors next year and thus appears ready to cling to power beyond 2022.16 Unified government is a plus amid crisis: Deng initiated the "core leader" concept in the dark days after the Tiananmen massacre, when the party faced internal rifts and potential regime collapse. In other words, it is in times of crisis that the party needs to reaffirm that rule-by-committee still requires a final arbiter at the top. This latter point is the most relevant for investors. It suggests that China's party leadership perceives itself to be in the midst, or on the brink, of a crisis. Why should this be the case? There has been an improvement in China's economic situation in 2016 - stimulus efforts have stabilized the economy and growth momentum is picking up (Chart I-21). Economic relations with Asian nations are also improving. All of this information has supported the China bulls, who argue that China is not particularly overleveraged, still has a long way to go in terms of economic development, and needs to stimulate demand in order to outgrow any problems it faces from debt and overcapacity (Chart I-22). Chart I-20Anti-Corruption ##br##Campaign Reaccelerating Anti-Corruption Campaign Reaccelerating Anti-Corruption Campaign Reaccelerating Chart I-21Chinese Economy##br## Improved This Year Chinese Economy Improved This Year Chinese Economy Improved This Year Chart I-22Chinese Capacity Utilization: ##br##A Historical Perspective Chinese Capacity Utilization: A Historical Perspective Chinese Capacity Utilization: A Historical Perspective Nevertheless, the latest reflation efforts have peaked (Chart I-23), and there are clear warning signs for what lies ahead. The RMB continues to weaken, capital outflows may reaccelerate as a result, the yield curve is flattening, and economic policy uncertainty remains markedly elevated (Chart I-24). As such, the China bears argue that exorbitant credit growth cannot continue indefinitely (Chart I-25). When credit growth slows, the credit-reliant economy will slow too, and China will face a cascade of bad loans and insolvent companies and banks. Chart I-23Latest Mini-Stimulus##br## Is Over Latest Mini-Stimulus Is Over Latest Mini-Stimulus Is Over Chart I-24China:##br## Who Is Driving This Bus? China: Who Is Driving This Bus? China: Who Is Driving This Bus? Chart I-25China's Corporate And Household Credit: ##br##The Sky's The Limit? China's Corporate And Household Credit: The Sky'S The Limit? China's Corporate And Household Credit: The Sky'S The Limit? While economists can argue over the nature of things, politicians do not have that luxury: China's government must be prepared for the worst-case scenario. The China bears may be right even if their economic analysis proves overly pessimistic or poorly timed, because policymakers may eventually decide they must do more to tackle excessive leverage and overcapacity. Chart I-26Rebalancing Is Slowing Down Rebalancing Is Slowing Down Rebalancing Is Slowing Down An optimistic long-term assumption about Xi's consolidation of power has been that he eventually intends to use that power to pursue painful structural reforms, as outlined at the Third Plenum in 2013.17 However, the intervening three years have shown that he is pragmatic and does not want to impose aggressive reforms that would undercut an already weak and slowing economy (Chart I-26). Thus, deep reforms are only going to occur if they are forced upon the leaders as a result of an intense bout of instability, uncertainty, and market riots. The implication of this is that Xi is concentrating power in preparation for further crisis points that may be thrust upon his administration. For instance, if recent efforts to tamp down on property prices end up bursting the bubble, then eventually China could be plunged into socio-political (as well as financial) turmoil. By that time, the party would not be able to re-centralize and consolidate power carefully and gradually. It would either have loyal tools at its disposal already, or would lose precious time (and likely make mistakes) trying to assemble them. Thus Xi's moves to consolidate power are marginally market-positive in an overall negative climate. He is making himself and the Politburo Standing Committee better prepared to handle a crisis, which suggests that he believes that a crisis is either occurring or close at hand. In short, the Communist Party is girding for war; a war for regime stability if and when the massive credit risks materialize. What about the 19th National Party Congress, set to take place next fall? We will revisit this topic in the future, but for now the key point is this: It would require a surprise and/or a new political dynamic to prevent Xi from getting his way in forming the Politburo Standing Committee next year. While there is a mixed record of policy stimulus for the years preceding the Chinese midterm leadership reshuffle, we certainly do not expect aggressive structural reforms to occur before then (Chart I-27). Policy tightening in the real estate sector and SOE restructuring efforts will be gradual. Chart I-27Unimpressive Record Of Stimulus Before Five-Year Party Congresses Unimpressive Record Of Stimulus Before Five-Year Party Congresses Unimpressive Record Of Stimulus Before Five-Year Party Congresses Only around the time of the party congress will it be possible to find out whether Xi wants his administration to be remembered for anything other than power consolidation - such as ambitious reforms. One reform effort we are confident will continue amid rising centralization, however, is tougher government policy against pollution. Pollution threatens social stability, especially among the restless new middle class, and stimulus efforts perpetuate the heavily polluting industries. Environmental spending has been the biggest growth category in government spending under Premier Li Keqiang.18 To capitalize on the darkening short-term outlook for stocks and Xi's policy momentum, we suggest shorting Chinese utilities, whose profit margins and share prices trade inversely with rising environmental spending (Chart I-28). Bottom Line: We remain overweight China relative to EM: The government has resources and is unified. However, the long-term outlook is mixed. Investors should steer clear of Chinese risk assets in absolute terms. Short utilities as a play on rising environmental spending and regulation, and stay short the RMB. Brexit Update: The "Legion Memorial" Is Alive And Well Chart I-28Anti-Pollution Push Hurts Utilities Anti-Pollution Push Hurts Utilities Anti-Pollution Push Hurts Utilities The Brexit movement encountered its first apparent setback last week when the country's High Court ruled that parliament must vote on invoking Article 50 of the Lisbon Treaty to initiate the withdrawal from the European Union. We have always held a high-conviction view that parliament approval would ultimately be necessary, as we wrote in July.19 But, politically, it matters a great deal whether parliament votes before or after the exit negotiations. The High Court ruling is an obstacle to the government's Brexit plan because it could result in (1) the parliament's outright blocking Brexit, though this outcome is highly unlikely; (2) the parliament's insisting on a "soft Brexit" that leaves U.K.-EU relations substantially the same as before the referendum on matters like immigration and market access. However, the saga is nowhere near finished. The government is appealing the ruling, the Welsh assembly is contesting the appeal, and the Supreme Court will decide the matter in December. Until then, we expect U.K. markets to benefit marginally, ceteris paribus, from the belief that the odds of a soft Brexit are rising. Investors could be encouraged by the continuation of monetary stimulus and a new blast of fiscal stimulus, which we think will surprise to the upside on November 23 when the annual Autumn Statement is released by the Chancellor of the Exchequer. The High Court-prompted rebound in U.K. assets will remain vulnerable for the following reasons: The Supreme Court has not yet ruled: It is not certain that the Supreme Court will uphold the High Court's insistence on a parliamentary role. Both views have legitimate arguments and the issue is not settled until the Supreme Court rules. Parliament's role is political, not merely legal: Assuming parliament gets to vote on whether to trigger the process of leaving the EU, the decision will depend on politics. For instance, it is highly unlikely that the Commons will flatly reject the popular referendum, and the House of Lords can at best delay it. Yes, parliament is sovereign, but that is because it represents the people. While the 1689 Glorious Revolution established the Bill of Rights and parliamentary supremacy, in as early as 1701 there was a crisis over whether parliament should flatly overrule popular will. At that time, the writer Daniel Defoe, representing "the people," delivered the so-called Legion Memorial directly to the Speaker of the Commons. It read: "Our name is Legion, for we are Many."20 Parliament backed down. The politics of the moment favor the government: Polling shows a stark divergence in popular opinion since the referendum in favor of the Tories (Chart I-29). This is a clear signal - on top of the referendum outcome and the sweeping Tory election win in 2015 - that the popular will favors leaving the European Union. It is also a clear signal that Prime Minister Theresa May has the mandate to do it her way. Her approval rating has waned a bit (Chart I-30), but she is still supported by nearly half the population. If the government fails to win parliamentary support on Brexit, it would likely lead to a vote of no confidence and early elections. Yet the current dynamics suggest an early election would return a Conservative majority with a clear mandate to vote for Brexit. Until those dynamics undergo a change, "Brexit means Brexit." Economics favor the government: One danger for the anti-Brexit coalition is that the Supreme Court may compel a parliamentary vote in the near future. The economy has not yet suffered much