Economy

Highlights The "Pocketbook Voter Theory" says that voters will reward politicians who deliver economic success; Nevertheless, congressional Republicans face significant headwinds in the mid-term elections in November; The popularity of the GOP tax cuts, especially among independent voters, bears constant monitoring this year; Beyond 2018, voters will face persistent inequality and demand policies that provide sustainable income gains; Trade protectionism and redistribution will be on the bill in the 2020 elections. Feature There is little debate in the investment community that politics matters more today than it did in the past. But most investors are still unsure about how to assess political risk - both to the upside and downside. The Geopolitical Strategy team has been providing a framework for analysis and applying political science concepts since its inception in May 2012. This report introduces an important idea that has been guiding our analysis over the years: the Pocketbook Voter (PBV) theory. The PBV theory rests on the important observation that in politics, voters are price makers and policymakers are price takers. This makes understanding voter preferences fundamental for forecasting policy outcomes. This is particularly important today because the combination of declining potential growth rates and elevated debt levels is a recipe for continued heightened policy uncertainty (Chart 1). Over the coming years, voters will continue to demand legislation that attempts to overcome the absence of sustainable and satisfactory gains in household income. More consequentially, the slow growth of the income pie may push voters toward redistributionist policies. Chart 1Income Down + Debt Up = Higher Policy Uncertainty Investors should prepare for considerable change to both domestic and international economic arrangements. As this publication has been arguing for the past several years, many of the investor-friendly policies that underpinned the glorious bull market in risk assets since the early 1980s will be reversed.1 Voters will ultimately determine how far the pendulum will swing. Pocketbook Voter Theory The PBV theory states that voters reward political leaders who deliver positive economic outcomes.2 A strong economy increases the likelihood of re-election, whereas a weak economy decreases it. The link between economic conditions and voting patterns tends to be strongest in the United States.3 Most of the academic literature on the PBV theory has emphasized retrospective assessments of the economy. The pre-election performance of important economic variables, such as the unemployment rate, GDP growth, and consumer confidence, is shown to predict electoral outcomes. According to these metrics, Republicans (GOP) in Congress should be confident heading into this November's mid-term elections. The unemployment rate is near 50-year lows, consumer confidence is at a 20-year high, and GDP growth has gained some momentum in recent quarters - with BCA's economists expecting further strength in 2018 (Chart 2). The recently passed Tax Cuts and Jobs Act (TCJA) will also put more money in voters' pocketbooks courtesy of Republican policymakers. However, both history and polling data are weighing on the GOP's chances in November. Currently, the U.S. government is unified, with Republicans controlling both the executive and legislative branches. Voters have rejected the incumbent party the last three times a mid-term election was held under unified government. Democrats were badly beaten in 1994, when Republicans won a stunning 54 seats in the House of Representatives; in 2006, voters rewarded Democrats with control of the House and de facto control of the Senate; and in 2010, Republicans thumped the Democrats in the House by the largest margin of victory in a mid-term election since 1938. The approval rating of Congressional Republicans and the president also present a problem for the GOP in November. As of December 11, 78% of voters disapproved of the way Congress was handling its job. That is slightly higher than the 77% congressional disapproval rating before the 2010 election loss for Democrats, and visibly higher than the 67% and 70% disapproval ratings before the 2006 and 1994 mid-term elections, respectively. Democrats also continue to hold on to a growing lead in the "generic ballot," which has some predictive power (Chart 3). Chart 2Cyclical Conditions Are Solid Chart 3Democrats Ahead In The Polls As we have highlighted in previous reports, President Trump's low approval rating of 39% also reduces the likelihood that Republicans will keep the 22 seats needed to remain the majority party in Congress (Chart 4). Chart 4Trump's Low Approval Ratings Is Bad For GOP In 2018 On balance then, the deck is stacked against the Republicans in the coming election. The economy is firing on all cylinders, but that was also the case in November 2016 when Americans voted for dramatic political change. In fact, the unemployment rate had fallen from 6.6% in 2014 to 4.6% in November 2016, whereas it has only marginally improved more recently. Meanwhile, only 25% of independent voters approve of the GOP's tax legislation.4 Heightened partisanship will make voter perceptions among independents a particularly important factor in determining the outcome of the 2018 election. Investors should monitor Trump's approval rating among these voters and their evolving view of the Republican tax legislation, which will certainly underpin the GOP's campaign message on why they should be re-elected (Chart 5). But it remains to be seen how the equity bull market will translate into Republican political fortunes, given that the median American voter is not heavily invested in stocks (Chart 6). Chart 5Only Republicans Like Trump Chart 6Most Voters Don't Directly Own Stocks Partisanship And The PBV Theory Voter perceptions of the economy have always been influenced by party identification. The role of partisanship in politics has become especially important in the U.S. as political polarization has reached its highest recorded level in 150 years (Chart 7). Reflecting the growing divide between the policy preferences of each party, the core political values held by American voters are not best described by demographic factors such as race, income, or religion, but by party identification - and by a wide margin (Chart 8). A recent Pew Research Center survey found that 86% of Americans believe that conflict between Democrats and Republicans is either strong or very strong.5 The same survey found that the likelihood of conflict based on race or income was only 65% and 60%, respectively. And since 2012, the percentage of Americans who see very strong conflict between the Democrats and Republicans has risen substantially from 47% to 64%. Chart 7Highest Level Of Polarization In 150 Years Chart 8Party Affiliation Means A Lot Today The link between partisanship and voter perceptions of the economy can be strong, and became very clear after the recent election. Before President Trump was elected, only 14% of Republicans felt that national economic conditions were excellent or good. After his victory, that same number skyrocketed to 57%.6 This implies that retrospective assessments of economic conditions will continue to be susceptible to partisan interpretations. However, the gap between some Republicans and Democrats on views regarding the role of government in the economy, the U.S.'s participation in the global economy, and the fairness of the current economic system has been narrowing. Specifically, the Pew Research Center recently divided Republicans into four distinct typologies: Core Conservatives, New Era Enterprisers, Country First Conservatives, and Market Skeptic Republicans. The latter two groups represented 43% of the Republicans surveyed - let's call them "Change Republicans," as they are most supportive of changes to the current economic system.7 Among Change Republicans, only 15% felt that the "U.S. economic system is generally fair to most Americans." Comparatively, 75% of the remaining two groups of GOP voters believe the current system is fair. This wide gap in current perceptions on the effectiveness of today's economic model makes Change Republicans more receptive to policies aimed at redefining the role of government and redistributing income. This conclusion has important consequences for policy beyond 2018. Prospective PBV Theory And The 2020 Election Although most analyses of the PBV theory have focused on retrospective assessments of economic well-being, scholar Michael Lewis-Beck and others have found that future expectations of income growth are statistically more important in determining voting patterns.8 As a result, prospective PBV theory suggests that voters will often look beyond current economic conditions and assess policy proposals that will influence future economic potential. In recent decades, income growth has slowed while debt levels have increased. In addition, inequality has increased on three important levels. Separating income inequality into three groups is useful because it helps forecast where voters will demand changes in policy. Chart 9Globalization: No Friend To DM Middle Class The first level of unequal growth has unfolded on the global stage, as middle-class voters in developed economies experienced the slowest level of income gains among the world's population - and by a large margin (Chart 9). The second level of inequality has occurred within the U.S. economy, between capital (owners) and labor (workers) (Chart 10). And the third level of inequality has materialized most starkly within labor, as the highest income earners have reaped big rewards while the rest of Americans have experienced basically zero gains in real income since the early 1980s (Chart 11). Chart 10Politically Unsustainable Chart 11Will The GOP Tax Bill Make America More Unequal? These observations are likely going to play a central role in the policy prescriptions offered by both candidates in the 2020 presidential election. In terms of U.S. trade policy, Republicans under Trump have become much less inclined to support free trade. Before the global financial crisis, 57% of GOP voters felt that trade agreements were a good thing for the United States. Fast-forward to April 2017, and only 36% of Republicans felt the same way.9 The near-term risk of protectionism centers on the renegotiation of NAFTA. The U.S. is much less economically dependent on NAFTA compared to Canada and Mexico and, more importantly, the political benefits associated with abrogating the deal could push President Trump and his mercantilist cabinet toward doing so.10 Investors should remain short the Mexican peso. The greater risk associated with voter demands for trade protectionism centers on China. The Trump administration began with a mere "shot across the bow" and has not initiated a trade war with the Chinese so far. However, a diplomatic resolution of U.S. tensions with North Korea, or a failure to renegotiate NAFTA, would put more pressure on President Trump to turn his attention to the large American trade deficit with China - as he often did during the 2016 presidential election. (As long as North Korea remains the top foreign policy priority, Trump will need Chinese cooperation that will in turn, at least partially, reduce his appetite for trade conflict.) Ironically, the growing share of income that has accumulated to capital owners relative to labor over the past 20 years did not dissuade Republicans from cutting corporate taxes. This strategy could prove to be very risky. In fact, just a few months before the passage of the GOP tax plan, a majority of Americans surveyed by Pew believed that tax rates on corporations and large businesses should be increased.11 Perhaps a more important reason for the widening gap between capital and labor has been technology. But a recent survey showed that only 7% of Americans feel that their own job or profession will be very vulnerable to robots or computers during their lifetime (Chart 12). This implies that voter demand for policies that reduce the impact of technology on inequality remain less likely than tax policies that put gradual downward pressure on corporate profits. Investors should expect Democrats to focus squarely on the rise in corporate profits and the absence of meaningful wage growth in the 2020 election. Chart 12Most People Don't Think They##br## Are Vulnerable To Technology The final piece of the puzzle for Democrats in the 2020 election will be redistributionist policies that shift income from the top earners to the rest of the population. This political strategy is supported by the effects of previous tax reform on income inequality - highlighted in Chart 11. Specifically, while previous rounds of tax reform have obviously benefited the U.S.'s highest income earners, the vast majority of Americans, as mentioned, experienced zero gains in real income after the Reagan and Bush tax plans were implemented. Compared to protectionism or redistribution from the corporate sector, movement on legislation to tax high-income earners could be relatively slow moving. First, only 43% of Americans think that taxes should be raised on people earning more than $250,000; and only a quarter of Republican voters support that proposition.12 And second, despite stark inequality and a low level of upward mobility in the United States, six-in-ten Americans still believe that people who work hard tend to get ahead.13 These two observations of voter preferences could weigh on the appeal of policy proposals that aim to redistribute income from the top 1% to the rest of the income pool. Trade protectionism, and a reversal of some of the corporate tax cuts, are more politically feasible. Concluding Thoughts Retrospective assessments of economic well-being can be helpful in forecasting electoral outcomes. The U.S. economy has found its footing, the labor market is strong, and confidence is up. However, these factors will likely prove insufficient to protect Republicans from the difficult task of retaining a majority government in the face of declining popular support. Divided government is not necessarily a bad outcome for investors. Recall that during the most recent period of divided government from November 2010 to November 2016, the S&P 500 rose by 80%! Even impeachment proceedings against the president could fail to derail the rising stock market, as occurred in the late 1990s.14 But as the 2020 election approaches, presidential candidates will be increasingly responding to voter demands for more protectionism, policies that shift income from companies to workers, and proposals that raise taxes on the wealthiest Americans. The former two will have some chance of passage. Jim Mylonas, Vice President Client Advisory & BCA Academy jim@bcaresearch.com 1 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, and BCA Geopolitical Strategy and Global Investment Strategy Special Report, "Populism Blues: How And Why Social Instability Is Coming To America," dated June 9, 2017, available at gps.bcaresearch.com. 2 For the seminal treatise on the PBV theory, please see Michael Lewis-Beck, Economics And Elections: The Major Western Democracies, (Ann Arbor: U of Michigan P, 2000). 3 Please see Alberto Alesina and Howard Rosenthal, Partisan Politics, Divided Government, And The Economy, (Cambridge: Cambridge UP, 1995). 4 Please see Frank Newport, "Public Opinion And The Tax Reform Law," Gallup, dated December 21, 2017, available at news.gallup.com. 5 Please see John Gramlich, "Far More Americans Say There Are Strong Conflicts Between Partisans Than Between Other Groups In Society," Pew Research Center, dated December 19, 2017. 6 Please see Pew Research Center, "Views Of Job Situation Improve Sharply, But Many Still Say They're Falling Behind Financially," dated November 7, 2017, available at www.people-press.org. 7 Please see Pew Research Center, "Political Typology Reveals Deep Fissures On The Right And Left," dated October 24, 2017, available at www.people-press.org. 8 See footnote 2, pp. 120. 9 Please see Bradley Jones, "Support For Free Trade Agreements Rebounds Modestly, But Wide Partisan Differences Remain," Pew Research Center, dated April 25, 2017, available at www.pewresearch.org. 10 Please see Global Investment Strategy Special Report, "NAFTA - Populism Vs. Pluto-Populism," dated November 10, 2017, available at gis.bcaresearch.com. 11 Please see Hannah Fingerhut, "More Americans Favor Raising Than Lowering Tax Rates On Corporations, High Household Incomes," Pew Research Center, dated September 27, 2017, available at www.pewresearch.org. 12 Please see footnote 11. 13 Please see footnote 7. 14 Please see BCA Geopolitical Strategy Special Report, "Break Glass In Case Of Impeachment," dated May 17, 2017, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights U.S. Treasuries: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in U.S. inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. Canada: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds and stay long inflation protection (both through linkers and CPI swaps). 