BCA Indicators/Model

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of December 30, 2016. The model has boosted its overweight in the Euro Area, especially in Italy, Spain and Netherland, financed mainly by a slight reduction in the large overweight in the U.S. Japan's underweight is back to the largest again, followed by the U.K. (Table 1). Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the non-U.S. model (Level 2) outperformed its benchmark by 206 bps in December, thanks to the overweight in Euro Area. The large overweight in the U.S. caused the Level 1 model to underperform by 27 bps. Overall, the GAA model outperformed its MSCI World benchmark by 15 bps in December. Since Inception, the GAA model outperformed its benchmark by 26 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) GAA U.S. Vs. Non U.S. Model (Level1) Chart 3GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) GAA Non U.S. Model (Level 2) For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model". http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of December 30, 2016. Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Chart 4Overall Model Performance bca.gaa_sa_2016_12_01_c4 bca.gaa_sa_2016_12_01_c4 The momentum component has shifted Info Tech from overweight to underweight. The valuation component indicated that Consumer Staples is no longer expensive. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

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

Highlights Multipolarity will peak in 2017 - geopolitical risks are spiking; Globalization is giving way to zero-sum mercantilism; U.S.-China relations are the chief risk to global stability; Turkey is the most likely state to get in a shooting war; Position for an inflation comeback; Go long defense, USD/EUR, and U.S. small caps vs. large caps. Feature Before the world grew mad, the Somme was a placid stream of Picardy, flowing gently through a broad and winding valley northwards to the English Channel. It watered a country of simple beauty. A. D. Gristwood, British soldier, later novelist. The twentieth century did not begin on January 1, 1900. Not as far as geopolitics is concerned. It began 100 years ago, on July 1, 1916. That day, 35,000 soldiers of the British Empire, Germany, and France died fighting over a couple of miles of territory in a single day. The 1916 Anglo-French offensive, also known as the Battle of the Somme, ultimately cost the three great European powers over a million and a half men in total casualties, of which 310,862 were killed in action over the four months of fighting. British historian A. J. P. Taylor put it aptly: idealism perished on the Somme. How did that happen? Nineteenth-century geopolitical, economic, and social institutions - carefully nurtured by a century of British hegemony - broke on the banks of the Somme in waves of human slaughter. What does this have to do with asset allocation? Calendars are human constructs devised to keep track of time. But an epoch is a period with a distinctive set of norms, institutions, and rules that order human activity. This "order of things" matters to investors because we take it for granted. It is a set of "Newtonian Laws" we assume will not change, allowing us to extrapolate the historical record into future returns.1 Since inception, BCA's Geopolitical Strategy has argued that the standard assumptions about our epoch no longer apply.2 Social orders are not linear, they are complex systems. And we are at the end of an epoch, one that defined the twentieth century by globalization, the spread of democracy, and American hegemony. Because the system is not linear, its break will cause non-linear outcomes. Since joining BCA's Editorial Team in 2011, we have argued that twentieth-century institutions are undergoing regime shifts. Our most critical themes have been: The rise of global multipolarity;3 The end of Sino-American symbiosis;4 The apex of globalization;5 The breakdown of laissez-faire economics;6 The passing of the emerging markets' "Goldilocks" era.7 Our view is that the world now stands at the dawn of the twenty-first century. The transition is not going to be pretty. Investors must stop talking themselves out of left-tail events by referring to twentieth-century institutions. Yes, the U.S. and China really could go to war in the next five years. No, their trade relationship will not prevent it. Was the slaughter at the Somme prevented by the U.K.