from Brexit, whatever it may do in future, so there is little motivation for widespread "Bregret," i.e. the desire to reverse course and stay in the EU. By contrast, in two years' time, the negative economic consequences and uncertainties of the actual exit plan, combined with ebbing popular enthusiasm, would likely give parliament a stronger position from which to soften or reverse Brexit. Although Article 50 is arguably irrevocable, it seems hard to believe that the EU would not find a way to allow the U.K. to stay in the union if its domestic politics shifted in favor of staying, since that is clearly in the EU's interest. The President of the European Council Donald Tusk has implied as much.21 Chart I-29Brexit Helped Tories, Hurt Labour Brexit Helped Tories, Hurt Labour Brexit Helped Tories, Hurt Labour Chart I-30Prime Minister May's Popularity Still Strong De-Globalization De-Globalization From the arguments above we can draw three conclusions. First, parliament will not simply repudiate the popular referendum. Second, if parliament must vote, the political context suggests it will vote on a bill that substantially favors the government's approach toward Brexit. If that happens, the High Court ruling this week will be only a pyrrhic victory for the Bremain camp. However, parliamentary involvement does imply a softer Brexit than otherwise, and it is possible that parliament could extract major concessions. Third, the High Court ruling makes Brexit more, not less, likely. This is because it is forcing parliamentarians to vote on Brexit so early in the process, when Brexit's negative consequences are yet not evident. What do the latest Brexit twists and turns portend for European and global growth? We do not see them as particularly damaging. The British turn toward greater fiscal spending adds yet another to the list of those countries supporting one of our key investment themes: "The Return of G," or government spending.22 As we predicted, Canada is overshooting its budget deficits, Japan is engaging in coordinated monetary and fiscal stimulus, and Italy is expanding spending and daring Germany and the European Council to stop it, especially in the face of badly needed earthquake reconstruction and the ongoing immigration crisis (Chart I-31). Chart I-31G7 Fiscal Thrust Is Going Up De-Globalization De-Globalization This leaves the United States and Germany as two outstanding questions. The U.S. election means that Trump will launch potentially large spending increases with a GOP-held Congress. As for Germany, the CDU/CSU appears to be shifting toward more government spending, but the direction will not be clear until the election in the fall of 2017. Bottom Line: The High Court ruling has made Brexit more rather than less likely. By forcing the parliament to make a ruling on Brexit before the economic damage is clear, the High Court has put parliamentarians in the difficult position of going against the public. We are closing our long FTSE 100 / short FTSE 250 Brexit hedge in the meantime. The market may, incorrectly, price a lower probability of Brexit, while domestic stimulus will aid the home-biased FTSE 250. Nonetheless, we remain short U.K. REITs to capitalize on the long-term uncertainty, as well as negative cyclical and structural factors that are affecting commercial real estate. We also expect the GBP/USD to remain relatively weak and vulnerable relative to the pre-Brexit period. We would expect the GBP/USD to retest its mid-October-low of 1.184 over the next two years. BOX I-1 Likely Successors To German Chancellor Angela Merkel If Merkel decides to retire, who are her potential successors? Wolfgang Schäuble, Finance Minister (CDU): The bane of the financial community, Schäuble is seen as the least market-friendly option due to his hardline position on bailouts and the euro area. In our view, this is an incorrect interpretation of Schäuble's heavy-handedness. He is by all accounts a genuine Europhile who believes in the integrationist project. At 74 years old, he comes from a generation of policymakers who consider European integration a national security issue for Germany. He has pursued a tough negotiating position in order to ensure that the German population does not sour on European integration. Nonetheless, we doubt that he will chose to take on the chancellorship if Merkel retires. He suffered an assassination attempt in 1990 that left him paralyzed and he has occasionally had to be hospitalized due to health complications left from this injury. As such, it is unlikely that he would replace Merkel, but he may stay on as Finance Minister and thus be as close to a "Vice President" role as Germany has. Ursula von der Leyen, Defense Minister (CDU): Most often cited as the likely replacement for Merkel, Leyen nonetheless is not seen favorably by most of the population. She is a strong advocate of further European integration and has supported the creation of a "United States of Europe." Leyen has gone so far as to say that the refugee crisis and the debt crisis are similar in that they will ultimately force Europe to integrate further. As a defense minister, she has promoted the creation of a robust EU army. She has also been a hardliner on Brexit, saying that the U.K. will not re-enter the EU in her lifetime. While the markets and pro-EU elites in Europe would love Leyen, the problem is that her Europhile profile may disqualify her from chancellorship at a time when most CDU politicians are focusing on the Euroskeptic challenge from the right. Thomas De Maizière, Interior Minster (CDU): Maizière is a former Defense Minister and a close confidant of Chancellor Merkel. He was her chief of staff from 2005 to 2009. Like Schäuble, he is somewhat of a hawk on euro area issues (he drove a hard bargain during negotiations to set up a fiscal backstop, the European Financial Stability Fund, in 2010) and as such could be a compromise candidate between the Europhiles and Eurohawks within the CDU ranks. However, he has also been implicated in scandals as Defense Minister and may be tainted by the immigration crisis due to his position as the Interior Minister. Julia Klöckner, Executive Committee Member, Deputy Chair (CDU): A CDU politician from Rhineland-Palatinate, Klöckner is a socially conservative protégé of Merkel. While she has taken a more right-wing stance on the immigration crisis, she has remained loyal to Merkel otherwise. She is a staunch Europhile who has portrayed the Euroskeptic AfD as "dangerous, sometimes racist." We think that she would be a very pro-market choice as she combines the market-irrelevant populism of anti-immigration rhetoric with market-relevant centrism of favoring further European integration. Hermann Gröhe, Minister of Health (CDU): Gröhe is a former CDU secretary general and very close to Merkel. He is a staunch supporter of the euro and European integration. Markets would have no problem with Grohe, although they may take some time to get to know who he is! Volker Bouffier, Minister President of Hesse (CDU): As Minister President of Hesse, home of Germany's financial center Frankfurt, Bouffier may be disqualified from leadership due to his apparent close links with Deutsche Bank. Nonetheless, he is a heavyweight within the CDU's leadership and a staunch Europhile. Fritz Von Zusammenbruch, Hardline Euroskeptic (CDU): This person does not exist! Section II: U.S. Election: Outcomes & Investment Implications Highlights Trump won by stealing votes from Democrats in the Midwest. His victory implies a national shift to the left on economic policy. Checks and balances on Trump are not substantial in the short term. U.S. political polarization will continue. Trump is good for the USD, bad for bonds, neutral for equities. Favor SMEs over MNCs. Close long alternative energy / short coal. Feature "Most Americans do not find themselves actually alienated from their fellow Americans or truly fearful if the other party wins power. Unlike in Bosnia, Northern Ireland or Rwanda, competition for power in the U.S. remains largely a debate between people who can work together once the election is over." — Newt Gingrich, January 2, 2001 Former Speaker of the House Newt Gingrich (and a potential Secretary of State pick), was asked on NBC's Meet the Press two days before the U.S. election whether he still thought that "competition for power in the U.S. remains largely a debate between people who can work together once the election is over." Gingrich made the original statement in January 2001, merely weeks after one of the most contentious presidential elections in U.S. history was resolved by the Supreme Court. Gingrich's answer in 2016? "I think, tragically, we have drifted into an environment where ... it will be a continuing fight for who controls the country." Despite an extraordinary victory - a revolution really - by Donald J. Trump, the fact of the matter remains that the U.S. is a polarized country between Republican and Democratic voters. As of publication time of this report, Trump lost the popular vote to Secretary Hillary Clinton. His is a narrower victory than either the epic Richard Nixon win in 1968 or George W. Bush squeaker in 2000. Over the next two years, the only thing that matters for the markets is that the U.S. has a unified government behind a Republican president-elect and a GOP-controlled Congress. We discuss the investment implications of this scenario below and caution clients to not over-despair. On the other hand, we also see this election as more evidence that America remains a deeply polarized country where identity politics continue to play a key role. What concerns us is that these identity politics appear to transcend the country's many cultural, ethical, political, and economic commonalities. Republicans and Democrats in the U.S. are fusing into almost ethnic-like groupings. To bring it back to Gingrich's quote at the top, that would suggest that the U.S. is no longer that much different from Bosnia or Northern Ireland.23 Election Post-Mortem Chart II-1Election Polls Usually##br## Miss By A Few Points De-Globalization