2017 Model Portfolio Performance Wrap-Up: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps of underperformance versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Feature Chart of the WeekGlobal Bond Yields Are Too Low 2018 has started much as 2017 ended, with growth-sensitive assets rallying alongside robust economic data. Most major global equity markets are already up 2-3% after the first week of the year, with the U.S. NASDAQ, Japanese Nikkei and Italian MIB indices advancing over 4%. Global credit markets are also off to a strong start, with spreads for U.S. High-Yield corporate debt and EM hard currency corporate debt tighter by -17bps and -8bps, respectively. Even commodity markets have joined the party, with the benchmark Brent oil price hitting the highest level in nearly three years. The pro-growth, pro-risk backdrop is keeping upward pressure on global government bond yields. This is occurring primarily through the inflation expectations component of yields, which are rising in all developed economies (even Japan). Real yields, which are not rising despite the strength of the broad-based global growth upturn (Chart of the Week), have been drifting lower, providing some offset to rising inflation expectations. The primary trend for global yields remains upward, however - especially if growth remains solid and inflation expectations continue to push higher, giving central banks like the U.S. Federal Reserve the confidence to continue hiking interest rates. We continue to favor below-benchmark duration exposure, and overweight corporate bond allocations versus government debt, for global fixed income investors over the next 6-9 months. U.S. Treasuries: Still More Reasons To Sell Than Buy U.S. Treasury market participants have a lot to things to be nervous about at the moment. Likely future Fed rate hikes, the weakening U.S. dollar, rising oil prices, ongoing U.S. labor market strength, persistently booming economic growth, the never-ending equity bull market, the potential impact of the Trump fiscal stimulus, the Fed starting its balance sheet runoff - all factors that should force bond investors to expect yields to rise. Yet longer-dated Treasury yields continue to trade too low relative to the bond-bearish fundamentals. The current benchmark 10-year Treasury yield at 2.48% remains well below the fair value from our 2-factor regression model, which is now up to 2.94% (Chart 2). That valuation gap of 46bps is close to the widest levels seen in July 2016 and September 2017, which were both episodes that proved to be excellent entry points for bearish Treasury positions. The two inputs into our Treasury yield model are the global manufacturing PMI and bullish sentiment towards the U.S. dollar (USD). The PMI is included as an indicator of global growth and currently sits at 54.5 - the highest level in nearly seven years - led by strong readings in almost every major economy (Chart 3). This has been the primary driver of the fair value for the 10-year Treasury yield since global growth bottomed out and began to accelerate in mid-2016. Chart 210-Year Treasuries Are##BR##Overvalued On Our Model Chart 3Global Growth##BR##Is Booming Sentiment towards the USD is the second input to our Treasury model. It is included as a weakening greenback represents an easing of monetary conditions that could trigger a need for more Fed rate hikes that can push the Treasury curve higher from the short-end (and vice versa for a rallying USD). At the same time, a depreciating USD can drive U.S. inflation higher through higher costs of imported goods & services, which can raise bond yields through higher inflation expectations or greater Fed tightening expectations (again, the opposite holds true for a strengthening USD). Right now, both the strong PMI and weak sentiment towards the dollar are boosting the fair value of the 10-year Treasury yield. The fall in value of the greenback is particularly unusual, as it is flying in the face of widening interest rate differentials between the U.S. and the rest of the world (Chart 4, top panel). This is clearly a function of the fact that global growth is rapidly improving - especially in Europe - but very few central banks have yet to respond to that growth with interest rate hikes that match what the Fed has been delivering. So while actual interest rate differentials remain USD-supportive, expectations of some eventual tighter monetary policy outside the U.S. that could narrow those interest rate gaps are triggering speculative inflows into non-USD currencies. With the trade-weighted USD now 5% below levels of a year ago, this should lead to higher headline inflation in the U.S. in the next few months (middle panel). Combined with the continued strength in global oil prices, that means that the two biggest factors that weighed on realized U.S. inflation- the USD rally and oil price collapse of 2014/15 - are now both acting to boost inflation expectations (bottom panel). Throw in the growing body of evidence that a tight U.S. labor market that is putting gentle upward pressure on wage growth, and U.S. inflation expectations - which still remain 40-50bps below levels consistent with the Fed's inflation target - should continue to move higher in the next six months. Rising longer-term inflation expectations would typically result in bear-steepening pressures on the Treasury yield curve. That is not happening at the moment, however, with the 2-year/10-year Treasury curve still at a relatively flat 53bps at the time this report went to press. The flatness of the Treasury curve has worried investors, and even some Fed officials, given the well-known leading relationship between the yield curve and U.S. economic growth. It is too early to draw any conclusions between the shape of the curve and future U.S. economic growth, however, for several reasons: As mentioned above, inflation expectations are still well below levels consistent with the Fed's 2% inflation target on the PCE deflator (which translates to 2.5% on the CPI index used to price TIPS and CPI swaps). Both the European Central Bank (ECB) and Bank of Japan (BoJ) are still buying bonds through their asset purchase programs, although at a slower pace than previous years. This continues to depress local bond yields in Europe and Japan with spillover effects into the U.S. Treasury market - even as the Fed begins the slow runoff of Treasuries from its massive balance sheet. Data on mutual fund and ETF flows shows that there has been significant and sustained buying of bond funds by U.S. retail investors over the past couple of months. There has also been net selling of equity funds, however, suggesting that U.S. retail investors are rebalancing as the equity markets surge higher. Investor positioning in the U.S. Treasury market is very short at the moment, with the J.P. Morgan survey of "active" bond manager duration exposure at an all-time low and the net positioning on Treasury futures now slightly favoring shorts (Chart 5). It makes little sense to interpret a flattening Treasury curve as a signal that the bond market believes that the Fed was making a policy mistake if professional bond investors were running massive duration underweight positions that would benefit if bond yields rise. Chart 4Upside Pressure On U.S. Inflation##BR##From Oil & The USD Chart 5Big Duration Underweight##BR##Among U.S. Bond Managers All these factors muddy the economic signal provided by the Treasury curve at the moment. Nonetheless, we remain of the view that the Fed would not continue on its rate hiking path without U.S. inflation expectations moving sustainably back to levels consistent with the Fed's inflation target. In other words, the Treasury curve must bearishly steepen first through rising inflation expectations before bearishly flattening later through actual Fed rate hikes. The latter will dampen future U.S. growth expectations and eventually result in a cyclical peak in longer-dated Treasury yields, but from levels closer to 3% on the 10-year after inflation expectations "fully" normalize. Bottom Line: U.S. Treasury yields are too low relative to the strength of global economic growth and the rising trend in inflation expectations. Maintain below-benchmark duration exposure in the U.S., stay underweight Treasuries versus global bond benchmarks, and continue to favor TIPS over nominals. The Bank Of Canada Keeps On Playing Catch-Up The Canadian economic story continues to be the best within the developed world. The year-over-year growth rate for real GDP accelerated to over 3% late last year, primarily on the back of robust consumer spending (Chart 6). Even the lagging parts of the economy, like business investment and government spending, began to perk up last year. The momentum remained powerful at the end of 2017, with the unemployment rate in December hitting a 40-year low. The economic boom forced the Bank of Canada (BoC) to begin lifting interest rates last year, with two 25bp hikes occurring in July and September that unwound the easing from 2015. The rapid pace of growth has absorbed spare capacity much faster than the BoC originally projected. More hikes will be required if the current pace of growth is maintained, particularly with the BoC estimating that the neutral policy rate is around 3% and the current Overnight Rate is only at 1%. The Canadian consumer has been enjoying a powerful shopping spree. Real consumer spending growth is at 4% on a year-over-year basis - the highest level since early 2008 (Chart 7). This is led by a powerful surge in spending on consumer durables, where annual growth has surged to 10% (middle panel). Consumer confidence is booming and Canadian workers are enjoying the fastest pace of income growth since 2014 (bottom panel). Chart 6Robust Canadian Growth,##BR##Led By The Consumer Chart 7Canadian Consumers Are##BR##Confidently Spending Surprisingly, the powerful surge in consumer spending has occurred alongside some cooling of the overheated Canadian housing market. The growth rates of existing home sales and prices have both decelerated massively from the pace of the boom years in 2012-16 (Chart 8). The performance of house prices in the three biggest Canadian cities is now a mixed bag, with Vancouver prices reaccelerating, prices in Toronto decelerating and prices in Montreal growing only modestly (middle panel). Regulatory actions to limit the speculative buying of Canadian real estate by foreigners has helped dampen the surge in house prices in some markets. Although the bigger macro-prudential measures designed to tighten mortgage finance rules and reduce the amount of leverage in Canadian housing transactions has likely had a bigger effect. Canadian banks must now conduct stress tests to check if borrowers are able to pay off their mortgages if Canadian interest rates continue to rise. This represents a reduction in the marginal supply of riskier mortgage lending that will help restrain house price inflation in Canada's major cities. In addition, the supply of Canadian homes is growing with new home-building activity, both for single and multiple units, having picked up and overall residential investment growth now up nearly 5% on a year-over-year basis (bottom panel). With signs that the Canadian housing market has stopped rapidly inflating, the BoC can focus its interest rate policy on domestic growth and inflation considerations without worrying about pricking the housing bubble. On that front, the latest edition of the BoC's Business Outlook Survey, released yesterday, provided plenty of reasons to tighten monetary policy further. The overall survey indicator surged back to the peak seen last summer just before the BoC delivered its first rate hike (Chart 9). Capital spending intentions also rebounded back to the 2017 peaks, which bodes well for future gains in investment spending (second panel). Chart 8Canadian Housing Looking##BR##A Bit Less Frothy Chart 9BoC Business Outlook Survey Signaling##BR##Tightening Capacity Constraints The most interesting parts of the Business Outlook Survey were the capacity utilization measures. A greater share of companies were reporting labor shortages (third panel), with the highest percentage of firms reported difficulties in meeting unexpected increases in demand since 2007 (bottom panel). This suggests that the recent surge in employment, wage growth and price inflation are all sustainable. Headline and core CPI inflation are up to 2.1% and 1.8%, respectively, as of November. This is around the midpoint of the BoC's 1-3% target range (Chart 10). The Bank of Canada forecasts that CPI inflation will continue to rise and remain near 2% target in 2018, but all the risks are to the upside. The unemployment rate is now down to 5.7%, the lowest level since 1976 and well below the OECD's estimate of the NAIRU level at 6.5%. Average hourly earnings growth has surged in response, rising to just under 3% on a year-over-year basis since the trough in early 2017. The Phillips Curve appears to be alive and well in Canada. Canadian interest rate markets have already responded aggressively to the stronger growth and inflation data. Our interest rate discounters now show that the money markets are now expecting 61bps of BoC rate hikes over the next six months and 91bps over the next twelve months (Chart 11). With a 25bp hike at next week's BoC meeting now priced with almost full certainty, the current market pricing suggests at least one more hike will happen by June and nearly three more hikes by year-end. That would be even more hikes than we expect from the Fed in 2018, which is important for the Canadian dollar (CAD). The CAD has appreciated 16% since it bottomed out in early 2016, occurring alongside the rise in global oil prices over the same period (second panel). The price of Canada's Western Select grade of crude oil has lagged the move in other oil benchmarks massively over the past several months, due to a lack of pipeline capacity getting oil out of Alberta that has created a supply glut. This may limit the degree to which additional gains in global energy prices benefit the Canadian dollar from a terms-of-trade perspective. This will not prevent the BoC from delivering additional rate hikes, however - especially if that merely matches the 75bps of Fed rate hikes that the FOMC is projecting, and which we expect, over the rest of the year. In terms of investment strategy, the combination of robust Canadian economic growth and rising inflation pressures leads us to continue recommending an underweight stance on Canadian government bonds, as we have maintained since July 11, 2017. This week, we are introducing two new tactical trades that should benefit as Canadian inflation moves higher and the BoC tightens more aggressively in response (Chart 12): Chart 10The Canadian Phillips Curve Is Not Dead Chart 11The Market Now Expects A Lot From The BoC Chart 12Two New Tactical Trades In Canada Short the June 2018 Canada Bankers' Acceptance futures contact vs. the December 2018 contract (middle panel). The market is now discounting the likely maximum amount of tightening that the BoC can deliver by year-end, while there are only little more than two hikes priced by June. Assuming that the BoC hikes next week, that means that there is only one more hike expected by June. With three more BoC meetings scheduled between next week and June, that provides plenty of opportunities for hawkish surprises from the BoC before then. In other words, this trade is a way to play for the BoC being forced to front-load more rate hikes into the first half of 2018 versus the latter half. Long 10yr inflation expectations through linkers versus nominal government bonds, or using CPI swaps (bottom panel). Given the pickup in domestic inflation pressures currently underway, plus the rise in global inflation coming from the surge in commodity prices, there is room for Canadian market-based inflation expectations to rise from the current level of 1.7%. Bottom Line: The Canadian economic data is moving from strength to strength, and now price and wage inflation data is moving higher. The Bank of Canada will likely hike rates next week with additional increases likely in 2018. Remain underweight Canadian government bonds. 