De-Globalization Donald Trump has won an upset over Hillary Clinton, but his campaign was not as much of a long-shot as the consensus believed. U.S. presidential polls have frequently missed the final tally by +/- 3% of the vote, which was precisely the end result of the 2016 election (Chart II-1). Therefore, as we pointed out in our last missive on the election, Trump's victory was not a "wild mathematical oddity."24 Why Did Trump Win The White House? Where Trump really did beat expectations was in the Midwest, and Wisconsin in particular. He ended up outperforming the poll-of-polls by a near-incredible 10%!25 His victories in Florida, Ohio, and Pennsylvania were well within the range of expectations. For example, the last poll-of-polls had Trump leading in both Florida (by a narrow 0.2%) and Ohio (by a solid 3.5%), whereas Clinton was up in Pennsylvania by the slightest of margins (just 1.9% lead). He ended up exceeding poll expectations in all three (by 2% in Florida, 6% in Ohio, and 3% in Pennsylvania), but not by the same wild margin as in Wisconsin. When all is said and done, Trump won the 2016 election by stealing votes away from the Democrats in the traditionally "blue" Midwest states of Michigan, Pennsylvania, and Wisconsin. This was a far more significant result than his resounding victories in Ohio (which Obama won in 2012) or Florida (where Obama won only narrowly in 2012). Our colleague Peter Berezin, Chief Strategist of the Global Investment Strategy, correctly forecast that Trump would be competitive in all three Midwest states back in September 2015! We highly encourage our clients to read his "Trumponomics: What Investors Need To Know," as it is one of the best geopolitical calls made by BCA in recent history.26 As Peter had originally thought, Trump cleaned up the white, less-educated, male vote in all of the three crucial Midwest states. He won 68% of this vote in Michigan, 71% in Pennsylvania, and 69% in Wisconsin. To do so, Trump campaigned as an unorthodox Republican, appealing to the blue-collar white voter by blaming globalization for their job losses and low wages, and by refusing to accept Republican orthodoxy on fiscal austerity or entitlement spending. Instead, Trump promised to outspend Clinton and protect entitlements at their current levels. This mix of an outsider, anti-establishment, image combined with a left-of-center economic message allowed Trump to win an extraordinary number of former Obama voters. Exit polls showed that Obama had a positive image in all three Midwest states, including with Trump voters! For example, 30% of Trump voters in Michigan approved of the job Obama was doing as president, 25% in Pennsylvania, and 27% in Wisconsin. That's between a quarter and a third of eventual people who cast their vote for Trump. These are the voters that Republicans lost in 2012 because they nominated a former private equity "corporate raider" Mitt Romney as their candidate. Romney had famously argued in a 2008 New York Times op-ed that he would have "Let Detroit go bankrupt." Obama repeatedly attacked Romney during the 2011-2012 campaign on this point. Back in late 2011, we suspected that this message, and this message alone, would win President Obama his re-election.27 Why is the issue of the Midwest Obama voters so important? Because investors have to know precisely why Donald Trump won the election. It wasn't his messages on immigration, law and order, race relations, and especially not the tax cuts he added to his message late in the game. It was his left-of-center policy position on trade and fiscal spending. Trump is beholden to his voters on these policies, particularly in the Midwest states that won him the election. Final word on race. Donald Trump actually improved on Mitt Romney's performance with African-American and Hispanic voters (Table II-1). This was a surprise, given his often racially-charged rhetoric. Meanwhile, Trump failed to improve on the white voter turnout (as percent of overall electorate) or on Romney's performance with white voters in terms of the share of the vote. To be clear, Republicans are still in the proverbial hole with minority voters and are yet to match George Bush's performance in 2004. But with 70% of the U.S. electorate still white in 2016, this did not matter. Table II-1Exit Polls: Trump's Win Was Not Merely About Race De-Globalization De-Globalization Congress: No Gridlock Ahead Republicans exceeded their expectations in the Senate, losing only one seat (Illinois) to Democrats. This means that the GOP control of the Senate will remain quite comfortable and is likely to grow in the 2018 mid-term elections when the Democrats have to defend 25 of 33 seats. Of the 25 Senate seats they will defend, five are in hostile territory: North Dakota, West Virginia, Ohio, Montana, and Missouri. In addition, Florida is always a tough contest. Republicans, on the other hand, have only one Senate seat that will require defense in a Democrat-leaning state: Nevada (and in that case, it will be a Republican incumbent contesting the race). Their other seven seats are all in Republican voting states. As such, expect Republicans to hold on to the Senate well into the 2020 general election. In the House of Representatives, the GOP will retain its comfortable majority. The Tea Party affiliated caucuses (Tea Party Caucus and the House Freedom Caucus) performed well in the election. The Tea Party Caucus members won 35 seats out of 38 they contested and the House Freedom Caucus won 34 seats out of 37 it contested. The race to watch now is for the Speaker of the House position. Paul Ryan, the Speaker of the incumbent House, is likely to contest the election again and win. Even though his support for Donald Trump was lukewarm, we expect Republicans to unify the party behind Trump and Ryan. A challenge from the right could emerge, but we doubt it will materialize given Trump's victory. The campaign for the election will begin immediately, with Republicans selecting their candidate by December (the official election will be in the first week of January, but it is a formality as Republicans hold the majority). Bottom Line: Trump's victory was largely the product of former Obama voters in the Midwest switching to the GOP candidate. This happened because of Trump's unorthodox, left-of-center, message. Trump will have a friendly Congress to work with for the next four years. How friendly? That question will determine the investment significance of the Trump presidency. Investment Relevance Of A United Government Most clients we have spoken to over the past several months believe that Donald Trump will be constrained on economic policies by a right-leaning Congress. His more ambitious fiscal spending plans - such as the $550 billion infrastructure plan and $150 billion net defense spending plan - will therefore be either "dead on arrival" in Congress, or will be significantly watered down by the legislature. Focus will instead shift to tax cuts and traditional Republican policies. We could not disagree more. GOP is not fiscally conservative: There is no empirical evidence that the GOP is actually fiscally conservative. First, the track record of the Bush and Reagan administrations do not support the adage that Republicans keep fiscal spending in check when they are in power (Chart II-2). Second, Republican voters themselves only want "small government" when the Democrats are in charge of the White House (Chart II-3). When a Republican President is in charge, Republicans forget their "small government" leanings. Chart II-2Republicans Are##br## Not Fiscally Responsible Republicans Are Not Fiscally Responsible Republicans Are Not Fiscally Responsible Chart II-3Big Government Is Only ##br##A Problem For Opposition bca.gps_mp_2016_11_09_s2_c3 bca.gps_mp_2016_11_09_s2_c3 Presidents get their way: Over the past 28 years, each new president has generally succeeded in passing their signature items. Congress can block some but probably not all of president's plans. Clinton, Bush, and Obama each began with their own party controlling the legislature, which gave an early advantage that was later reversed in their second term. Clinton lost on healthcare, but achieved bipartisan welfare reform. For Obama, legislative obstructionism halted various initiatives, but his core objectives were either already met (healthcare), not reliant on Congress (foreign policy), or achieved through compromise after his reelection (expiration of Bush tax cuts for upper income levels). Median voter has moved to the left: Donald Trump won both the GOP primary and the general election by preaching an unorthodox, left-of-center sermon. He understood correctly that the American voter preferences on economic policies have moved away from Republican laissez-faire orthodoxies.28 Yes, he is also calling for significant lowering of both income and corporate tax rates. However, tax cuts were never a focal point of his campaign, and he only introduced the policy later in the race when he was trying to get traditional Republicans on board with his campaign. Newsflash: traditional Republicans did not get Trump over the hump, Obama voters in the Midwest did! Investors should make no mistake, the key pillars of Trump's campaign are de-globalization, higher fiscal spending, and protecting entitlements at current levels. And he will pursue all three with GOP allies in Congress. What are the investment implications of this policy mix? USD: More government spending, marginally less global trade, and pressure on multi-national corporations (MNCs) to scale back their global operations should be positive for inflation. If growth surprises to the upside due to fiscal spending, it will allow the Fed to hike more than the current 57 bps expected by the market by the end of 2018. Given easy monetary stance of central banks around the world, and lack of significant fiscal stimulus elsewhere, economic growth surprise in the U.S. should be positive for the dollar in the long term. At the moment, the market is reacting to the Trump victory with ambivalence on the USD. In fact, the dollar suffered as Trump's probability of victory rose in late October. We believe that this is a temporary reaction. We see both Trump's fiscal and trade policies as bullish. BCA's currency strategist Mathieu Savary believes that the dollar could therefore move in a bifurcated fashion in the near term. On the one hand, the dollar could rise against EM currencies and commodity producers, but suffer - or remain flat - against DM currencies such as the EUR, CHF, and JPY.29 Bonds: More inflation and growth should also mean that the bond selloff continues. In addition, if our view on globalization is correct, then the deflationary effects of the last three decades should begin to reverse over the next several years. BCA thesis that we are at the "End Of The 35-Year Bond Bull Market" should therefore remain cogent.30 As one of our "Trump hedges," our colleague Rob Robis, Chief Strategist of the BCA Global Fixed Income Strategy, suggested a 2-year / 30-year Treasury curve steepener. This hedge is now up 18.7 bps and we suggest clients continue to hold it. Fed policy: Trump's statements about monetary policy have been inconsistent. Early on in his campaign he described himself as "a low interest rate guy", but he has more recently become critical of current Federal Reserve policy - and Fed Chair Janet Yellen in particular - claiming that while higher interest rates are justified, the Fed is keeping them low for "political reasons." What seems certain is that Janet Yellen will be replaced as Fed Chair when her term expires in February 2018. Yellen is unlikely to resign of her own volition before then and it would be legally difficult for the President to remove a sitting Fed Chair prior to the end of her term. But Trump will get the opportunity to re-shape the composition of the Fed's Board of Governors as soon as he is sworn in. There are currently two empty seats on the Board need to be filled and given that many of Trump's economic advisers have "hard money" leanings, it is very likely that both appointments will go to inflation hawks. Equities: In terms of equities, Trump will be a source of uncertainty for U.S. stocks as the market deals with the unknown of his presidency. In addition, markets tend to not like united government in the U.S. as it raises the specter of big policy moves (Table II-2). However, Trump should be positive for sectors that sold off in anticipation of a Clinton victory, such as healthcare and financials. We also suspect that he will continue the outperformance of defense stocks, although that would have been the case with Clinton as well. Table II-2Election: Industry Implications De-Globalization De-Globalization In the long term, Trump's proposal for major corporate tax cuts should be good for U.S. equities. However, we are not entirely sure that this is the case. First, the effective corporate tax rate in the U.S. is already at its multi-decade lows (Chart II-4). As such, any corporate tax reform that lowers the marginal rate will not really affect the effective rate. Why does this matter? Because major corporations already have low effective tax rates. Any lowering of the marginal rate will therefore benefit the small and medium enterprises (SMEs) and the domestic oriented S&P 500 corporations. If corporate tax reform also includes closing loopholes that benefit the major multi-national corporations (MNCs), then Trump's policy will not necessarily benefit all firms in the U.S. equally. Chart II-4How Low Can It Go? bca.gps_mp_2016_11_09_s2_c4 bca.gps_mp_2016_11_09_s2_c4 Investors have to keep in mind that Trump has not run a pro-corporate campaign. He has accused American manufacturing firms of taking jobs outside the U.S. and tech companies of skirting taxes. It is not clear to us that his corporate tax reform will therefore necessarily be a boon for the stock market. In the long term, we like to play Trump's populist message by favoring America's SMEs over MNCs. If we are ultimately correct on the USD and growth, then export-oriented S&P 500 companies should suffer in the face of a USD bull market and marginally less globalization. Meanwhile, lowering of the marginal corporate tax rate will benefit the SMEs that do not get the benefit of K-street lobbyist negotiated tax loopholes. Global Assets: The global asset to watch over the next several weeks is the USD/RMB cross. China is forced by domestic economic conditions to continue to slowly depreciate its currency. We have expected this since 2015, which is why we have shorted the RMB via 12-month non-deliverable forwards (NDF). Risk to global assets, particularly EM currencies and equities, would be that Beijing decides to depreciate the RMB before Trump is inaugurated on January 20. This could re-visit the late 2015 panic over China, particularly the narrative that it is exporting deflation. Our view is that even if China does not undertake such actions over the next two months, Sino-American tensions are set to escalate. It is much easier for Trump to fulfill his de-globalization policies with China - a geopolitical rival with which the U.S. has no free trade agreement - than with NAFTA trade partners Canada and Mexico. This will only deepen geopolitical tensions between the two major global powers, which has been our secular view since 2011. Finally, a quick note on the Mexican peso. The Mexican peso has already collapsed half of its value in the past 18 months and we believe the trade is overdone. Investors have used the currency cross as a way to articulate Trump's victory probability. It is no longer cogent. We believe that the U.S. will focus on trade relations with China under a Trump presidency, rather than NAFTA trade partners. Our Emerging Markets Strategy believes that it is time to consider going long MXN versus other EM currencies, such as ZAR and BRL. Investors should also watch carefully the Cabinet appointments that Trump makes over the next two months. Since Carter's administration, cabinet announcements have occurred in early to mid-December. Almost all of these appointments were confirmed on Inauguration Day (usually January 20 of the year after election, including in 2017) or shortly thereafter. Only one major nomination since Carter was disapproved. These appointments will tell us how willing Trump is to reach to traditional Republicans who have served on previous administrations. We suspect that he will go with picks that will execute his fiscal, trade, and tax policies. Bottom Line: After the dust settles over the next several weeks, we suspect that Trump will signal that he intends to pursue his fiscal, trade, immigration, and tax policies. These will be, in the long term, positive for the USD, negative for bonds (including Munis, which will lose their tax-break appeal if income taxes are reduced), and likely neutral for equities. Within the equity space, Trump will be positive for U.S. SMEs and negative for MNCs. This means being long S&P 600 over S&P 100. Lastly, close our long alternative energy / short coal trade for a loss of -26.8%. Constraints: Don't Bet On Them Domestically, the American president can take significant action without congressional support through executive directives. Lincoln raised an army and navy by proclamation and freed the slaves; Franklin Roosevelt interned the Japanese; Truman tried to seize steel factories to keep production up during the Korean War. Truman's case is almost the only one of a major executive order being rebuffed by the Supreme Court. The Reagan and Clinton administrations have shown that a president thwarted by a divided or adverse congress will often use executive directives to achieve policy aims and satisfy particular interest groups and sectors. Though the number of executive orders has gone down in recent administrations (Chart II-5), the economic significance has increased along with the size and penetration of the bureaucracy (Chart II-6). The economic impact of executive orders is always debatable, but the key point is that the president's word tends to carry the day.31 Chart II-5Rule By Decree De-Globalization De-Globalization Chart II-6Executive Branch Is Growing De-Globalization De-Globalization Trade is a major area where Trump would have considerable sway. He has repeatedly signaled his intention to restrict American openness to international trade. The U.S. president can revoke international treaties solely on their own authority. Congressionally approved agreements like the North American Free Trade Agreement (NAFTA) cannot be revoked by the president, but Trump could obstruct its ongoing implementation.32 He would also have considerable powers to levy tariffs, as Nixon showed with his 10% "surcharge" on most imports in 1971.33 Bottom Line: Presidential authority is formidable in the areas Trump has made the focus of his campaign: immigration and trade. Without a two-thirds majority in Congress to override him, or an activist federal court, Trump would be able to enact significant policies simply by issuing orders to his subordinates in the executive branch. Long-Term Implications: Polarization In The U.S. Does the Republican control of Congress and the White House signal that polarization in America will subside? We began this analysis by focusing on the investment implications when Republicans control the three houses of the American government. But long-term implications of polarization will not dissipate. Investors may overstate the importance of a Republican-controlled government and thus understate the relevance of continued polarization. We doubt that Donald Trump is a uniting figure who can transcend America's polarized politics, especially given his weak popular mandate (he lost the popular vote as Bush did in 2000) and the sub-50% vote share. And, our favorite chart of the year remains the same: both Donald Trump and Hillary Clinton have entered the history books as the most disliked presidential candidates ever on the day of the election (Chart II-7). Chart II-7Clinton And Trump Are Making (The Wrong Kind Of) History De-Globalization De-Globalization According to empirical work by political scientists Keith