2017 GFIS Model Bond Portfolio Performance: A Brief Review The turn of the year marked the end of the first full calendar year for the Global Fixed Income Strategy (GFIS) model bond portfolio. This now allows us to report the performance of the portfolio on the same basis as our clients. In the future, we will publish quarterly reviews of the portfolio returns after the end of each quarter in a calendar year (in April, July, October and January). The GFIS model portfolio returned 3.45% in 2017. This underperformed our custom performance benchmark (a blend of the Barclays Global Aggregate Index with global high-yield corporate debt) by -13bps (Chart 13). That underperformance can be entirely attributed to our government bond duration allocations, which lagged the benchmark by -46bps. Our recommended credit positions were a positive contributor, generating 33bps of outperformance primarily through overweights to U.S. Investment Grade and High-Yield corporate bonds. The detailed breakdown of the 2017 returns is presented in Table 1. In terms of the government bond portion of the portfolio, the underperformance can be isolated completely to the longest maturity bucket (10+ years). The combined performance of that bucket for all countries lagged that of the benchmark by -52bps. Given our expectation that global yield curves would bear-steepen in the latter half of 2017, it is no surprise that the bulk of our underperformance came by having too little exposure at the long-end. Also, having too much exposure in Japanese government bonds offering no yield also represented a major drag on the income component of the model portfolio's returns (Chart 14). Chart 13GFIS Model Bond Portfolio##BR##2017 Return Breakdown Table 1GFIS Model Bond Portfolio##BR##2017 Return Breakdown In terms of our credit allocations, favoring U.S. corporate exposure vs. non-U.S. corporates was the right call, generally speaking (Chart 15). However, we did not have enough portfolio weight in that trade to offset the drag on the overall yield from the Japan government bond overweight. Chart 14GFIS Model Portfolio Government Bond Performance Attribution By Country Chart 15GFIS Model Portfolio Spread Product Performance Attribution Looking ahead, the new model bond portfolio allocation for 2018 that we discussed in our final report of 2017 should offer a better chance of outperforming the benchmark.1 Specifically, we dialed down the Japan overweight, increased the U.S. Investment Grade corporate bond overweight, and reduced the curve steepening exposure in Euro Area governments. This not only boosted the overall yield of the portfolio, but also moderated the overall portfolio duration underweight. This portfolio will do well in the first half of 2018 if our base case of an inflation-driven rise in global government bond yields, led primarily by the U.S. where corporate debt is also expected to outperform Treasuries, comes to fruition. Bottom Line: We closed the books on the first full calendar year of our model bond portfolio with a total return of 3.75%. This was a small -13bps underperformance of versus our custom benchmark, coming entirely from underweight positions on longer-dated developed market government bonds that offset the asset allocation gains from overweights to corporate debt. Robert Robis, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Ray Park, Research Analyst ray@bcaresearch.com 1 Please see BCA Global Fixed Income Strategy Weekly Report, "Our Model Bond Allocation In 2018: A Tale Of Two Halves", dated December 19th 2017, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Upbeat economic reports for December set the stage for a solid 2018. The FOMC minutes acknowledged the flatter curve and only a minority of members discounted the signal from the curve. A majority thought that a tighter labor market would lead to higher inflation. The Citi Economic Surprise Index is peaking, but risk assets should hold up as the Index rolls over. Feature The first week of 2018 brought more good news for risk assets. U.S. stocks beat bonds, oil prices rose, and credit spreads narrowed amid a solid set of economic data. Several high-profile U.S. companies announced share buybacks, and/or one-time bonuses or wage increases linked to the tax cut plan passed by Congress at the end of 2017. Moreover, there were hints of further economic stimulus as lawmakers from both sides of the aisle discussed relaxing the sequester rules that would lift federal spending this year. Markets shrugged off a fresh round of saber rattling between the U.S. and North Korea. Gold prices nudged higher and the U.S. dollar fell despite the upbeat economic news. December's reports on manufacturing and service sector ISM, vehicle sales and the labor market, along with November's numbers on construction spending, trade and factory orders, all lifted estimates for Q4 GDP and boosted the prospects for corporate earnings in Q4 2017 and beyond. Chart 1 shows that the elevated ISM figures provide a favorable backdrop for earnings and sales in 2018. Moreover, Chart 2 indicates that IP, a proxy for S&P 500 sales, is poised to advance in 2018 and provide a lift to corporate profits. We will preview the S&P 500's Q4 2017 earnings reports in next week's U.S. Investment Strategy. Chart 1Favorable Macro Backdrop For Earnings And Sales Chart 2ISM Components Suggest IP Poised To Accelerate The Atlanta Fed GDP Now estimate stood at 2.7% on January 5, while the New York Fed's Nowcast for Q4 GDP was a healthy 4% (Chart 3). Both soundings are well above the FOMC's assessment of the economy's long-term potential growth rate (1.8%) and puts GDP growth in 2017 above the Fed's forecast. The implication is that the output gap pushed deeper into positive territory as 2017 ended, setting the stage for higher inflation in 2018. The December 2017 jobs report, released last Friday, January 5, does not change BCA's outlook for the U.S. economy or the Fed. The U.S. economy added a lower than expected 148,000 new jobs in December, which left the unemployment rate unchanged at 4.1%. Despite the softer than anticipated data, the 3-month average of payrolls growth is still a very healthy 204,000. The monthly increase in wages quickened to 0.3% m/m in December, up from 0.1% m/m last month. However, annual wage inflation remains modest at just 2.5% (Chart 4). Chart 3U.S. Economic Growth Well##BR##Ahead Of Potential In Q4 Chart 4Labor Market Still Tightening Despite##BR##Soft December Report The indications for Q4 GDP growth are solid. Aggregate hours worked rose 2.5% at an annualized rate in Q4 2017. Assuming modest growth in productivity, the payrolls data are consistent with over 3% GDP growth in Q4. There is nothing in the December payroll data to suggest that the underlying trajectory in the U.S. economy has changed. The economy continues to grow above trend. Wage gains are modest at the moment, but should accelerate as the labor market keeps tightening with above-trend GDP growth. This upbeat economic outlook is also supported the December 2017 non-manufacturing ISM survey, also released last Friday. While the overall index fell from 57.4 to 55.9, it is still consistent with solid GDP growth. Moreover, the employment index rose from 55.3 to 56.3, which signals firm job gains, and the prices paid index held steady at a fairly elevated level of 60.8. Bottom Line: It's been solid start to 2018 and it's steady as she goes for the U.S. economy and the Fed. FOMC Minutes: A Rubric BCA's U.S. Bond Strategy service expects that the 2/10 yield curve will languish between 0 and 50 bps in 2018. The curve will steepen from 51 bps at the end of 2017 through mid-year 2018, and then flatten into year-end (Chart 5). Which asset classes would benefit if our curve call is accurate? BCA's "The Bucket List"1 explains our view of the curve in 2018 and details the past performance of various U.S. assets in differing yield curve environments. Chart 5A Flat Yield Curve Is OK For Most Risk Assets BCA expects that the yield curve will first steepen in 2018, then become flatter, ultimately spending most of the year between 0 and 50 bps. A flat curve is the ideal environment for the S&P 500 and the stock-to-bond ratio. However, small cap stocks struggle when the curve is flat; BCA's view is that small caps will outperform large caps in 2018. A flat yield curve raises the risk of a sell-off in high yield, but provides a favorable grounding for oil, which is in line with BCA's fundamental view. BCA expects EPS growth will be positive this year; earnings growth is higher 75% of the time when the curve is flat. The yield curve's slope was a focus of debate at the FOMC's December 12-13, 2017 meeting. Participants cited several reasons for the flat curve2: recent increases in the target range for the federal funds rate; reductions in investors' estimates of the longer-run, neutral real interest rate; lower longer-term inflation expectations; lower term premiums Fed economists recently updated their quantitative assessments of the FOMC's minutes. The note provides a guide (Table 1 in the Fed paper3 and Tables 1 and 2 below) to the number of quantitative descriptors in the minutes (one, a couple, a few, etc.). We use this rubric to assess the committee's latest views on the yield curve and inflation. Table 1FOMC Assessment Of The Yield Curve Table 2FOMC Assessment Of Inflation In short, the FOMC acknowledged the flatter curve and only a minority of members discounted the signal from the curve. Moreover, a majority thought that a tighter labor market would lead to higher inflation. Only one participant held the view that secular trends were muting inflation. Bottom Line: BCA expects the Fed to deliver 3 to 4 rate hikes in 2018, which is still not fully priced in by the market. Investors should maintain below-benchmark duration in fixed income portfolios. Asset allocators should remain overweight stocks versus bonds. Growth is strong and the yield curve is not inverted yet. Therefore, it is still early to de-risk portfolios. Is Economic Surprise Peaking? The Citigroup (Citi) Economic Surprise Index is elevated relative to its recent history, but it may have further to run. Economic prospects were cheery following the 2016 presidential election and the economic data exceeded those lofty projections, aided by a warmer than usual winter. However, the temperate conditions borrowed activity from the spring, which was cooler and wetter than normal, and the combination of lofty expectations and seasonal distortions sent the Citi Economic Surprise Index spiraling lower through mid-year 2017. Since its bottom in June 2017 at -78.6%, the index climbed for 135 days before its peak in late December 2017 (Chart 6, panel 1). On average since 2010, the Citi Index moved from trough-to-peak in 96 days, which means the recent run-up was much longer than usual. However, that phenomenon may have been due to the raised economic expectations and variable weather patterns at the start of 2017. Chart 6Economic Surprise Index Has Surged, But Expectations Remain Muted At 80.7%, the Index has been above zero for 68 days (Chart 6, panel 1). It typically takes 46 days for it to climb from zero to its zenith. Table 3 shows the performance of financial markets and other assets after the Index moves from zero to the peak. The most recent episode (October through December 2017) matched historical averages across most asset classes, although the underperformance of small caps versus large ran counter to the past as the Surprise Index climbed from zero. Table 3Risk Assets Perform Well As Surprise Index Climbs Since 2010, the Index has stayed above 40 for an average of 51 days (Chart 6, panel 1). The Index has been over 40 since November 16, 2017, or 35 days. This suggests that it can remain elevated for another month or so before it again moves lower. However, the Index is mean reverting and investors wonder what will happen to risk assets after economic surprise rolls over. Table 4 and Chart 7 shows the performance of key financial markets and commodities when the Citi Index returned to zero from 40-plus. There have been six such intervals since 2010. On average, gold and oil perform well as the surprise index dips to zero. Stocks and credit outperform Treasuries during these episodes, and small caps beat large caps. Rising economic surprise (Table 3) is a more favorable environment for stocks, credit and oil than when the surprise index is rolling over. However, the performance of gold and small caps is better after the Citi Surprise Index peaks (Table 4). Table 4Risk Assets Hold Up When Citi Surprise Index Rolls Over Chart 7U.S. Assets As Economic Surprise Rolls Over Nonetheless, muted economic expectations will limit the downside in the Index in the coming months. Panel 3 of Chart 6 shows that the outlook for both hard and soft economic data remained muted through the end of November 2017, especially when compared with the significant improvement in economic prospects in late 2016 and early 2017. Bottom Line: Risk assets outperformed as the Citi Economic Surprise Index climbed in the second half of 2017. The Index can stay near recent peaks for several more months thanks to subdued economic forecasts, but it will roll over eventually. However, the elevated level of the Index suggests that there are near-term risks for equities and credit because a lot of good economic news is already priced in. Still, we recommend that investors ride out the volatility given our view that stocks will outperform bonds in the next 6-12 months. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com 1 Please see BCA Research's U.S. Investment Strategy Weekly Report "The Bucket List", published December 18, 2017. Available at usis.bcaresearch.com. 2 https://www.federalreserve.gov/monetarypolicy/fomcminutes20171213.htm 3 https://www.federalreserve.gov/econres/notes/feds-notes/the-fomc-meeting-minutes-an-update-of-counting-words-20170803.htm

Highlights The dollar continues to suffer as global growth remains strong. The year-end performance of the dollar rarely heralds things to come for the next six to twelve months. Signs are slowly accumulating that global growth may soften, but it could take a quarter to happen. In the meanwhile, the dollar could continue to weaken. Already boosted by global growth, the euro received a further fillip as markets upgraded the anticipated terminal interest rate in Europe. The U.S. terminal rate will be upgraded too, but only when this happen will the dollar be able to rally. Stay cautious. Feature As a cold snap engulfed North America, the U.S. dollar finished 2017 falling as fast as the mercury. This move is worrisome, as it pushed the greenback to the edge of a cliff. If the DXY punches below 91, the low hit on September 7, the greenback could hit 88. For EUR/USD, a decisive break above 1.21 constitutes the same threshold, and would indicate that the euro will rally to 1.25. Vigilance is required. A December Signal? The performance of the dollar in the last two weeks of December rarely offers a reliable signal of things to come. As Table I-1 illustrates, based on more than 20 years of data, the performance of the dollar index in the last weeks of a year has been negatively correlated with the dollar's performance over the following six to 12 months. This would imply that investors fighting dominating trends over the course of the prior 12 months capitulate in the last two weeks of the year, cleaning the slate in the process. Table I-1A Cold Snap Doesn't Make A Winter When it comes to specific pairs, relationships vary. The correlation of EUR/USD's subsequent six-month and 12-month returns with its year-end performance is zero, thus there is little to glean from the euro's recent strength in terms of its implications for 2018. However, interestingly, there is a strong negative correlation between the AUD/USD's year-end performance and the Aussie's returns over the next six to 12 months. It would seem the AUD's blistering rally is to be sold, not bought. The weakness in the USD was supercharged by the greenback's countercyclical nature. Our global synchronicity indictor - which measures the proportion of DM economies with PMIs above 50 - displays a negative correlation with the dollar's returns. This indicator's extraordinarily strong performance elucidates why the dollar was so weak last year, and also why the euro performed so well (Chart I-1). Going forward, two key leading indicators of our global synchronicity measure are saying that the global upswing could lose power (Chart I-2). The performance of Swedish equities relative to U.S. stocks and the annual change in U.S. 10-year yields reveal that even if global growth remains above trend, it will decelerate from current elevated readings. This could support the dollar index. However, we should keep an eye on the performance of EM carry trades.1 EM carry trades had been indicating that the best days for global growth are also behind us (Chart I-3), but lately EM carry trades have regained some vigor. If this strength is maintained, the message from the relative performance of Swedish equities and of U.S. bond yields will be invalidated. Such a move could be associated with a DXY breaking down below 91, potentially hitting 88; and EUR/USD rallying above 1.21 to 1.25. Chart I-1Strong Global Growth Hurts The Dollar Chart I-2Will This Synchronized Boom Peter Off? Chart I-3EM Carry Trades And Growth When all these forces are taken together, the picture for the dollar remains murky. The recent weakness in the Baltic Dry Index as well as the outperformance of oil relative to metals prices suggests we are entering a late cycle environment where even if global growth remain above trend, it is likely to be peaking. Thus, even if the dollar were to sell off further in the coming weeks, the downside will be limited. Nonetheless, a rally in the USD will have to wait for clear signs that U.S. inflation is picking up. It is best to stay on the sidelines for now. Bottom Line: The performance of the dollar in the last weeks of the year is rarely a good gauge of the dollar trend for the next six to 12 months. However, the dollar has been suffering on the back of strong global growth. While important metrics are suggesting that global growth could lose some momentum, other essential indicators such as EM carry trades are regaining some vigor. For now, limiting directional dollar bets is a safer strategy. The dollar will only rally once U.S. inflation picks up. EUR/USD And Terminal Rates The recent strength in the euro is linked to strong global growth. However, EUR/USD has been supercharged by domestic factors. In December, the differential in expected terminal policy rates between the European Central Bank and the Federal Reserve moved violently in favor of the euro. This move reflected a forceful upgrade of the anticipated terminal policy rate in the euro area (Chart I-4). This sudden upgrade in Europe makes sense: the European economy is strong. Euro area PMIs are at record highs, German unemployment has hit post-unification lows and German inflation regained gumption. Moreover, Benoit Coeure, a member of the ECB's Executive Board, expressed some very hawkish views. The market is correct to upgrade the outlook for the ECB. However, interest rate markets continue to expect too-shy-a-Fed over the remainder of the cycle. This leaves room to upgrade the expected terminal interest rate for the U.S. The U.S. economy is also firing on all cylinders. The U.S. ISM came in at 59.7 this week, with the new order component standing at a very strong 69.4. Additionally, total hours worked have been accelerating (Chart I-5). Together, these point to very robust GDP growth. Already, the Atlanta Fed GDPNow tracker foresees growth of 3.2% for Q4. Chart I-4EM Carry Trades And Growth Chart I-5U.S. Growth Set To Accelerate Strong U.S. growth is materializing in an environment of increasingly significant capacity constraints, which has historically been associated with rising inflationary pressures (Chart I-6). The recent easing in U.S. financial conditions only reinforces this message, and argues that U.S. inflation has upside (Chart I-7). Moreover, U.S. compensation costs have been accelerating, from a low of 1.9% in 2016 to 2.5% today. Hence, U.S. inflation should perk up this year, letting the Fed increase rates more than what markets currently foresee. Chart I-6Inflationary Backdrop In The U.S. Chart I-7U.S. Financial Conditions Furthermore, the relative growth picture indicates that the increase in U.S. terminal rate should outpace the eurozone's. The Goldman Sachs Current Activity Indicator in the euro area has rolled over relative to the U.S., highlighting that the euro has tightened relative financial conditions enough to now harm the growth profile of Europe vis-à-vis the U.S. (Chart I-8). Moreover, European economic surprises are slowing sharply relative to the U.S. and the Euro Stoxx is re-testing its cycle low against the S&P 500, further corroborating the message from the Current Activity Indicator (Chart I-9). Chart I-8EUR/USD Starting To Hurt European ##br## Relative Growth Prospects Chart I-9Strains In The ##br##Eurozone Despite these dynamics, it is not clear that making a bet today on a weak euro is the proper tactic. At the time of writing, EUR/USD was flirting with its previous high of 2017; any break above 1.21 would likely push EUR/USD toward 1.25. Thus, we recommend investors continue to play pairs like short EUR/SEK to take advantage of the tightening in euro area financial conditions rather than bet outright on EUR/USD. To make this latter bet, investors will need either a marked failure of EUR/USD to break out, thus invalidating previous bullish technical signals, or a pick-up in U.S. inflation, whose timing remains unclear. Bottom Line: The euro's rally has been supercharged by an upgrade of the market's expected terminal policy rates in Europe relative to the U.S. While upgrading the ECB makes sense, markets should also upgrade the U.S. policy path as the American economy is just as strong and closer to capacity constraints, thus more likely to generate inflation. However, fighting the momentum in EUR/USD is currently dangerous. Thus, we recommend investors to wait for U.S. inflation to pick up before selling the euro. Instead, sell EUR/SEK. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Foreign Exchange Strategy Weekly Report, titled "Canaries In The Coal Mine Alert: EM/JPY Carry Trades", dated December 1, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been positive: Personal consumption expenditure and core personal expenditure grew at 1.8% YoY and 1.5% YoY respectively. Both measures increased from last month's reading. ISM manufacturing PMI came in at 59.7, surprising significantly to the upside. This measure also increased from last month. Meanwhile, ISM prices paid came in at 69, smashing expectations. The dollar ended 2017 on a free fall, as the enigma of low inflation in an environment of very low unemployment continues to puzzle investors. Meanwhile global growth continues to be very strong, adding an additional handicap to the dollar. We continue to believe that the Fed will hike more than expected, pushing the dollar upwards. However for this process to star, inflation must first emerge in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in Europe has been positive: M3 Money supply yearly growth surprised to the upside, coming in at 4.9%. Moreover, Europe's Markit manufacturing PMI, came in line with expectations at 60.6. Finally, Germany's headline inflation also outperformed expectations, coming in at 1.6%. However this number did decline from the previous month. EUR/USD has rallied by almost 2% since Christmas. This has been mainly due to the rhetoric by ECB members, who appear to be much less dovish than before. Indeed, ECB board member Mersch warned that the ECB "must be careful not to act too timidly and too late and to fall behind the curve". Overall, we continue to believe that the Fed will surprise the market more than the ECB will. However to have an outright bullish dollar view inflation will have to pick up in the U.S. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Temporary Short-Term Rates - November 10, 2017 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been positive: Retail trade yearly growth came in at 2.2%, exceeding expectations by a wide margin. Meanwhile, housing starts also surprised to the upside, as they contracted by only 0.4%. Tokyo CPI ex fresh food yearly growth also beat expectations, coming in at 0.8%. Finally, the unemployment rate declined to 2.7%. The yen has appreciated against the U.S. dollar, with USD/JPY falling by about 0.7%. Meanwhile, Kuroda continued to assert that no change is needed to the BoJ's yield curve control program. Overall, in spite of the improved global outlook which is benefiting the Japanese economy, it is unlikely that Japan will abandon its extremely dovish monetary policy unless inflation rises much further. This is unlikely to happen in the near future. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Riding The Wave: Momentum Strategies In Foreign Exchange Markets - December 8, 2017 The Xs And The Currency Market - November 24, 2017 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Gross domestic product growth surprised to the upside, coming in at 1.7%. However this number did decline from the previous quarter. Additionally, total business investment yearly growth also outperformed expectations, coming in at 1.7%. However, Markit manufacturing PMI underperformed expectations, coming in at 56.3. Moreover, construction PMI also surprised to the downside, coming in at 52.2. Since Christmas, cable has gone up by roughly 1.5%. Overall we believe that the BoE is unlikely to raise rates meaningfully, as they will be more cautious than otherwise as the U.K. muddles through the Brexit negotiations. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Private sector credit yearly growth increased relatively to last month, coming in at 5.4%. However the AiG Performance of Manufacturing Index declined relatively to last month, coming in at 56.2 in December versus 57.3 in November. Finally, the RBA Commodity SDR Index, which in an early indicator of export price changes, contracted by 5.9%, a decline from last month's 4% contractions. The Australian dollar has rallied by more than 2.6% since Christmas, as multiple indicators point to continued strength in global growth. However we expect a temporary slowdown, as a result of tightening financial conditions in China. This will be negative for the AUD. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Currency Hedging: Dynamic Or Static? - A Practical Guide For Global Investors - September 29, 2017 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 The kiwi has increased by roughly 1.2% since Christmas, partly because of the decline of the U.S. dollar. However the New Zealand dollar has depreciated against almost every single G10 currency. Overall, we expect the NZD to appreciate relative to the AUD, given that the Australian dollar is much more sensitive to Chinese tightening financial conditions. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Reverse Alchemy: How To Transform Gold Into Lead - November 3, 2017 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been mixed: Gross Domestic Product month-on-month growth underperformed expectations, coming in at 0%. However, Markit manufacturing PMI surprised to the upside, coming in at 54.7. This measure also increased relatively to last month's. USD/CAD has plunged by nearly 2.8%. We expect the Canadian dollar to outperform the AUD and the NZD, as oil should outperform metals in the commodity space. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Market Update - October 27, 2017 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been positive: The KOF leading indicator surprised to the upside, coming in at 111.3 in December. This measure also increased relative to November's reading. Meanwhile, the SVME Purchasing Manager's Index also outperformed expectations, coming in at 65.2. Finally, the ZEW survey expectations component increased relatively to last month, coming in at 52. EUR/CHF has continued its appreciation into the New Year. This is good news for the SNB, as this will provide an easing in financial conditions. Overall, we expect the franc to have limited downside against the euro, as the still low inflation in Switzerland will keep the SNB intervening in currency markets. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 The Xs And The Currency Market - November 24, 2017 Updating Our Long-Term Fair Value Models - September 15, 2017 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been mixed: Retail sales growth for November increased relatively to last month's number, coming in at 2.1%. However, registered unemployment surprised negatively, as it increased from 2.3% to 2.4%. Since Christmas, USD/NOK has plunged by nearly 3%, as it has been battered by very strong oil prices. Overall, we expect USD/NOK to find upside, however this will happen only when rate expectations in the U.S. rise meaningfully. In order for this to happen, inflation must once again accelerate. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Retail sales yearly growth outperformed expectations, coming in at 2.8%. This measure also increased from last month's reading. Producer price inflation also increased from last month's number, coming in at 2.7%. However, Manufacturing PMI declined in December relatively to November, coming in at 60.4. In line with multiple indicators signaling that global growth continues to improve, USD/SEK has plunged by more than 2.5% since Christmas. Investors willing to bet on a temporary slowdown in the euro area, caused by tightening financial conditions should short EUR/SEK. Report Links: 10 Charts To Digest With The Holiday Trimmings - December 22, 2017 Canaries In The Coal Mine Alert 2: More On EM Carry Trades And Global Growth - December 15, 2017 The Xs And The Currency Market - November 24, 2017 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Question #1: Will global growth remain above trend? Yes. Question #2: Will growth continue to outperform outside the U.S.? No. Question #3: Will productivity growth pick up? Yes, but only cyclically. The structural outlook remains bleak. Question #4: Will continued strong global growth finally deliver higher inflation? Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Feature Global Growth In Focus We wish all our readers a joyous and prosperous 2018. As the new year begins, four questions about the global growth outlook loom large. Question #1: Will global growth remain above trend? Our answer: Yes. It is likely that global growth will come down a notch from its current elevated pace. However, it should remain firmly above trend. For one thing, the global economy continues to exhibit a lot of positive momentum. Real-time measures of economic activity, such as the Goldman Sachs Current Activity Indicator (CAI), highlight that global real GDP is rising at a robust pace (Chart 1). Our global leading indicator, as well as a wide swath of PMI data, suggest that this trend has legs (Chart 2). Chart 1APositive Global Growth Momentum Can Be Seen Here Chart 1BPositive Global Growth Momentum Can Be Seen Here Since 1980, above-trend global growth in one year has been accompanied by above-trend growth in the following year nearly three-quarters of the time. This bodes well for 2018. Chart 2... And Here Too Chart 3Financial Conditions Tend To Lead Growth By Six-To-Nine Months Global financial conditions eased significantly in 2017, thanks mainly to higher equity prices and narrower credit spreads. Easier financial conditions tend to benefit growth with a 6-to-9 month lag (Chart 3). The 6-month global credit impulse, which tends to lead activity, is also positive (Chart 4). Fiscal policy should remain stimulative. The fiscal thrust moved into positive territory in advanced economies in 2016-17 and this should remain the case in 2018 (Chart 5). Tax cuts will add about 0.3 percentage points to U.S. growth, while hurricane reconstruction spending and a likely congressional agreement to raise the cap on federal discretionary spending will add another 0.2 points. Chart 4Positive Credit Impulse Is Another Tailwind For Growth Chart 5Fiscal Policy Has Turned More Stimulative Our political strategists expect further fiscal easing in Japan this year. They also believe that German coalition talks will produce more government spending, with the SDP extracting concessions from Merkel on public investment and the CSU securing a commitment for more defense expenditure. On the flipside, our strategists expect some fiscal tightening in France as President Macron takes steps to trim France's bloated welfare state. Question #2: Will growth continue to outperform outside the U.S.? Our answer: No. Global revisions were more favorable outside the U.S. in the first nine months of 2017, which helps explain why the dollar came under downward pressure (Chart 6). More recently, U.S. growth estimates have begun to drift higher. As a result, the U.S. surprise index has surged relative to those of other economies (Chart 7). Chart 6U.S. Growth Expectations Were Lagging... ##br## But Not Anymore Chart 7U.S. Economic Surprise Index Increased ##br## Relative To Those Of Other Countries We expect the data to continue to favor the U.S. Aggregate U.S. hours worked in November was up 3.4% at an annualized rate over Q3 levels. If we add in productivity growth, Q4 GDP growth was probably in excess of 4% - well above current consensus estimates. Financial conditions have eased a lot more in the U.S. than in the rest of the world. Fiscal policy is also set to loosen relatively more in the U.S. Euro area growth is likely to tick lower next year from its current stellar pace, as the impact of a stronger euro begins to bite. The 6-month credit impulse has already turned negative there. Japanese growth should also cool somewhat from the heady pace of 2.7% seen over the past two quarters. The Chinese economy will decelerate modestly in 2018. The authorities are tightening the screws on the shadow banking system, expediting efforts to reduce excess capacity in the industrial sector, and clamping down on corruption. All of these reforms will pay off in the long run, but they could dent growth in the short run. Question #3: Will productivity growth pick up? Our Answer: Yes, but only cyclically. The structural outlook remains bleak. U.S. nonfarm productivity rose by 1.5% over the prior year in Q3, well above the post-2010 average of 0.8%. This improvement occurred despite the fact that low-skilled workers continue to re-enter the labor market - dragging down output-per-hour in the process - a phenomenon that is not well captured by the official productivity data. Productivity growth elsewhere in the world also appears to be on the upswing (Chart 8). Increased business investment should support productivity in 2018. Corporate surveys indicate that a rising percentage of companies anticipate boosting capital budgets (Chart 9). This often happens in the last few innings of business-cycle expansions, as more companies begin to experience capacity constraints. Chart 8Productivity Growth Showing Signs Of ##br## A Tentative Recovery Chart 9Surveys Are Signaling Acceleration ##br## In Capex Unfortunately, while the cyclical outlook for productivity is improving, the structural backdrop remains downbeat. As we have discussed in the past, flagging educational achievement, decreased creative destruction, and a shift in technological innovation towards consumers and away from businesses all augur poorly for future productivity trends.1 The much-hyped Amazon effect makes for good news stories, but is not borne out by the data.2 Question #4: Will continued strong global growth finally deliver higher inflation? Our answer: Yes, although the increase in inflation will be gradual and concentrated in economies that already have little spare capacity. Chart 10A Pick-Up In Wage Growth Would Put Upward Pressure ##br## On Service Inflation Going into 2017, the Fed had expected core PCE inflation to end the year at 1.9%. It is likely to have finished the year at only 1.5%. We expect core PCE inflation to move toward 2% by the end of 2018. Wage growth should accelerate as the labor market continues to tighten. This should put upward pressure on service inflation (Chart 10). Goods price inflation should also recover due to the lagged effects of a weaker dollar and the bleed-through of higher energy prices into several core components of the CPI (airline fares being a notable example). Slower rent growth will dampen inflation. However, this will be partially offset by higher health care prices. The cost control measures introduced in the Affordable Care Act helped push down PCE health care services inflation from 3% in late 2010 to less than 0.5% in early 2016 (Chart 11). Many of these measures have been realized, and as a consequence, health care inflation has begun to revert to its long-term trend (though in level terms, the savings to consumers remain). The Republican tax bill could put some upward pressure on health care costs. The Congressional Budget Office estimates that the repeal of the Individual Mandate will raise premiums on health care exchanges by 10% because a larger share of healthy individuals will decide to forgo buying health insurance.3 Japanese inflation should move modestly higher in 2018, but from extremely depressed levels. The Japanese unemployment rate is now a full percentage point lower than in 2007 and the ratio of job opening-to-applicants has reached the highest level since 1974 (Chart 12). Chart 11U.S. Inflation Breakdown Chart 12Japan's Tightening Labor Market Euro area inflation will be held down by the lagged effects of a stronger euro and continued high levels of slack across southern Europe. Outside Germany, labor market underutilization is still 6.3 percentage points higher than it was in 2008 (Chart 13). U.K. inflation should edge lower as the spike in import prices stemming from the post-Brexit pound depreciation dissipates. Chart 13There Is Still Labor Market Slack Outside Of Germany Investment Conclusions A shift in global growth leadership back towards the U.S. would benefit the beleaguered U.S. dollar. Higher U.S. inflation will prompt the Fed to raise rates four times in 2018, one more hike than implied by the dots and two more hikes than implied by current market expectations. Rising inflation should also keep Treasury yields on an upward trajectory. We expect the 10-year yield to finish 2018 at around 3%. As long as inflation is rising in response to stronger growth, and from below-target levels, both U.S. and global risk assets should continue to rally. Only once U.S. inflation rises above 2% in 2019, and growth begins to slow on the back of binding supply-side constraints, will equities flounder. Stay long stocks for now, but look to significantly trim exposure towards the end of the year. Regionally, we favor euro area and Japanese equities over U.S. stocks for the next 12 months on a currency-hedged basis. Both the euro area and Japanese stock markets are dominated by large multinational companies whose prospects are geared more towards global growth than demand in their own regions. Above-trend global growth and rising capital spending should disproportionately benefit European and Japanese bourses, given that they have a greater tilt towards cyclically-sensitive companies. Valuations also tend to favor non-U.S. stocks. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Is Slow Productivity Growth Good Or Bad For Bonds?," dated May 31, 2017; Weekly Report, "A Secular Bottom In Inflation," dated July 28, 2017; and Weekly Report, "Is The Phillips Curve Dead Or Dormant?" dated September 22, 2017. 2 Please see Global Investment Strategy Special Report, "Did Amazon Kill The Phillips Curve?" dated September 1, 2017. 3 Please see "Repealing the Individual Health Insurance Mandate: An Updated Estimate," Congressional Budget Office, dated November 8, 2017. Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights A "decision tree" for the allocation to Chinese stocks highlights several key questions for investors over the coming year. The equity allocation decision hinges on the condition of the global economy, the stance of monetary policy, the pace of structural reforms, and the character of the ongoing economic slowdown. Despite several identifiable risks, our "decision tree" suggests that investors should be overweight Chinese vs global stocks. Feature Unlike in past years, BCA's China Investment Strategy service published its 2018 themes report in December, as an addendum to BCA's special year end Outlook report.1 Our final report for 2017 echoed our key themes by recapping some of the most important developments in China last year, as well as their longer-term implications.2 These reports outline our framework for evaluating China's economy in 2018, and will serve as an important reference point over the coming months relating to the pace of China's economic slowdown, policymakers' actions and priorities, and investor attitudes toward Chinese assets. In today's brief report, we begin the New Year by walking through the Chinese equity "decision tree" that flows from the framework that we detailed in our themes piece noted above (Chart 1). The chart presents a set of questions that should be answered over the coming 6-12 months in order to decide on the ideal allocation to Chinese equities within a global portfolio. We elaborate on the decision tree below. Chart 1The Chinese Equity "Decision Tree" Is The Global Economy Slowing Significantly?: Developments in China need to be considered within a global context. We have noted in previous reports that a synchronized global economic slowdown was a key factor behind China's economic slowdown in 2015.3 If global growth were to slow significantly this year, it would bode poorly for the relative performance of Chinese stocks. Next week's report will discuss the evolution of the alpha and beta characteristics of China's investable stock market; while our research is still ongoing, the evidence suggests that Chinese equities in US$ terms have become a high-beta market that would likely suffer in relative terms if the global equity market stumbles. Chart 1 highlights that the appropriate allocation to Chinese equities vs global stocks is underweight if the answer to this first question is yes, with the upgrade/downgrade bias determined simply by whether there has been an appropriate response from Chinese and global policymakers. Is Significant Further Monetary Policy Tightening Likely?: Overly tight monetary policy was the second ingredient that contributed to the 2015 slowdown. Monetary conditions tightened somewhat in the first half of 2017 (Chart 2), but the overall stance is not restrictive. Taken alone, hawkish rhetoric from the PBOC would imply that significant further tightening is imminent. However our sense is that the bark of monetary authorities will be worse than their bite over the coming months, especially since growth momentum and house price appreciation has already peaked. Is The Pace Of Renewed Structural Reforms Likely To Be Aggressive?: October's Party Congress heralded stepped-up reform efforts in 2018 and beyond, which we have highlighted is a risk to a constructive stance towards Chinese stocks. While the "status quo" scenario of no significant reforms is highly unlikely, the intensity of reforms pursued over the coming year will have to be closely monitored by policymakers to avoid a repeat of the 2015 experience. Even if policymakers feel that their threshold for pain will be higher in 2018 than has previously been the case, they are very likely to avoid a significant slowdown as it would raise the risk of returning to the exact set policies that they are trying to turn away from. In other words, an intense pace of reform would risk turning a "two steps forward, one back" situation into a full-blown retreat from structural reform momentum. For now, our China Reform Monitor continues to suggest that reform intensity will be consistent with a rising equity market (Chart 3). Chart 2Chinese Monetary Conditions ##br##Have Tightened Chart 3Investors Don't Believe That Reforms##br## Will Upset The Apple Cart Is The Existing Slowdown In China's Growth Momentum Metastasizing? Our view of China's significant growth slowdown in 2015 suggests that the end of the recent economic "mini-cycle" is likely to be benign and controlled, absent a policy mistake or a major global shock. However, it is possible that the lagged effect of a deceleration in export growth and tighter monetary policy, both of which have already occurred, could cause a broader or deeper slowdown in economic growth beyond what we have already observed. In order to gauge this risk, we tested a wide range of commonly-watched macro data series for signs that they reliably lead economic activity in China,4 using the Li Keqiang index as our proxy for the business cycle. We concluded that measures of money & credit are among the most important predictors, and presented a composite leading indicator of the Li Keqiang index based on six series that passed our test criteria (Chart 4). For now, our indicator suggests that the Chinese economy will continue to slow over the coming months, but that the pace and magnitude of the decline will be benign and controlled. The first question in our decision tree is the easiest to answer: The highly synchronized nature of global economic growth suggests that a significant slowdown is not imminent, even if the pace of growth becomes narrower or slows modestly (Chart 5). While our decision tree highlights that answering "yes" to any of the last three questions means that investors should have a negative bias towards Chinese investable stocks (and should downgrade them in response to a technical breakdown), these questions are still addressing risks rather than probable events. This supports our current recommendation of being overweight Chinese investable equities with a positive bias. Chart 4The Chinese Economy##br## Will Gradually Slow Chart 5No Sign Of A Significant ##br##Global Economic Slowdown As a final point, some investors and market participants have noted that investable Chinese stocks experienced a non-trivial selloff at the end of 2017, with some questioning whether it is a harbinger of a more pronounced economic slowdown. Our answer is no, for two reasons. First, there is some evidence to suggest that the selloff was technical in nature, as the sectors that had experienced the largest gains prior to the selloff also experienced the largest declines (Chart 6). Second, the timing of the relative selloff in Chinese stocks coincided exactly with a relative selloff in the global tech sector (Chart 7), which is strongly indicative of a common, global, factor. But given the underlying strength in the global economy, we regard this event as idiosyncratic and do not view it as a threat to the relative performance of Chinese vs global stocks over the coming year. Chart 6The Late-Year Selloff Was Partially ##br##Driven By Technical Conditions Chart 7Global Tech Also Drove The Selloff##br## In Chinese Relative Performance Bottom Line: While there are several identifiable risks that need to be monitored in 2018, for now our "decision tree" for the relative allocation to Chinese equities suggests that investors should be overweight within a global equity portfolio. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com 1 Please see BCA Special Report, "2018 Outlook - Policy And The Markets: On A Collision Course," dated November 20, 2017, and Weekly Report, "Three Themes For China In The Coming Year", dated December 7, 2017, available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "Legacies Of 2017", dated December 21, 2017, available at cis.bcaresearch.com. 3 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle", dated October 12, 2017, and "China's Economy - 2015 vs Today (Part 1): Trade", dated October 26, 2017, available at cis.bcaresearch.com. 4 Please see China Investment Strategy Special Report, "The Data Lab: Testing The Predictability Of China's Business Cycle", dated November 30, 2017, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights Before re-capping the performance of our recommendations last year - up 77%, led by oil calls, which posted an average gain of 111% - we take a look at what the re-emergence of financial and monetary factors will mean for commodities this year. Fundamentals - supply, demand, inventories - drove the evolution of industrial commodity prices over the past two years, and will remain supportive for oil and, to a lesser degree, base metals in 1H18. Thereafter, in 2H18, we believe financial and monetary variables will begin to re-assert their importance in the evolution of commodity prices. Forecasting commodity prices becomes more difficult, as a result, as it is not clear the Fed or other systematically important central banks, understand what is driving their principal policy variables - particularly inflation - or how they are evolving. Despite these central-bank uncertainties, we remain long broad commodity exposure via the S&P GSCI (up 6.4% since it was recommended in Dec/17), long call spreads in Brent and WTI across 2018 deliveries (up 78%); and long gold (up 6.7%). 2018 Weightings Energy: Overweight. WTI and Brent crude oil forward curves will become more backwardated as the combination of OPEC 2.0 production discipline and continued strength in demand draws inventories lower. This will boost S&P GSCI returns.1 Base Metals: Neutral. Base metals will continue to be supported through 1Q18 by China's environmental reforms, which are reducing supply in the face of continued strength in global demand. Strong demand ex-China will offset weaker Chinese growth, supporting metals prices. Precious Metals: Neutral. While we expect four rate hikes by the Fed this year, we are wary of policy errors at systemically important central banks, which makes forecasting monetary policy highly uncertain. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Still-high supplies outside the corn market; policy uncertainty re NAFTA; and uncertainty over Fed policy likely keep grain prices weak. A stronger USD would weaken demand for U.S.-sourced grains and softs. Feature Chart of the WeekFundamentals Continue To##BR##Support Commodities That was quick! Oil prices are closely hewing to fundamentals as the year opens. We revised our Brent forecast to $67/bbl in early December (up from a $65/bbl forecast in mid-October 2017), based on our fundamental assessment of the market - supply, demand and inventories - and, voilà, contracts for Mar/18 delivery got there by the end of 2017. Our $63/bbl forecast for WTI is still ~ $2.50/bbl from being realized, but we continue to expect this gap to close. At the moment, fundamentals for industrial commodities - oil and, to a slightly lesser extent, base metals - will support firmer prices in 1H18 (Chart of the Week). For oil, this will be an extension of the fundamental realignment initiated by OPEC 2.0 at the end of 2016. The producer coalition agreed to remove ~ 1.1mm b/d from the market, which, along with another 300k to 400k barrels of natural declines, tightened the supply side considerably. On the demand side, the synchronized global economic upturn that powered consumption up by 1.65mm b/d last year, by our estimation, will push demand higher by 1.67mm b/d this year. Supply-side adjustments in base metals, particularly copper, where strikes and natural disasters combined to tighten markets, will be augmented by the ongoing environmental reforms in China (Chart 2). These supply-side effects in industrial commodities occurred against a backdrop of stronger-than-expected economic growth worldwide last year - the first such upturn since the Global Financial Crisis (GFC) in 2008 (Chart 3). Chart 2Fundamentals Supported Metals Chart 3Global Upturn Powers Commodity Demand We expect this to continue. Part of the recovery in aggregate demand worldwide can be attributed to the massive monetary stimulus by systematically important central banks - led by the Fed, the ECB and BoJ. Lower energy prices last year, which acted like a tax cut, put more discretionary income in consumers' hands and also boosted aggregate demand.2 Monetary Policy Will Re-Assert Itself Chart 4The USD Will Re-Emerge As A##BR##Driver Of Commodity Prices The influence of monetary policy - chiefly how the Fed's actions affect the USD - has been de minimis over the past two years relative to fundamentals, which have driven price formation in industrial commodities (Chart 4). While the Fed raised its policy rate 3 times last year, monetary conditions remained relatively loose in the U.S., which was supportive of commodity prices. Looser monetary conditions kept the USD better offered than other major currencies in 4Q17, which allowed gold prices to recover late in the year. A weaker USD also supported grain markets, which also have staged a somewhat subdued recovery following a mid-2017 sell-off. For at least 1H18, we see commodities generally continuing to be supported by strong fundamentals and relatively accommodative monetary policy globally, even with the Fed lifting its policy rate as many as four times this year, per our House view. Inflation Pressures Could Start Building By 2H18, inflationary pressures could start to build: In the U.S., tax cuts coupled with fiscal stimulus from the federal government in the form of disaster relief and higher discretionary spending - could add ~ 0.5% to GDP growth this year, based on calculations by BCA's Global Investment Strategy team (Chart 5).3 This should, all else equal, increase demand for labor and push the U.S. unemployment rate lower, lifting wages, inflation and inflation expectations in turn (Chart 6). At least that's how it's supposed to work. Our colleagues in BCA Research's U.S. Bond Strategy note, the "dichotomy between stronger growth and a tight labor market on the one hand and low inflation on the other gets to the heart of the first big challenge that incoming Fed Chairman Jay Powell will face next year. Specifically, how much faith should the Fed have in its framework for forecasting inflation? Chart 5U.S. Inflation Is Ticking Higher Chart 6Still Waiting On The Phillips Curve "... Janet Yellen's Phillips Curve model of core inflation does not explain this year's decline.1 It also shows that inflation is close to 0.5% below fair value, almost the largest deviation since 1995."4 We're inclined to agree with former Fed Chair Ben Bernanke on this. In 2016, he noted that, given the years-long stretch of errors in forecasting key economic variables - output, unemployment and the Fed funds rate - "Fed-watchers should probably focus on incoming data and count a bit less on Fed policymakers for guidance."5 This is a mixed blessing (or curse) for commodity markets: Increased economic