Poole and Howard Rosenthal, polarization in Congress is at its highest level since World War II (Chart II-8). Their research shows that the liberal-conservative dimension explains approximately 93% of all roll-call voting choices and that the two parties are drifting further apart on this crucial dimension.34 Chart II-8The Widening Ideological Gulf In The U.S. Congress De-Globalization De-Globalization Meanwhile, a 2014 Pew Research study has shown that Republicans and Democrats are moving further to the right and left, respectively. Chart II-9 shows the distribution of Republicans and Democrats on a 10-item scale of political values across the last three decades. In addition, "very unfavorable" views of the opposing party have skyrocketed since 2004 (Chart II-10), with 45% of Republicans and 41% of Democrats now seeing the other party as a "threat to the nation's well-being"! Chart II-9U.S. Political Polarization: Growing Apart De-Globalization De-Globalization Chart II-10Live And Let Die De-Globalization De-Globalization Much ink has been spilled trying to explain the mounting polarization in America.35 Our view remains that politics in a democracy operates on its own supply-demand dynamic. If there was no demand for polarized politics, especially at the congressional level, American politicians would not be so eager to supply it. We believe that five main factors - in our subjective order of importance - explain polarization in the U.S. today: Income Inequality and Immobility The increase in political polarization parallels rising income inequality in the U.S. (Chart II-11). The U.S. is a clear and distant outlier on both factors compared to its OECD peers (Chart II-12). However, Americans are not being divided neatly along income levels. This is because Republicans and Democrats disagree on how to fix income inequality. For Donald Trump voters, the solutions are to put up barriers to free trade and immigration while reducing income taxes for all income levels. For Hillary Clinton voters, it means more taxes on the wealthy and large corporations, while putting up some trade barriers and expanding entitlements. This means that the correlation between polarization and income inequality is misleading as there is no causality. Rather, rising income inequality, especially when combined with a low-growth environment, shifts the political narrative from the "politics of plenty" towards "politics of scarcity." It hardens interest and identity groups and makes them less generous towards the "other." Chart II-11Inequality Breeds Polarization Inequality Breeds Polarization Inequality Breeds Polarization Chart II-12Opportunity And Income: Americans Are Outliers De-Globalization De-Globalization Generational Warfare The political age gap is increasing (Chart II-13). This remains the case following the 2016 election, with 55% Millennials (18-29 year olds) having voted for Hillary Clinton. The problem for older voters, who tend to identify far more with the Republican Party, is that the Millennials are already the largest voting bloc in America (Chart II-14). And as Millennial voters start increasing their turnout, and as Baby Boomers naturally decline, the urgency to vote for Republican policymakers' increases. Chart II-13The Age Gap In American Politics The Age Gap In American Politics The Age Gap In American Politics Chart II-14Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Millennials Are The Biggest Bloc Geographical Segregation Noted political scientist Robert Putnam first cautioned that increasing geographic segregation into clusters of like-minded communities was leading to rising polarization.36 This explains, in large part, how liberal elites have completely missed the rise of Donald Trump. Left-leaning Americans tend to live in a left-leaning community. They share their morning cup-of-Joe with Liberals and rarely mix with the plebs supporting Trump. And of course vice-versa. University of Toronto professors Richard Florida and Charlotta Mellander have more recently shown in their "Segregated City" research that "America's cities and metropolitan areas have cleaved into clusters of wealth, college education, and highly-paid knowledge-based occupations."37 Their research shows that American neighborhoods are increasingly made up of people of the same income level, across all metropolitan areas. Florida and Mellander also show that educational and occupational segregation follows economic segregation. Meanwhile, the same research shows that Canada's most segregated metropolitan area, Montreal, would be the 227th most segregated city if it were in the U.S.! This form of geographic social distance fosters increasing polarization by allowing voters to remain aloof of their fellow Americans, their plight, needs, and concerns. The extreme urban-rural divide of the 2016 election confirms this thesis. Immigration Much as with income inequality, there is a close correlation between political polarization and immigration. The U.S. is on its way to becoming a minority-majority country, with the percent of the white population expected to dip below 50% in 2045 (Chart II-15). Hispanic and Asian populations are expected to continue rising for the rest of the century. For many Americans facing the pernicious effects of low-growth, high debt, and elevated income inequality, the rising impact of immigration is anathema. Not only is the country changing its ethnic and cultural make-up, but the incoming immigrants tend to be less educated and thus lower-income than the median American. They therefore favor - or will favor, when they can vote - redistributive policies. Many Americans feel - fairly or unfairly - that the costs of these policies will have to be shouldered by white middle-class taxpayers, who are not wealthy enough to be indifferent to tax increases, and may be unskillful enough to face competition from immigrants. There is also a security component to the rising concern about immigration. Although Muslims are only 1% of the U.S. population, many voters perceive radical Islam to be a vital security threat to the nation. As such, immigration and radical Islamic terrorism are seen as close bedfellows. Media Polarization The 2016 election has been particularly devastating for mainstream media. According to the latest Gallup poll, only 32% of Americans trust the mass media "to report the news fully, accurately and fairly." This is the lowest level in Gallup polling history. The decline is particularly concentrated among Independent and Republican respondents (Chart II-16). With mainstream media falling out of favor for many Americans, voters are turning towards social media and the Internet. Facebook is now as important for political news coverage as local TV for Americans who get their news from the Internet (Chart II-17). Chart II-15Racial Composition Is Changing De-Globalization De-Globalization Chart II-16A War Of Words bca.gps_mp_2016_11_09_s2_c16 bca.gps_mp_2016_11_09_s2_c16 Chart II-17New Sources Of News Not Always Credible De-Globalization De-Globalization The problem with getting your news coverage from Facebook is that it often means getting news coverage from "fake" sources. A recent experiment by BuzzFeed showed that three big right-wing Facebook pages published false or misleading information 38% of the time while three large left-wing pages did so in nearly 20% of posts.38 The Internet allows voters to self-select what ideological lens colors their daily intake of information and it transcends geography. Two American families, living next to each other in the same neighborhood, can literally perceive reality from completely different perspectives by customizing their sources of information. Chart II-18Gerrymandering Reduces Competitive Seats bca.gps_mp_2016_11_09_s2_c18 bca.gps_mp_2016_11_09_s2_c18 In addition to these five factors, one should also reaffirm the role of redistricting, or "gerrymandering." Over the last two decades, both the Democrats and Republicans (but mainly the latter) have redrawn geographical boundaries to create "ideologically pure" electoral districts. Of the 435 seats in the House of Representatives, only about 56 are truly competitive (Chart II-18). This improves job security for incumbent politicians and legislative-seat security for the party; but it also discourages legislators from reaching across the ideological aisle in order to ensure re-election. Instead, the main electoral challenge now comes from the member's own party during the primary election. For Republicans, this means that the challenge is most often coming from a candidate that is further to the right. Incumbent GOP politicians in Congress therefore have an incentive to maintain highly conservative records lest a challenge from the far-right emerges in a primary election. Given that the frequency of elections is high in the House of Representatives (every two years), legislators cannot take even a short break from partisanship. Redistricting deepens polarization, therefore, by changing the political calculus for legislators facing ideologically pure electorates in their home districts. Bottom Line: Polarization in the U.S. is a product of structural factors that are here to stay. Trump's narrow victory will in no way change that. But How Much Worse? Chart II-19Party Is The Chief Source Of Identity De-Globalization De-Globalization Political polarization is not new. Older readers will remember 1968, when social unrest over the Vietnam War was at its height. Richard Nixon barely got over the finish line that year, beating Vice-President Hubert Humphrey by around 500,000 votes.39 Another contested election in a contested era. Our concern is that the Republican and Democrat "labels" - or perhaps conservative and liberal labels - appear to be ossifying. For example, Pew Research showed in 2012 that the difference between Americans on 48 values is the greatest between Republicans and Democrats. This has not always been the case, as Chart II-19 shows. We suspect that the data would be even starker today, especially after the divisive 2016 campaign that has bordered on hysterical. This means that "Republican" and "Democrat" labels have become real and almost "sectarian" in nature. In fact, one's values are now determined more by one's party identification than race, education, income, religiosity, or gender! This is incredible, given America's history of racial and religious divisions. Why is this happening? We suspect that the shift in urgency and tone is motivated at least in part by the changing demographics of America. Two demographic groups that identify the most with the Republican Party - Baby Boomers and rural or suburban white voters - are in a structural decline (the first in absolute terms and the second in relative terms). Both see the writing on the political wall. Given America's democratic system of government, their declining numbers (or, in the case of suburban whites, declining majorities) will mean significant future policy decisions that go against their preferences. America is set to become more left-leaning, favor more redistribution, and become less culturally homogenous. Not only are Millennials more socially liberal and economically left-leaning, but they are also "browner" than the rest of the U.S. As we pointed out early this year, 2016 was an election that the GOP could reasonably attempt to win by appealing exclusively to white and older voters. The "White Hype" strategy was mathematically cogent ... at least in 2016.40 It will get a lot more difficult to pursue this strategy in 2020 and beyond. Not impossible, but difficult. We suspect that conservative voters know this. As such, there was an urgency this year to lock-in structural changes to key policies before it is too late. Donald Trump may have been a flawed messenger for many voters, but it did not matter. The clock is ticking for a large segment of America and therefore Trump was an acceptable vehicle of their fears and anger. Bottom Line: Polarization in the U.S. is likely to increase. Two key Republican/conservative constituencies - Baby Boomers and rural or suburban white voters - are backed into the corner by demographic trends. But it also means that a left counter-revolution is just around the corner. And we doubt that the Democratic Party will chose as centrist of a candidate the next time around. Final Thoughts: What Have We Learned 1. Economics trump PC: Civil rights remain a major category of the American public's policy concerns. However, the Democratic Party's prioritization of social issues on the margins of the civil rights debate has not galvanized voters in the face of persistent negative attitudes about the economy. More specifically, the surge in cheap credit since 2000 that covered up the steady decline of wages as a share of GDP has ended, leaving households exposed to deleveraging and reduced purchasing power (Chart II-20). American households have lost patience with the slow, grinding pace of economic recovery, they reject the debt consequences of low inflation with deflationary tail risks, and they resent disappointed expectations in terms of job security and quality. Concerns about certain social preferences - as opposed to basic rights - pale in comparison to these economic grievances. Chart II-20Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income Credit No Longer Hides Stagnant Income 2. Polls are OK, but beware the quant models that use them: On two grave political decisions this year, in two advanced markets with the "best" quality of polling, political modeling turned out to be grossly erroneous. To be fair, the polls themselves prior to both Brexit and the U.S. election were within a margin of error. However, quantitative models relying on these polls were overconfident, leading investors to ignore the risks of a non-consensus outcome. As we warned in mid-October - with Clinton ahead with a robust lead - the problem with quantitative political models is that they rely on polling data for their input.41 To iron-out the noise of an occasional bad poll, political analysts aggregate the polls to create a "poll-of-polls." But combining polls is mathematically the same as combining bad mortgages into securities. The philosophy behind the methodology is that each individual object (mortgage or poll) may be flawed, but if you get enough of them together, the problems will all average out and you have a very low risk of something bad happening. Well, something bad did happen. The quantitative models were massively wrong! We tried to avoid this problem by heavily modifying our polls-based-model with structural factors. Many of these structural variables - economic context, political momentum, Obama's approval rating - actually did not favor Clinton. Our model therefore consistently gave Donald Trump between 35-45% probability of winning the election, on average three and four times higher than other popular quant models. This caused us to warn clients that our view on the election was extremely cautious and recommend hedges. In fact, Donald Trump had 41% chance of winning the race on election night, according to the last iteration of our model, a very high probability.42 3. Professor Lichtman was right: Political science professor Allan Lichtman has once again accurately called the election - for the ninth time. The result on Nov. 8 strongly supports his life's work that presidential elections in the United States are popular referendums on the incumbent party of the last four years. Structural factors undid the Democrats (Table II-3), and none of the campaign rhetoric, cross-country barnstorming, or "horse race" polling mattered a whit. The Republicans had momentum from previous midterm elections, Clinton had suffered a strong challenge in her primary, the Obama administration's achievements over the past four years were negligible (the Affordable Care Act passed in his first term). These factors, along with the political cycle itself, favored the Republicans. Trump's lack of charisma did not negate the structural support for a change of ruling party. Investors should take note: no amount of mathematical horsepower, big data, or Silicon Valley acumen was able to beat the qualitative, informed, contemplative work of a single historian. Table II-3Lichtman's Thirteen Keys To The White House* De-Globalization De-Globalization 4. Non-linearity of politics: Lichtman's method calls attention to the danger of linear assumptions and quantitative modeling in attempting the art of political prediction. Big data and quantitative econometric and polling models have notched up key failures this year. They cannot make subjective judgments regarding whether a president has had a major foreign policy success or failure or a major policy innovation - on all three of those counts, the Democrats failed from 2012-16. There really is no way to quantify political risk because human and social organizations often experience paradigm shifts that are characterized by non-linearity. Newtonian Laws will always work on planet earth and as such we are not concerned about what will happen to us if we board an airplane. Laws of physics will not simply stop working while we are mid-air. However, social interactions and political narratives do experience paradigm shifts. We have identified several since 2011: geopolitical multipolarity, de-globalization, end of laissez-faire consensus, end of Chimerica, and global loss of confidence in elites and institutions.43 5. No country is immune to decaying institutions: The United States has, with few exceptions, the oldest written constitution among major states, and it ensures checks and balances. But recent decades have shown that the executive branch has expanded its power at the expense of the legislative and judicial branches. Moreover, executives have responded to major crisis - like the September 11 attacks and the 2008 financial crisis - with policy responses that were formulated haphazardly, ideologically divisive, and difficult to implement: the Iraq War and the Affordable Care Act. The result is that the jarring events that have blindsided America over the past sixteen years have resulted in wasted political capital and deeper polarization. The failure of institutions has opened the way for political parties to pursue short-term gains at the expense of their "partners" across the aisle, and to bend and manipulate procedural rules to achieve ends that cannot be achieved through consensus and compromise. 6. U.S. is shifting leftward when it comes to markets: Inequality and social immobility have, with Trump's election, entered the conservative agenda, after having long sat on the liberals' list of concerns. The shift in white blue-collar Midwestern voters toward Trump reflects the fact that voters are non-partisan in demanding what they want: they want to retain their existing rights, privileges, and entitlements, and to expand their wages and social protections. Marko Papic, Senior Vice President Geopolitical Strategy marko@bcaresearch.com Matt Gertken, Associate Editor mattg@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 2 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 5 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. 6 Please see BCA Global Alpha Sector Strategy Special Report, "Brothers In Arms," dated October 28, 2016, available at gss.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, available at gps.bcaresearch.com. 8 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Special Report, "The Great Migration - Europe, Refuges, And Investment Implications," dated September 23, 2015, available at gps.bcaresearch.com. 10 The BBC is exemplary of the mainstream Western press on this point. Please see Stephen McDonell, "The Ever-Growing Power Of China's Xi Jinping," BBC News, China Blog, dated October 29, 2016, available at www.bbc.com. 11 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Special Report, "China: Two Factions, One Party - Part II," dated September 12, 2012, available at gps.bcaresearch.com. 13 Please see the "Eighteenth Communist Party Of China Central Committee Sixth Plenary Session Communique," dated October 27, 2016, available at cpc.people.com.cn. 14 Jiang Zemin, China's ruler from roughly 1993 to 2002, was also referred to as the "core" leader, but he received this moniker from Deng Xiaoping. Xi is following in Deng's footsteps by declaring himself to be the core and winning support from the party. As for his centralizing efforts, prior to being named the "core leader," Xi had already waged a sweeping crackdown on political opponents and dissidents. He had used his position as head of the party, the state bureaucracy, and the armed forces to reshuffle personnel in these bodies extensively. He had already created new organizational bodies, including the National Security Commission, and initiated plans to restructure the military to emphasize joint-operations under regional battle commands. A weak leader would not have advanced so quickly. 