activity raises demand for commodities, so at least in 1H18, and most likely for the second half as well, commodity demand will remain well supported globally. If we do get higher inflation, the Fed likely would feel it could lean into its rate-normalization with greater vigor, and start guiding to more frequent or bigger rate hikes. If we don't see higher inflation - if, as Chicago Fed President Charles Evans fears, inflation expectations have been marked down in a meaningful way - and the Fed cannot justify further rate hikes, we could see the real side of the global economy take another leg higher, lifting commodity demand in the process.6 This is the big issue for the coming year. We cannot say at this point how it plays out, which is why we recommend commodity investors remain in tactical mode, as we did a year ago. Recapping 2017's Recommendations Our trade recommendations were up an average of 77% last year, led by a 111% gain in our oil calls. This was a touch better than the 95% average gain we posted on our oil recommendations in 2016 (Table 1). Table 1Average Quarterly Returns 2017 Without a doubt, most of our recommendations were in the oil markets, as the accompanying tables show, and we maintained an exposure of one sort or another in oil throughout the year (Table 2). Table 2Trades Closed In 2017 The big drivers of our view in oil markets were fundamentals: On the supply side, we maintained the view OPEC 2.0 would not waver in its commitment to draining global storage levels, particularly in the OECD commercial inventories via supply reductions. On the demand side, by mid-2017, it became apparent to us the big data providers - the U.S. EIA and the IEA in Paris - and most of the sell-side analysts were underestimating demand. Information flows during 1H17 were often contradictory, which injected enormous volatility in crude-oil spread markets - particularly the calendar spreads trading markets employ to take a view on the shape of the forward curve (e.g., long a near-term futures contract like Dec/17 Brent, vs. short a deferred delivery contract like Dec/18). This intense volatility drove us toward the relative safety of call-option spreads in 2H17, where the risk of loss is limited to the net premium paid for the call spread. As we did last year, we constructed an information ratio (IR) to determine whether the additional volatility produced by our recommendations was adequately compensated for by the returns (simple percent changes of the opening level for a recommendation vs. the closing level). Our IR uses the S&P GSCI as a benchmark, given it has a relatively high weight in energy-related exposures. Our ratio looks at the average excess return of the active portfolio against this benchmark. This average excess return is divided by its standard deviation (also referred to as the tracking error volatility) in order to generate a risk-adjusted metric to measure returns on our recommendations relative to the risk we took to generate them. BCA's IR thus is calculated as: The higher the IR, the better the risk-adjusted relative performance of the portfolio. Three elements can explain a high IR: High returns in the portfolio; low returns in the benchmark, or low tracking error volatility. Hence, this measure provides a numeric value to analyze the risk-reward trade-off; it tells us whether or not the risk assumed in our trades was compensated for by larger returns. Viewing our energy recommendations as a portfolio over the course of 2017, our average return was 111%, while the GSCI return was 5.8%. The tracking error volatility was 112%.7 Using these inputs, the IR of our recommendations was 0.94. While not as stellar as our 2016 IR of 1.47, this risk-adjusted return is still stout, and indicates the consistent positive excess returns of our portfolio relative to passive GSCI exposure compensated for the high volatility of those returns. Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Research Analyst HugoB@bcaresearch.com 1 OPEC 2.0 is the name we've given the OPEC + non-OPEC producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia. 2 For a summary of our 2018 outlooks, please see BCA Research's Commodity & Energy Strategy Weekly Report "Oil Fundamentals Remain Bullish Heading Into 2018," published on December 21, 2017, and "Opposing Forces: Stay Neutral Metals In 2018" in the same issue. It is available at ces.bcaresearch.com. 3 Please see BCA Research's Global Investment Strategy Weekly Report, "Don't Fear A Flatter Yield Curve," published December 22, 2017. It is available at gis.bcaresearch.com. 4 Please see BCA Research's U.S. Bond Strategy Weekly Report, "Ill Placed Trust?," published December 19, 2017. It is available at usbs.bcaresearch.com. 5 Please see "The Fed's shifting perspective on the economy and its implications for monetary policy," by Ben S. Bernanke, published by the Brookings Institution on its website August 8, 2016. 6 Please see "All Talk, Few Answers From FOMC for Yellen's Long Inflation Miss," published by bloomberg.com on January 3, 2018. 7 Note: In order to find the standard deviation of the portfolio's excess returns (tracking error volatility), we averaged the daily percentage change in each trade's underlying assets. Any given trade only weighed in the daily average return if it was open during that day of the year. We are not accounting for the type of trades (spreads, pairs or single trades), we only track the underlying asset returns. From these daily average returns we subtracted the daily return of the preferred benchmark to obtain the daily excess return. Using this, we computed an historical standard deviation (based on 20-day periods) for every day during which a trade was open in our portfolio (we had 224 days with at least one energy trade opened). Lastly, we annualized this standard deviation to obtain our tracking-error volatility. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in 2017

Feature Chilean stocks have surged recently following the victory of conservative businessman Sebastian Pinera in the presidential elections. Odds are that we could be witnessing the beginning of a period of Chilean outperformance against the EM equity benchmark, rather than just a short-term political relief rally. Pieces have fallen into place to produce a re-rating in Chilean equities relative to other emerging markets, as illustrated by the top panel of Chart I-1. The cyclically adjusted P/E ratio shows that Chilean stocks are cheap relative to their EM peers. Furthermore, Chilean stocks in common currency terms are presently near a 20-year bottom relative to EM equities (Chart I-1, bottom panel). Hence, just from a mean reversion perspective, Chile's performance relative to EM stocks has the potential to rise. Besides the above points, Chile's business cycle and monetary policy also warrant this bourse's outperformance versus the EM benchmark. A Sweet Spot For Equities There are several signs that the business cycle has passed its bottom and is slowly recovering (Chart I-2). Chart I-1Chilean Stocks Relative To EM Chart I-2Chilean Economy Is Reviving... Moreover, there are also several factors that will lead the Central Bank of Chile (CBC) to keep monetary policy easy for the coming 6-12 months. This will create a sweet spot for share prices where economic growth starts to pick up but the central bank does not tighten. Capital expenditures in real terms and the bank loan impulse to corporations - the second derivative of outstanding commercial loans - might have bottomed although they are still very weak (Chart I-3, top panel). Furthermore, residential and non-residential construction starts are still shrinking while the improvement in the housing loan impulse seems to be stalling (Chart I-3, bottom panel). This suggests that the capex and credit cycles - the two most interest rate-sensitive segments of the economy - remain feeble, justifying low interest rates for a while. Most importantly, there are no signs of inflationary pressures: the output gap is negative and widening, which historically has led to falling core inflation (Chart I-4). Chart I-3...But Interest Rate Sensitive Sectors Are Still Weak Chart I-4Chile: The Output Gap And Inflation A wide range of inflation measures - consumer services and trimmed mean inflation rates - are low and remain in a downtrend (Chart I-5). The key driver and measure of underlying genuine inflation is wages. Overall and key sectors' wage growth are either slowing or muted (Chart I-6). Chart I-5Chile: Inflation Is Low Chart I-6Chile: Wage Growth Is Tame Notably, the number of unemployed people is still rising while the number of job vacancies has plummeted to very low levels (Chart I-7). This heralds low wage growth and disinflationary pressures ahead. Chilean local rates, unlike high-yielding EM local fixed-income markets, will not rise if commodities prices relapse and the Chilean peso depreciates. On the contrary, the CBC can and probably will cut interest rates if the economic recovery is endangered. Therefore, we expect money supply in Chile to continue outgrowing the same measure for aggregate EM. This tends to help Chilean stocks outperform the EM equity benchmark (Chart I-8). Chart I-7Chile: A Lot Of Slack In Labor Market Chart I-8Upgrade Chilean Stocks Versus EM Finally, the health of the Chilean banking system is better than that of some other EM peers as the former is well provisioned and not exposed to foreign currency risk. This will also help this equity market to outperform. As to absolute performance in U.S. dollar terms, it depends on copper prices and the trend in EM absolute performance. Our base case remains that copper prices will relapse due to a deceleration in Chinese capital expenditures in general and construction (both infrastructure and property development) in particular (Chart I-9). This will drive both the Chilean peso (and probably equity prices) down. In a nutshell, the equity valuations in absolute terms are neutral. Chart I-10 illustrates that the cyclically adjusted P/E ratio for the MSCI Chile index is 21, around its fair value. Barring a reversal in EM risk assets (which we expect to start sooner rather than later), share prices could rise further. Chart I-9Downside Risks To Copper Prices Chart I-10Chile: Cyclically-Adjusted P/E Ratio Investment Conclusions We recommend EM dedicated equity investors to upgrade their allocation to Chile from neutral to overweight. The macro backdrop favors Chilean assets over their emerging markets peers. As such we recommend an overweight allocation in equity and corporate credit portfolios within their respective EM benchmarks. Can Chilean stocks outperform EM when copper prices fall? Chart I-11 suggests yes: historically there were periods when copper prices and Chile's relative equity performance versus EM were not correlated or even negatively correlated. Hence, our decision to upgrade Chilean stocks to an overweight while being negative on copper prices is not inconsistent. Chart I-11Copper Prices & Chilean Equities Versus EM: Not Always Positively Correlated For absolute return investors, the risk-reward profile for Chilean assets is not attractive if our baseline negative view on EM and industrial commodities prices plays out. Finally, we have been recommending to complement a short position in copper with a long leg in the Chilean peso. This allows traders to earn a bit of carry while waiting for copper prices to gap down. The CLP has lagged the recent spike in copper prices but we reiterate this position as risks to copper prices remain to the downside over the next six months. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Special Report

Highlights The Li Keqiang Index (LKI) is particularly relevant for global investors, who are most concerned with China's investable stock performance and the country's impact on global exports. BCA's view is that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. U.S. financial assets tend to perform better when the LKI is rising, than when it is decelerating. Correlations between China's economy and the S&P 500 have increased in the past few decades. Feature In the past three months, BCA's China Investment Strategy team has significantly heightened its focus on the cyclical condition of China's economy. Our colleagues presented their framework for tracking the end of China's mini-cycle in an October Weekly Report.1 This was followed by a two-part report that examined the key differences between China today and mid-20152 when the economy operated below what investors and market participants considered a stable pace of growth. These articles were anchored by BCA's view that in 2015 China's economy suffered from a double whammy: a weak external demand environment and overly tight monetary conditions. In a Special Report released in late November, BCA's China Investment Strategy took a different approach to gauge the slowdown in China's economy. The strategist tested a wide range of commonly watched macro data series for signs that reliably lead economic activity.3 The study surprisingly showed that measures of money and credit have been the most reliable predictors of China's economy since 2010. A composite leading indicator of these predictors suggests that the country's economy will continue to slow in the coming months. However, the pace and magnitude of the decline are consistent with BCA's view that China will experience a benign, controlled deceleration, and will not repeat its 2015 uncontrolled slowdown. A Brief Methodological Overview We provide a brief overview of our approach and address two questions: what are we trying to predict and what series do we use as predictors,4 to explain the Chinese business cycle? What are we trying to predict? We use the Li Keqiang Index (LKI) as a proxy for China's business cycle for three reasons: Despite the potential to become a consumer-oriented society, the economy remains highly geared to investment (and the industrial sector). Investors are familiar with the LKI since a 2007 U.S. diplomatic cable (leaked in late-2010) quoted Li, then Communist Party Secretary of Liaoning, telling U.S. Ambassador Randt that China's GDP figures were man-made and unreliable. Li's focus on electricity consumption, rail cargo volume and bank loans subsequently became a standard metric for China analysts. Most importantly, we use the LKI as a proxy because it continues to provide key information about China's economy. Chart 1 highlights that LKI leads China's nominal import growth. The index is particularly relevant for global investors who are concerned with China's investable stock performance and the country's impact on global exports. Chart 1The Li Keqiang Index Predicts Chinese Import Growth What series were used in our approach? To test the predictability of China's business cycle, we compiled a list of 40 highly tracked macroeconomic variables (presented in Appendix Table 1) and grouped them into six categories: Economy-wide measures, such as composite LEIs and models of GDP growth. Measures related to investment and the corporate sector, such as PMIs, fixed-asset investment and industrial production. Variables related to the consumer sector, such as consumer confidence, retail sales and the employment component of official PMIs. Housing indicators, such as house price indexes and residential floor space sold. Government spending. A variety of measures including money, credit and financial conditions. All series, including the LKI, were smoothed with a three-month moving average. The exception was government spending, which was smoothed with a six-month average. Chart 2Measures Of Money & Credit Are ##br## The Best Predictors Of The LKI Money And Credit: Results From The Data Lab Chart 2 presents the average correlation profiles for the six data categories described above, alongside the ideal profile. The chart allows us to draw several important conclusions: First, it highlights that while economy-wide measures and those related to investment and the corporate sector tended to have a high correlation with the LKI, their correlation profiles lag rather than lead. In other words, the LKI predicts these variables, not vice versa. The Markit/Caixin and NBS manufacturing PMIs are notable exceptions. Furthermore, variables related to both consumer spending and government expenditures appear to have little ability to predict China's business cycle. In the case of government spending, the evidence suggests that the LKI reliably leads expenditures by approximately a year. This implies that fiscal policy in China is responsive and countercyclical (but not leading). Finally, measures of money and credit, and housing to a lesser degree, appear to fulfill our first two criteria to be good leading indicators of the LKI. Both profiles peak in advance of t=0, and at least in the case of money and credit, have a strong relationship (Chart 2). BCA's results show that it is more accurate to state that money supply measures cause the LKI than vice versa, which means that money growth should be closely watched as an economic indicator. Chart 3 presents a composite leading indicator for the LKI based on the six variables presented above. The indicator is advanced by four months and suggests that the LKI will retrace about 50% of its rise from late-2015 to early-2017. This is consistent with our call that China's economy will experience a benign, controlled deceleration. An additional factor that strengthens our conviction is that the weakest components of the indicator on a year-over-year basis, M2 and M3 (as defined by BCA's Emerging Markets Strategy service), have increased more rapidly in the past three months (Chart 4). Chart 3Our Composite LKI Indicator