15 Deng named Mao the "core" of the first generation of leaders, but it was evident that he sought a different leadership model. 16 Specifically, Xi could prevent the preferment of successors for 2022, he could reduce the size of the Politburo Standing Committee further to five members, or he could modify or make exceptions to the informal rule that top officials must not be promoted if they are 68 or older. Please see Minxin Pei, "A Looming Power Struggle For China?" dated October 28, 2016, available at www.cfr.org. 17 Please see "Communique of the Third Plenary Session of the 18th Central Committee of the Communist Party of China," dated January 15, 2014 [adopted November 12, 2013], available at www.china.org.cn. 18 Please see "China: The Socialist Put And Rising Government Leverage," in BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 19 Please see BCA Geopolitical Strategy Special Report, "Brexit Update: Does Brexit Really Mean Brexit?" dated July 15, 2016, available at gps.bcaresearch.com. For the High Court ruling, please see the U.K. Courts and Tribunals Judiciary, "R (Miller) -V- Secretary of State for Exiting the European Union," dated November 3, 2016, available at www.judiciary.gov.uk. 20 At that time a Tory majority in the House of Commons had enraged the populace by imprisoning a group of petitioners from Kent. Both the Kentish Petition and the Legion Memorial demanded that parliament heed the will of the populace. 21 Presumably, the European Council could vote unanimously under Article 50 to extend the negotiation period for a very long time. 22 Please see BCA Geopolitical Strategy Monthly Report, "Nuthin' But A G Thang," dated August 12, 2015, available at gps.bcaresearch.com. 23 Except that it is better armed. 24 Please see BCA Geopolitical Strategy Client Note, "U.S. Election: Trump's Arrested Development," dated November 8, 2016, available at gps.bcaresearch.com. 25 However, Wisconsin polling was rather poor as most pollsters assumed that it was a shoe-in for Democrats. One problem with polling in Midwest states is that they were, other than Pennsylvania and Ohio, assumed to be safe Democratic states. Note for example the extremely tight result in Minnesota and the absolute dearth of polling out of that state throughout the last several months. 26 Please see BCA Global Investment Strategy Special Report, "Trumponomics: What Investors Need To Know," dated September 4, 2015, available at gis.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Special Report, "U.S. General Elections And Scenarios: Implications," dated July 11, 2012, available at gps.bcaresearch.com. 28 Please see BCA Geopolitical Strategy Special Report, "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 29 Please see BCA Foreign Exchange Strategy Weekly Report, "When You Come To A Fork In The Road, Take It," dated November 4, 2016, available at fes.bcaresearch.com. 30 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gps.bcaresearch.com. 31 Only a two-thirds majority of Congress, or a ruling by a federal court, can undo an executive action, and that is exceedingly rare. The real check on executive orders is the rotation of office: a president can undo with the stroke of a pen whatever his predecessor enacted. Congress has the power of the purse, but it is sporadic in its oversight and has challenged less than 5% of executive orders, even though those orders often re-direct the way the executive branch uses funds Congress has allocated. More often, Congress votes to codify executive orders rather than nullify them. 32 Trump is not alone in calling for renegotiating or even abandoning NAFTA. Clinton called for renegotiation in 2008, and Senator Bernie Sanders has done so in 2016. 33 In Proclamation 4074, dated August 15, 1971, Nixon suspended all previous presidential proclamations implementing trade agreements insofar as was required to impose a new 10% surcharge on all dutiable goods entering the United States. He justified it in domestic law by invoking the president's authority and previous congressional acts authorizing the president to act on behalf of Congress with regard to trade agreement negotiation and implementation (including tariff levels). He justified the proclamation in international law by referring to international allowances during balance-of-payments emergencies. 34 The "primary dimension" of Chart II-8 is represented by the x-axis and is the liberal-conservative spectrum on the basic role of the government in the economy. The "second dimension" (y-axis) depends on the era and is picking up regional differences on a number of social issues such as the civil rights movement (which famously split Democrats between northern Liberals and southern Dixiecrats). 35 We have penned two such efforts ourselves. Please see BCA Geopolitical Strategy Special Report, "Polarization In America: Transient Or Structural Risk?," dated October 9, 2013, and "A House Divided Cannot Stand: America's Polarization," dated July 11, 2012," available at gps.bcaresearch.com. 36 Putnam, Robert. 2000. Bowling Alone. New York: Simon and Schuster. 37 Please see Martin Prosperity Institute, "Segregated City," dated February 23, 2015, available at martinprosperity.org. 38 Please see BuzzFeedNews, "Hyperpartisan Facebook Pages Are Publishing False And Misleading Information At An Alarming Rate," dated October 20, 2016, available at buzzfeed.com. 39 Nonetheless, due to the third-party candidate George Wallace carrying the then traditionally-Democratic South, Nixon managed to win the Electoral College in a landslide. 40 Please see BCA Global Investment Strategy and Geopolitical Strategy Special Report, "U.S. Election: The Great White Hype," dated March 9, 2016, available at gps.bcaresearch.com. 41 Please see BCA Geopolitical Strategy Special Report, "You've Been Trumped!," dated October 21, 2016, available at gps.bcaresearch.com. 42 For comparison, Steph Curry, the greatest three-point shooter in basketball history, and a two-time NBA MVP, has a career three-point shooting average of 44%. With that average, he is encouraged to take every three-pointer he can by his team. In other words, despite being less than 50%, this is a very high percentage. 43 Please see BCA Geopolitical Strategy, "Strategy Outlook 2015 - Paradigm Shifts," dated January 21, 2015, and "Strategy Outlook 2016 - Multipolarity & Markets," dated December 9, 2015, available at gps.bcaresearch.com. Section III: Geopolitical Calendar

Highlights Chile's economy is headed for recession. Facing strong external and domestic headwinds, any policy stimulus will be too late to prevent the impending contraction in economic activity. Investors should receive 3-year interest swaps and stay short CLP / long USD. South Africa's cyclical and structural outlook remains bleak. Banks have been selling foreign assets and repatriating capital which has helped the rand to appreciate. However, as this capital repatriation tapers, the rand will enter a renewed bear market. Stay short the rand versus the U.S. dollar and long MXN / short ZAR. Feature Chile: Stimulus Will Arrive Too Late To Prevent Recession Chart I-1Chile: From Stagflation To Recession? Chile: From Stagflation To Recession? Chile: From Stagflation To Recession? The stagflationary environment in Chile over the past two years - a combination of sluggish growth and high inflation - will give way to outright recession (Chart I-1). As economic activity downshifts further, we are doubtful that policymakers will be able to push through stimulus measures in time, and of sufficient size, to stave off recession. On the fiscal front, the government is unlikely to preemptively engage in a significant spending push. The deceleration in economic activity will soon translate into lower fiscal revenue at a time when the fiscal deficit is already quite wide, at 2.8% of GDP. Furthermore, a renewed fall in copper prices (more on this below) means mining revenue will also be weaker than currently expected, inflicting substantial damage on the government's budget. Meanwhile, monetary policy is unlikely to become stimulative in the near term. Having concluded a two-year battle to tame sticky core inflation, the central bank is unlikely cut interest rates too fast. Besides, as the current term of Central Bank President Rodrigo Vergara ends in December, chances of a new rate cut cycle before he is replaced are low. On the whole, the lack of imminent policy stimulus means economic growth is set to fall much further. Investors can profit by receiving 3-year swap rates (Chart I-2). Although the central bank will be late to cut rates, long-term interest rates will fall because Chilean growth is facing strong headwinds on several fronts: Copper prices have failed to rally amid the reflation trade of the past nine months, and are set to drop to new lows as Chinese property construction and demand for industrial metals contracts anew (Chart I-3). As a result, copper exports will continue to act as a serious drag on Chilean growth (Chart I-4). Chart I-2Receive 3-Year Interest ##br##Rate Swaps In Chile Receive 3-Year Interest Rate Swaps In Chile Receive 3-Year Interest Rate Swaps In Chile Chart I-3China's Industrial Metals ##br##Demand To Contract China's Industrial Metals Demand To Contract China's Industrial Metals Demand To Contract Chart I-4Exports Will Remain ##br##A Drag On Growth Exports Will Remain A Drag On Growth Exports Will Remain A Drag On Growth Capital expenditures will contract, partially due to very downbeat business confidence owing to the uncertain political environment created by the government's reforms agenda since 2014 (Chart I-5, top panel). As discussed in detail in our December 2014 Special Report on Chile,1 from a big-picture perspective, these reforms have shifted the structure of the economy toward higher government expenditures at the expense of the private sector. This has severely eroded business confidence. In addition, the downturn in the housing market will gain momentum, further depressing activity (Chart I-5, bottom panel). Meanwhile, employment growth has been weak and income growth has been decelerating steadily - and we foresee further downside ahead (Chart I-6). Importantly, the economy's credit impulse is now turning negative (Chart I-7). Higher delinquencies in turn will force banks to curtail lending going forward. Chart I-5Chile: Capex To Remain Weak Chile: Capex To Remain Weak Chile: Capex To Remain Weak Chart I-6Chile: Labor Market Will Weaken Further Chile: Labor Market Will Weaken Further Chile: Labor Market Will Weaken Further Chart I-7Negative Credit Impulse##br## Will Weigh On Growth Negative Credit Impulse Will Weigh On Growth Negative Credit Impulse Will Weigh On Growth Finally, narrow (M1) money supply growth, a very good leading indicator for economic activity, is now decelerating sharply (Chart I-8). Consistently, our marginal propensity to consume proxy points to weak spending and lower consumer price inflation (Chart I-9). Chart I-8Chile: Narrow Money Growth, ##br##Economic Activity And Inflation Chile: Narrow Money Growth, Economic Activity And Inflation Chile: Narrow Money Growth, Economic Activity And Inflation Chart I-9Consumption Is Set ##br##To Decelerate Further Consumption Is Set To Decelerate Further Consumption Is Set To Decelerate Further The economy has developed considerable downward momentum. Any policy stimulus is likely to come too late to prevent the economy from falling into recession. Therefore, local interest rates in Chile are headed to new lows. An economic recession and lower copper prices are clearly bearish for the Chilean peso, and we maintain that its 8.5% rally this year versus the U.S. dollar will be followed by new lows (Chart I-10). Turning to equities, lower interest rates will help only marginally as equity valuations are not cheap (Chart I-11). Moreover, as Chilean banks account for 20% of the MSCI market cap and, while they are better run and more conservative than many others in the EM, they are not immune to a decelerating credit and business cycle. Besides, this bourse's Latin American consumer plays will also likely disappoint. As such, dedicated EM investors should stay neutral on Chilean stocks relative to the EM equity benchmark (Chart I-12). Chart I-10Chilean Peso Valuation Chilean Peso Valuation Chilean Peso Valuation Chart I-11Chilean Equities Are At Fair Value Chilean Equities Are At Fair Value Chilean Equities Are At Fair Value Chart I-12Chilean Equities: Stay ##br##Neutral Relative To EM Benchmark Chilean Equities: Stay Neutral Relative To EM Benchmark Chilean Equities: Stay Neutral Relative To EM Benchmark Lastly, as highlighted in our recent in-depth Special Report on EM corporate credit,2 credit investors should stay long Chilean and Russian corporate debt versus China. Chilean corporate credit will likely outperform Chinese corporate credit, as the latter is more frothy - overbought and expensive. Bottom Line: The Chilean economy is heading into recession, and policymakers will be late with stimulus to prevent it. Fixed-income investors should receive 3-year interest rate swaps. Dedicated EM equity investors should maintain a neutral stance on the Chilean bourse versus the EM equity benchmark. Stay short CLP / long USD. Santiago E. Gomez Associate Vice President santiago@bcaresearch.com South Africa: Flows Versus Fundamentals Chart II-1Improving Trade Has Helped The ZAR Improving Trade Has Helped The ZAR Improving Trade Has Helped The ZAR The South African rand has rallied since the start of the year on the back of an improving trade balance (Chart II-1) and strong capital inflows. However, it is facing a key technical resistance level, as are many other EM assets. We expect these resistance levels to hold for EM risk assets in general and the South African rand in particular. The underlying reasons behind our outlook center around our expectations of a stronger U.S. dollar, rising U.S. and G7 bond yields and a relapse in commodities prices. This is in addition to a lack of cyclical recovery and poor structural fundamentals in South Africa. A well-known explanation as to how South Africa has been able to finance its wide current account deficit is that there have been strong foreign portfolio inflows stemming from the global search for yield. What is less known is that South African banks have in the past year been selling foreign assets and repatriating capital back into South Africa (Chart II-2). Over the past 12 months, this repatriation of capital has amounted to US$ 6.5 billion, which effectively allowed the country to fund 50% of its current account deficit. While there is no doubt that this repatriation of capital has aided the rally in the rand and domestic bonds, it remains to be seen whether these flows will continue. Our suspicion is that with South African banks' holdings of foreign bonds dropping from US$ 18 billion in December 2015 to US$ 12 billion at the end of June 2016, and G7 bond yields rising, the speed of capital repatriation will likely slow. In the meantime, fundamentals in South Africa remain weak: The household sector, which accounts for 60% of GDP, has been sluggish. Private consumption growth has been anemic and credit growth to households has been falling rapidly (Chart II-3). Chart II-2South Africa: Banks Have Been ##br##Repatriating Capital Enormously South Africa: Banks Have Been Repatriating Capital Enormously South Africa: Banks Have Been Repatriating Capital Enormously Chart II-3South African ##br##Consumption Is Anemic South African Consumption Is Anemic South African Consumption Is Anemic The corporate sector is not painting a reassuring picture either. South African firms are not investing; real gross fixed capital formation is contracting (Chart II-4, top panel) and business confidence is at an all-time low (Chart II-4, bottom panel). The ongoing dynamic of persistently high wage growth - despite negative productivity growth - only reinforces the gloomy outlook as it creates downward pressure on corporate profit margins, or upward pressure on inflation (Chart II-5). Chart II-4Contracting Capex And ##br##Record-Low Business Confidence Contracting Capex And Record-Low Business Confidence Contracting Capex And Record-Low Business Confidence Chart II-5Toxic Structural Dynamics: Contracting ##br##Productivity And High Wage Growth Toxic Structural Dynamics: Contracting Productivity And High Wage Growth Toxic Structural Dynamics: Contracting Productivity And High Wage Growth Along with renewed weakness in the rand, higher wage growth will raise interest rate expectations. The fixed-income market is currently discounting no policy rate hikes during the next 12 months making it vulnerable to potential depreciation in the rand. In addition to a poor economic backdrop, uncertainty regarding economic policy is considerable. Chart II-6South Africa's Central ##br##Bank's Liquidity Injections South Africa's Central Bank's Liquidity Injections South Africa's Central Bank's Liquidity Injections First, fiscal policy will not be market friendly. The poor performance of the ANC in the last municipal elections shows the ANC is clearly losing support from the population. This will lead President Zuma and ANC to adopt even more populist policies. This is bearish for both the fiscal accounts and the structural growth outlook. As such, this will cap the upside in the rand and put a floor under domestic bond yields. Second, the central bank will not defend the exchange rate if the latter comes under selling pressure anew. In fact, monetary policy remains somewhat unorthodox. Specifically, the Reserve Bank of South Africa continues to inject liquidity into the system to cap interbank rates (Chart II-6). This will facilitate ZAR depreciation. Investment Conclusions Stay short the rand versus the U.S. dollar. Three weeks ago we also initiated a long MXN / short ZAR trade, and this trade remains intact as the MXN is oversold and the ZAR is overbought. Dedicated EM equity investors should maintain a neutral allocation to South African stocks. On the back of a fragile and deteriorating consumer sector, we recommend staying short general retailer stocks. Their share prices seem to be breaking down despite the rebound in the rand and a drop in domestic bond yields (Chart II-7). Policy uncertainty and pressure for populist policies is still an overarching issue for South Africa, especially compared to Russia. As such we suggest fixed income investors continue to underweight South African sovereign credit within the EM sovereign credit universe (Chart II-8), and maintain the relative trade of being long South African CDS / short Russian CDS. Chart II-7Stay Short South ##br##African General Retailers Stay Short South African General Retailers Stay Short South African General Retailers Chart II-8Stay Underweight South ##br##African Credit And Short Rand Stay Underweight South African Credit And Short Rand Stay Underweight South African Credit And Short Rand Stephan Gabillard, Research Analyst stephang@bcaresearch.com 1 Please refer to the Emerging Markets Strategy & Geopolitical Strategy Special Report titled, "Chile: A New Economic Model?," dated December 3, 2014 available at ems.bcaresearch.com 2 Please refer to the Emerging Markets Strategy Special Report titled, "EM Corporate Health Is Flashing Red," dated September 14, 2016. Equity Recommendations Fixed-Income, Credit And Currency Recommendations