Suggests ##br## A Benign Slowdown In Growth Chart 4Money Supply Growth ##br## Has Recently Rebounded BCA's stance is that investors should remain overweight Chinese investable stocks relative to the EM and global benchmarks. However, what does a retracement of the LKI and a slowdown in China's economy mean for U.S. asset classes? Charts 5 and 6 and Tables 1 and 2 show how several key financial markets have performed in periods when the LKI decelerated and accelerated. Chart 5Performance Of U.S. Financial Assets As The LKI DeceleratesChart 6Performance Of U.S. Financial Assets As The LKI AcceleratesTable 1Performance Of U.S. Financial Assets As The LKI DeceleratesTable 2Performance Of U.S. Financial Assets As The LKI Accelerates The Implications For U.S. Assets U.S. risk assets tend to perform better when the LKI accelerates. BCA has identified seven episodes since 1988 when the LKI slowed (Table 1) and an equal number when the LKI climbed (Table 2). The median returns for the S&P 500, high-yield and investment-grade corporates, small caps, gold, and oil, are all higher when the LKI speeds up. However, the dollar is apt to fall when the LKI accelerates and S&P 500 EPS growth is only one third as fast when the LKI gathers speed versus when the LKI is decelerating. The improved performance of U.S. risk assets when the LKI climbs is noteworthy, given that three U.S. recessions overlap with intervals of escalating LKI, and only one of seven phases of falling LKI intersects with an economic downturn in the U.S. There are pitfalls using LKI data before 2000. The basic structure of China's economy has shifted several times since the late 1980s. This first occurred during the early-to-mid-2000s as China transitioned from its rural roots to a manufacturing and export-led economy. In 2010, Chinese growth slowed as the government guided the economy toward a more consumer-led profile. Nonetheless, even if we exclude the pre-2000 interval, we draw the same conclusions about the performance of U.S. assets as the LKI picks up the pace and slows down. The LKI provided an excellent roadmap for U.S. assets from 2013-2017. The LKI index lost speed as the dollar rose, and oil prices peaked and then rolled over in late 2013 through September 2015. Then it began to reaccelerate in September 2015, five months before oil prices and U.S. equities prices bottomed in early 2016, and moved higher through early 2017. BCA's stock-to-bond ratio, the S&P 500, investment-grade and high-yield bonds, all performed better from September 2015 through early 2017 than in the 2013-2016 episode. As the LKI picked up pace between 2015 and 2017, the performance of small caps, gold, S&P 500 earnings growth and oil were also better than during the 2013-2015 timeframe when the LKI was in a lull. Rising Correlations The S&P 500 has become more sensitive to China's economy over time. Chart 7 presents the relationship between year-over-year shifts in the LKI and annual changes in the S&P 500 in three different eras: Chart 7Correlations Between LKI And S&P 500 Since 2000 2000-2005, as China entered the world stage as an economic power after joining the WTO in the early 2000s; 2005 through 2007, after China revalued the yuan, but before the onset of the Great Recession; and 2007-2009, during and immediately following the Great Recession. It is difficult to find any positive correlation between the LKI and the S&P 500 in the early 2000s. However, a relationship began unfolding between 2005 and 2007, and from 2007 to 2009, the positive connection became even more defined. Many asset classes were highly correlated during and just after 2009, but the jump in the correlation between 2005-2007 and 2007-2009 is unmistakable. More recently (2009-present) the link weakened slightly, but it remains stronger than in the 2000-2007 period (not shown). The rise in foreign earnings as a share of total S&P 500 profits in recent years helps to explain the stronger link between China and U.S. equities. China has become a key driver of globally-sourced earnings as China share of global GDP has risen in the past two decades. Bottom Line: China's economy and financial markets play a much more critical role in the performance of U.S. financial assets than in the recent past. History suggests that U.S. assets perform better when the LKI picks up speed. However, BCA's stance is that the LKI is poised to decelerate modestly. This is consistent with our view that China's economy will experience a benign, controlled slowdown and not a sudden downturn, such as in late 2015 and early 2016. History suggests that U.S. assets perform better when the LKI is accelerating, not decelerating. John Canally, CFA, Senior Vice President U.S. Investment Strategy johnc@bcaresearch.com Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Appendix Appendix Table 1List Of Macroeconomic Data Series Included In Our Study 1 Please see China Investment Strategy Weekly Report, "Tracking The End Of China's Mini-Cycle," published October 12, 2017. Available at cis.bcaresearch.com. 2 Please see China Investment Strategy Weekly Report, "China's Economy - 2015 Vs. Today (Part II): Monetary Policy", published November 9, 2017. Available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report, "The Data Lab: Testing the Predictability Of China's Business Cycle," published November 30, 2017. Available at cis.bcaresearch.com. 4 The original China Investment Strategy Special Report also explains how we judge which series are "useful" in explaining the Chinese business cycle.

Special Report

2018 is a pivotal year for China, as it will set the trajectory for President Xi Jinping's second term ... and he may not step down in 2022. Poverty, inequality, and middle-class angst are structural and persistent threats to China's political stability. The new wave of the anti-corruption campaign is part of Xi's attempt to improve governance and mitigate political risks. Yet without institutional checks and balances, Xi's governance agenda will fail. Without pro-market reforms, investors will face a China that is both more authoritarian and less productive. Hearts rectified, persons were cultivated; persons cultivated, families were regulated; families regulated, states were rightly governed; states rightly governed, the whole world was made tranquil and happy. - Confucius, The Great Learning Comparisons of modern Chinese politics with Confucian notions of political order have become cliché. Nevertheless, there is a distinctly Confucian element to Chinese President Xi Jinping's strategy. Xi's sweeping anti-corruption campaign, which will enter "phase two" in 2018, is essentially an attempt to rectify the hearts and regulate the families of Communist Party officials and civil servants. The same could be said for his use of censorship and strict ideological controls to ensure that the general public remains in line with the regime. Yet Xi is also using positive measures - like pollution curbs, social welfare, and other reforms - to win over hearts and minds. His purpose is ultimately the preservation of the Chinese state - namely, the prevention of a Soviet-style collapse. Only if the regime is stable at home can Xi hope to enhance the state's international security and erode American hegemony in East Asia. This would, from Beijing's vantage, make the whole world more tranquil and happy. Thus, for investors seeking a better understanding of China in the long run, it is necessary to look at what is happening to its governance as well as to its macroeconomic fundamentals and foreign relations.1 China's greatest vulnerability over the long run is its political system. Because Xi Jinping's willingness to relinquish power is now uncertain, his governance and reform agenda in his second term will have an outsized impact on China's long-run investment outlook. The Danger From Within From 1978-2008, the Communist Party's legitimacy rested on its ability to deliver rising incomes. Since the Great Recession, however, China has entered a "New Normal" of declining potential GDP growth as the society ages and productivity growth converges toward the emerging market average (Chart II-1). In this context, Chinese policymakers are deathly afraid of getting caught in the "middle income trap," a loose concept used to explain why some middle-income economies get bogged down in slower growth rates that prevent them from reaching high-income status (Chart II-2).2 Chart II-1The New Normal Chart II-2Will China Get Caught In The Middle-Income Trap? Such a negative economic outcome would likely prompt a wave of popular discontent, which, in turn, could eventually jeopardize Communist Party rule. The quid pro quo between the Chinese government and its population is that the former delivers rising incomes in exchange for the latter's compliance with authoritarian rule. The party is not blind to the fate of other authoritarian states whose growth trajectory stalled. The threat of popular unrest in China may seem remote today. The Communist Party is rallying around its leader, Xi Jinping; the economy rebounded from the turmoil of 2015 and its cyclical slowdown in recent months is so far benign; consumer sentiment is extremely buoyant; and the global economic backdrop is bright (Chart II-3). Yet these positive political and economic developments are cyclical, whereas the underlying political risks are structural and persistent. China has made massive gains in lifting its population out of poverty, but it is still home to 559 million people, around 40% of the population, living on less than $6 per day, the living standard of Uzbekistan. It will be harder to continue improving these workers' quality of life as trend growth slows and the prospects for export-oriented manufacturing dry up. This is why the Xi administration has recently renewed its attention to poverty alleviation. The government is on target in lifting rural incomes, but behind target in lifting urban incomes, and urban-dwellers are now the majority of the nation (Chart II-4). The plight of China's 200-250 million urban migrants, in particular, poses the risk of social discontent. Chart II-3China's Slowdown So Far Benign Chart II-4Urban Income Targets At Risk Moreover, while China knows how to alleviate poverty, it has less experiencing coping with the greatest threat to the regime: the rapid growth of the middle class, with its high expectations, demands for meritocracy and social mobility, and potential for unrest if those expectations are spoiled (Chart II-5). Democracy is not necessarily a condition for reaching high-income status, but all of Asia's high-income countries are democracies. A higher level of wealth encourages household autonomy vis-à-vis the state. Today, China has reached the $8,000 GDP per capita range that often accompanies the overthrow of authoritarian regimes.3 The Chinese are above the level of income at which the Taiwanese replaced their military dictatorship in 1987; China's poorest provinces are now above South Korea's level in that same year, when it too cast off the yoke of authoritarianism (Chart II-6). Chart II-5The Communist Party's Greatest Challenge Chart II-6China's Development Beyond Point At Which Taiwan And Korea Overthrew Dictatorship This is not an argument for democracy in China. We are agnostic about whether China will become democratic in our lifetime. We are making a far more humble point: that political risk will mount as wealth is accumulated by the country's growing middle class. Several emerging markets - including Thailand, Malaysia, Turkey and Brazil - have witnessed substantial political tumult after their middle class reached half of the population and stalled (Chart II-7). China is approaching this point and will eventually face similar challenges. Chart II-7Middle Class Growth Troubles Other EMs The comparison reveals that an inflection point exists for a society where the country's political establishment faces difficulties in negotiating the growing demands of a wealthier population. As political scientists have shown empirically, the very norms of society evolve as wealth erodes the pull of Malthusian and traditional cultural variables.4 Political transformation can follow this process, often quite unexpectedly and radically.5 Clearly the Chinese public shows no sign of large-scale, revolutionary sentiment at the moment. And political opposition does not necessarily result in regime change. Nevertheless, it is empirically false that the Chinese people are naturally opposed to democracy or representative government. After all, Sun Yat Sen founded a Republic of China in 1912, well before many western democratic transformations! And more to the point, the best survey evidence shows that the Chinese are culturally most similar to their East Asian neighbors (as well as, surprisingly, the Baltic and eastern European states): this is not a neighborhood that inherently eschews democracy. Remarkably, recent surveys suggest that China's millennial generation, while not wildly enthusiastic about democracy, is nevertheless more enthusiastic than its peers in the western world's liberal democracies (Chart II-8)! Chart II-8Chinese People Not Less Fond Of Democracy Than Others China is also home to one of the most reliable predictors of political change: inequality. China's economic boom is coincident with the rise of extreme inequalities in income, wealth, region, and social status. True, judging by average household wealth, everyone appears to be a winner; but the average is misleading because it is pulled upward by very high net worth individuals - and China has created 528 billionaires in the past decade alone. A better measure is the mean-to-median wealth ratio, as it demonstrates the gap that opens up between the average and the typical household. As Chart II-9 demonstrates, China is witnessing a sharp increase in inequality relative to its neighbors and peers. More standard measures of inequality, such as the Gini coefficient, also show very high readings in China. And this trend has combined with social immobility: China has a very high degree of generational earnings elasticity, which is a measure of the responsiveness of one's income to one's parent's income. If elasticity is high, then social outcomes are largely predetermined by family and social mobility is low. On this measure, China is an extreme outlier - comparable to the U.S. and the U.K., which, while very different economies, have suffered recent political shocks as a result of this very predicament (Chart II-10). Chart II-9Inequality: A Severe Problem In China Chart II-10China An Outlier In Inequality And Social Immobility "China does not have voters" unlike the U.S. and U.K., is the instant reply. Yet that statement entails that China has no pressure valve for releasing pent-up frustrations. Any political shock may be more, not less, destabilizing. In the U.S. and the U.K., voters could release their frustrations by electing an anti-establishment president or abrogating a trade relationship with Europe. In China, the only option may be to demand an "exit" from the political system altogether. Note that there is already substantial evidence of social unrest in China over the past decade. From 2003 to 2007, China faced a worrisome increase in "mass incidents," at which point the National Bureau of Statistics stopped keeping track. The longer data on "public incidents" suggests that the level of unrest remains elevated, despite improvements under the Xi administration (Chart II-11). Broader measures tell a similar story of a country facing severe tensions under the surface. For instance, China's public security spending outstrips its national defense spending (Chart II-12). Chart II-11Chinese Social Unrest Is Real Chart II-12China Spends More On ##br##Domestic Security Than Defense In essence, Chinese political risk is understated. This conclusion may seem counterintuitive, given Xi's remarkable consolidation of power. But is ultimately structural factors, not individual leaders, that will carry the day. The Communist Party is in a good position now, but its leaders are all-too-aware of the volcanic frustrations that could be unleashed should they fail to deliver the "China Dream." This is why so much depends upon Xi's policy agenda in the second half of his term. To that question we will now turn. Bottom Line: The Communist Party is at a cyclical high point of above-trend economic growth and political consolidation under a strongman leader. However, political risk is understated: poverty, inequality, and middle-class angst are structural and persistent and the long-term potential growth rate is slowing. If we assume that China is not unique in its historical trajectory, then we can conclude that it is approaching one of the most politically volatile periods in its development. Chart II-13Xi's Anti-Corruption Campaign The Governance And Reform Agenda Since coming to office in 2012-13, President Xi has spearheaded an extraordinary anti-corruption campaign and purge of the Communist Party (Chart II-13). The campaign has understandably drawn comparisons to Chairman Mao Zedong's Cultural Revolution (1966-76). Yet these are not entirely fair, as Xi has tried to improve governance as well as eradicate his enemies. As Xi prepares for his "re-election" in March 2018, he has declared that he will expand the anti-corruption campaign further in his second term in office: details are scant, but the gist is that the campaign will branch out from the ruling party to the entire state bureaucracy, on a permanent basis, in the form of a new National Supervision Commission.6 There are three ways in which this agenda could prove positive for China's long-term outlook. First, the regime clearly hopes to convince the public that it is addressing the most burning social grievances. Corruption persistently ranks at the top of the list, insofar as public opinion can be known (Chart II-14). Public opinion is hard to measure, but it is clear that consumer sentiment is soaring in the wake of the October party congress (see Chart II-3 above). It is also worth noting that the Chinese public's optimism perked up in Xi's first year in office, when the policy agenda on offer was substantially the same and the economy had just experienced a sharp drop in growth rates (Chart II-15). Reassuring the public over corruption will improve trust in the regime. Chart II-14Chinese Public Grievances Chart II-15Anti-Corruption Is Popular Chart II-16Productivity Requires Institutional Change Second, the anti-corruption campaign feeds into Xi's broader economic reform agenda. Productivity growth is harder to generate as a country's industrialization process matures. With the bulk of the big increases in labor, capital, and land supply now complete in China, the need to improve total factor productivity becomes more pressing (Chart II-16). Unlike the early stages of growth, this requires reaching the hard-to-get economic conditions, such as property rights, human capital, financial deepening, entrepreneurship, innovation, education, technology, and social welfare. On this count, the Xi administration's anti-corruption campaign has been a net positive. The most widely accepted corruption indicators suggest that it has made a notable improvement to the country's governance. Yet the country remains far below its competitors in the absolute rankings, notably its most similar neighbor Taiwan (Chart II-17 A&B). The institutionalization of the campaign could thus further improve the institutional framework and business environment. Chart II-17AAnti-Corruption Campaign Is A Plus... Chart II-17B...But There's A Long Way To Go Third, the anti-corruption campaign can serve as a central government tool in enforcing other economic reforms. Pro-productivity reforms are harder to execute in the context of slowing growth because political resistance increases among established actors fighting to preserve their existing advantages. If the ruling party is to break through these vested interests, it needs a powerful set of tools. Recently, the central government in Beijing has been able to implement policy more effectively on the local level by paving the way through corruption probes that remove personnel and sharpen compliance. Case in point: the use of anti-corruption officials this year gave teeth to environmental inspection teams tasked with trimming overcapacity in the industrial sector (Chart II-18). And there are already clear signs that this method will be replicated as financial regulators tackle the shadow banking sector.7 Chart II-18Reforms Cut Steel Capacity, ##br##Reduced Need For Scrap These last examples - financial and environmental regulatory tightening - are policy priorities in 2018. The coercive aspect of the corruption probes should ensure that they are more effective than they would otherwise be. And reining in asset bubbles and reducing pollution are clear long-term positives for the regime. Ideally, then, Xi's anti-corruption campaign will deliver three substantial improvements to China's long-term outlook: greater public trust in the government, higher total factor productivity, and reduced systemic risks. The administration hopes that it can mitigate its governance deficit while improving economic sustainability. In this way it can buy both public support and precious time to continue adjusting to the new normal. The danger is that these policies will combine to increase downside risks to growth in the short term.8 Bottom Line: Xi's anti-corruption campaign is being expanded and institutionalized to cover the entire Chinese administrative state. This is a consequential campaign that will take up a large part of Xi's second term. It is the administration's major attempt to mitigate the socio-political challenges that await China as it rises up the income ladder. Absolute Power Corrupts Absolutely? The problem, however, is that Xi may merely use the anti-corruption campaign to accrue more power into his hands. As is clear from the above, Xi's governance agenda is far from impartial and professional. The anti-corruption campaign is being used not only to punish corrupt officials but also to achieve various other goals. Xi has even publicly linked the campaign to the downfall of his political rivals.9 In essence, the campaign highlights the core contradiction of the Xi administration: can Xi genuinely improve China's governance by means of the centralization and personalization of power? Chart II-19China's Governance Still Falls Far Behind Over the long haul, the fundamental problem is the absence of checks and balances, i.e. accountability, from Xi's agenda. For instance, the National Supervision Commission will be granted immense powers to investigate and punish malefactors within the state - but who will inspect the inspectors? Xi's other governance reforms suffer the same problem. His attempt to create "rule of law" is lacking the critical ingredients of judicial independence and oversight. The courts are not likely to be able to bring cases against the party, central government, or powerful state-owned firms, and they will not be able to repeal government decisions. Thus, as many commentators have noted, Xi's notion of rule of law is more accurately described as "rule by law": the reformed legal system will in all probability remain an instrument in the hands of the Communist Party. Likewise, Xi's attempt to grant the People's Bank of China greater powers of oversight in order to combat systemic financial risk suffers from the fact that the central bank is not independent, and will remain subordinate to the State Council, and hence to the Politburo Standing Committee. This is not even to mention the lamentable fact that Xi's campaign for better governance has so far coincided with extensive repression of civil society, which does not mesh well with the desire to improve human capital and innovation.10 Thus it is of immense importance whether Xi sets up relatively durable anti-corruption, legal, and financial institutions that will maintain their legitimate functions beyond his term and political purposes. Otherwise, his actions will simply illustrate why China's governance indicators lag so far behind its peers in absolute terms. Corruption perceptions may improve further, but there will be virtually no progress in areas like "voice and accountability," "political stability and absence of violence," "rule of law," and "regulatory quality," each of which touches on the Communist Party's weak spots in various ways (Chart II-19). Analysis of the Communist Party's shifting leadership characteristics reinforces a pessimistic view of the long run if Xi misses his current opportunity.11 The party's top leadership increasingly consists of career politicians from the poor, heavily populated interior provinces - i.e. the home base of the party. Their educational backgrounds are less scientific, i.e. more susceptible to party ideology. (Indeed, Xi Jinping's top young protégé, Chen Miner, is a propaganda chief.) And their work experience largely consists of ruling China's provinces, where they earned their spurs by crushing rebellions and redistributing funds to placate various interest groups (Chart II-20). While one should be careful in drawing conclusions from such general statistics, the contrast with the leadership that oversaw China's boldest reforms in the 1990s is plain. Chart II-20China's Leaders Becoming More 'Communist' Over Time Bottom Line: Xi's reform agenda is contradictory in its attempt to create better governance through centralizing and personalizing power. Unless he creates checks and balances in his reform of China's institutions, he is likely to fall short of long-lasting improvements. The character profiles of China's political elite do not suggest that the party will become more likely to pursue pro-market reforms in Xi's wake. Xi Jinping's Choice Xi is the pivotal player because of his rare consolidation of power, and 2018 is the pivotal year. It is pivotal because it will establish the policy trajectory of Xi's second term - which may or may not extend into additional terms after 2022. So far, the world has gained a few key takeaways from Xi's policy blueprint, which he delivered at the nineteenth National Party Congress on October 18: Xi has consolidated power: He and his faction reign supreme both within the Communist Party and the broader Chinese state; Xi's policy agenda is broadly continuous: Xi's speech built on his administration's stated aims in the first five years as well as the inherited long-term aims of previous administrations; China is coming out of its shell: In the international realm, Xi sees China "moving closer to center stage and making greater contributions to mankind"; The 2022 succession is in doubt: Xi refrained from promoting a successor to the Politburo Standing Committee, the unwritten norm since 1992. Markets have not reacted overly negatively to these developments (Chart II-21), as the latter do not pose an immediate threat to the global rally in risk assets. The reasons are several: Chart II-21Market Not Too Worried About ##br##Party Congress Outcomes Maoism is overrated: While the Communist Party constitution now treats Xi Jinping as the sole peer of the disastrous ruler Mao Zedong, the market does not buy the Maoist rhetoric. Instead, it sees policy continuity, yet with more effective central leadership, which is a plus. Reforms are making gradual progress: Xi is treading carefully, but is still publicly committed to a reform agenda of rebalancing China's economic model toward consumption and services, improving governance and productivity, and maintaining trade openness. Whatever the shortcomings of the first five years, this agenda is at least reformist in intention. China's tactic of "seeking progress while maintaining stability" is certainly more reassuring than "progress at any cost" or "no progress at all"! Trump and Xi are getting along so far: Xi's promises to move China toward center stage threaten to increase geopolitical tensions with the United States in the long run, yet markets are not overly alarmed. China is imposing sanctions on North Korea to help resolve the nuclear missile standoff, negotiating a "Code of Conduct" in the South China Sea, and promoting the Belt and Road Initiative (BRI), which will marginally add to global development and growth. Trump is hurling threatening words rather than concrete tariffs. 2022 is a long way away: Markets are unconcerned with Xi's decision not to put a clear successor on the Politburo Standing Committee, even though it implies that Xi will not step down at the end of his term in five years. Investors are implicitly approving Xi's strongman behavior while blissfully ignoring the implication that the peaceful transition of power in China could become less secure. Are investors right to be so sanguine? Cyclically, BCA's China Investment Strategy is overweight Chinese investible equities relative to EM and global stocks. Geopolitical Strategy also recommends that clients follow this view and overweight China relative to EM. Beyond this 6-12 month period, it depends on how Xi uses his political capital. If Xi is serious about governance and economic reform, then long-term investors should tolerate the other political risks, and the volatility of reforms, and overweight China within their EM portfolio. After all, China's two greatest pro-market reformers, Deng Xiaoping and Jiang Zemin, were also heavy-handed authoritarians who crushed domestic dissent, clashed with the United States from time to time, and hesitated to relinquish control to their successors. However, if Xi is not serious, then investors with a long time horizon should downgrade China/EM assets - as not only China but the world will have a serious problem on its hands. For Deng Xiaoping and Jiang Zemin always reaffirmed China's pro-market orientation and desire to integrate into the global economic order. If Xi turns his back on this orientation, while imprisoning his rivals for corruption, concentrating power exclusively in his own person, and contesting U.S. leadership in the Asia Pacific, then the long-run outlook for China and the region should darken rather quickly. Domestic institutions will decay and trade and foreign investment will suffer. How and when will investors know the difference? As mentioned, we think 2018 is critical. Xi is flush with political capital and has a positive global economic backdrop. If he does not frontload serious efforts this year then it will become harder to gain traction as time goes by.12 If he demurs, the Chinese political system will not afford another opportunity like this for years to come. The country will approach the 2020s with additional layers of bureaucracy loyal to Xi, but no significant macro adjustments to its governance or productivity. It is not clear how long China's growth rate is sustainable without pro-productivity reforms. It is also not clear that the world will wait five years before responding to a China that, without a new reform push, will appear unabashedly mercantilist, neo-communist, and revisionist. Bottom Line: The long-run investment outlook for China hinges on Xi Jinping's willingness to use his immense personal authority and concentration of power for the purposes of good governance and market-oriented economic reform. Without concrete progress, investors will have to decide whether they want to invest in a China that is becoming less economically vibrant as well as more authoritarian. We think this would be a bad bet. Matt Gertken Associate Vice President Geopolitical Strategy Marko Papic Senior Vice President Chief Geopolitical Strategist Geopolitical Strategy 1 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 2 Chinese policymakers are expressly concerned about the middle-income trap. Please see the World Bank and China's Development Research Center of the State Council, "China 2030: Building A Modern, Harmonious, And Creative Society," 2013, available at www.worldbank.org. Liu He, who is perhaps Xi Jinping's top economic adviser, had a hand in drafting this report and is now a member of the Politburo and shortlisted to take charge of the newly established Financial Stability and Development Commission at the People's Bank of China. 3 Please see Indermit S. Gill and Homi Kharas, "The Middle-Income Trap Turns Ten," World Bank, Policy Research Working Paper 7403 (August, 2015), available at www.worldbank.org 4 Please see Ronald Inglehart and Christian Welzel, Modernization, Cultural Change and Democracy: the Human Development Sequence (Cambridge: CUP, 2005). 5 For example, the collapse of the Soviet Union and the Arab Spring, as well as the downfall of communist regimes writ large, were completely unanticipated. 6 Specifically, Xi is creating a National Supervision Commission that will group a range of existing anti-graft watchdogs under its roof at the local, provincial, and central levels of administration, while coordinating with the Communist Party's top anti-graft watchdog. More details are likely to be revealed at the March legislative session, but what matters is that the initiative is a significant attempt to institutionalize the anti-corruption campaign. Please see BCA Geopolitical Strategy Special Report, "China's Party Congress Ends ... So What?" dated November 1, 2017, available at gps.bcaresearch.com. 7 China has recently drafted top anti-graft officials, such as Zhou Liang, from the powerful Central Discipline and Inspection Commission and placed them in the China Banking Regulatory Commission, which is in charge of overseeing banks. Authorities have already imposed fines in nearly 3,000 cases in 2017 affecting various kinds of banks, including state-owned banks. On the broader use of anti-corruption teams for economic policy, please see Barry Naughton, "The General Secretary's Extended Reach: Xi Jinping Combines Economics And Politics," China Leadership Monitor 54 (Fall 2017), available at www.hoover.org. 8 Please see BCA Geopolitical Strategy Special Report, "Three Questions For 2018," dated December 13, 2017, available at gps.bcaresearch.com. 9 Please see Gao Shan et al, "China's President Xi Jinping Hits Out at 'Political Conspiracies' in Keynote Speech," Radio Free Asia, January 3, 2017, available at www.rfa.org 10 Xi has cranked up the state's propaganda organs, censorship of the media, public surveillance, and broader ideological and security controls (including an aggressive push for "cyber-sovereignty") to warn the public that there is no alternative to Communist Party rule. This tendency has raised alarms among civil rights defenders, lawyers, NGOs, and the western world to the effect that China's governance is actually regressing despite nominal improvement in standard indicators. This is the opposite of Confucius's bottom-up notion of order. 11 Please see BCA Geopolitical Strategy Special Report, "China: Looking Beyond The Party Congress," dated July 19, 2017, available at gps.bcaresearch.com. 12 Xi faces politically sensitive deadlines in the 2020-22 period: the economic targets in the thirteenth Five Year Plan; the hundredth anniversary of the Communist Party in 2021; and Xi's possible retirement at the twentieth National Party Congress in 2022. At that point he will need to focus on demonstrating the Communist Party's all-around excellence and make careful preparations either to step down or cling to power.