-German economic relationship? In fact, our own strategy service may no longer make sense in the new epoch. "Geopolitics" is not some add-on to investor's asset-allocation process. It is as much a part of that process as are valuations, momentum, bottom-up analysis, and macroeconomics. To modify the infamous Milton Friedman quip, "We are all geopolitical strategists now." Five Decade Themes: We begin this Strategic Outlook by updating our old decade themes and introducing a few new ones. These will inform our strategic views over the next half-decade. Below, we also explain how they will impact investors in 2017. From Multipolarity To ... Making America Great Again Our central theme of global multipolarity will reach its dangerous apex in 2017. Multipolarity is the idea that the world has two or more "poles" of power - great nations - that pursue their interests independently. It heightens the risk of conflict. Since we identified this trend in 2012, the number of global conflicts has risen from 10 to 21, confirming our expectations (Chart 1). Political science theory is clear: a world without geopolitical leadership produces hegemonic instability. America's "hard power," declining in relative terms, created a vacuum that was filled by regional powers looking to pursue their own spheres of influence. Chart 1Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity Frequency Of Geopolitical Conflicts Increases Under Multipolarity The investment implications of a multipolar world? The higher frequency of geopolitical crises has provided a tailwind to safe-haven assets such as U.S. Treasurys.8 Ironically, the relative decline of U.S. power is positive for U.S. assets.9 Although its geopolitical power has been in relative decline since 1990, the U.S. bond market has become more, not less, appealing over the same timeframe (Chart 2) Counterintuitively, it was American hegemony - i.e. global unipolarity after the Soviet collapse - that made the rise of China and other emerging markets possible. This created the conditions for globalization to flourish and for investors to leave the shores of developed markets in search of yield. It is the stated objective of President-elect Donald Trump, and a trend initiated under President Barack Obama, to reduce the United States' hegemonic responsibilities. As the U.S. withdraws, it leaves regional instability and geopolitical disequilibria in its wake, enhancing the value-proposition of holding on to low-beta American assets. We are now coming to the critical moment in this process, with neo-isolationist Trump doubling down on President Obama's aloof foreign policy. In 2017, therefore, multipolarity will reach its apex, leading several regional powers - from China to Turkey - to overextend themselves as they challenge the status quo. Chaos will ensue. (See below for more!) The inward shift in American policy will sow the seeds for the eventual reversal of multipolarity. America has always profited from geopolitical chaos. It benefits from being surrounded by two massive oceans, Canada, and the Sonora-Chihuahuan deserts. Following both the First and Second World Wars, the U.S.'s relative geopolitical power skyrocketed (Chart 3). Chart 2America Is A Safe-Haven,##br## Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline America Is A Safe-Haven, Despite (Because Of?) Relative Decline Chart 3America Is Chaos-Proof bca.gps_so_2016_12_14_c3 bca.gps_so_2016_12_14_c3 Over the next 12-24 months, we expect the chief investment implications of multipolarity - volatility, tailwind to safe-haven assets, emerging-market underperformance, and de-globalization - to continue to bear fruit. However, as the U.S. comes to terms with multipolarity and withdraws support for critical twentieth-century institutions, it will create conditions that will ultimately reverse its relative decline and lead to a more unipolar tendency (or possibly bipolar, with China). Therefore, Donald Trump's curious mix of isolationism, anti-trade rhetoric, and domestic populism may, in the end, Make America Great Again. But not for the reasons he has promised-- not because the U.S. will outperform the rest of the world in an absolute sense. Rather, America will become great again in a relative sense, as the rest of the world drifts towards a much scarier, darker place without American hegemony. Bottom Line: For long-term investors, the apex of multipolarity means that investing in China and broader EM is generally a mistake. Europe and Japan make sense in the interim due to overstated political risks, relatively easy monetary policy, and valuations, but even there risks will mount due to their high-beta qualities. The U.S. will own the twenty-first century. From Globalization To ... Mercantilism "The industrial glory of England is departing, and England does not know it. There are spasmodic outcries against foreign competition, but the impression they leave is fleeting and vague ... German manufacturers ... are undeniably superiour to those produced by British houses. It is very dangerous for men to ignore facts that they may the better vaunt their theories ... This is poor patriotism." Ernest Edwin Williams, Made in Germany (1896) The seventy years of British hegemony that followed the 1815 Treaty of Paris ending the Napoleonic Wars were marked by an unprecedented level of global stability. Britain's cajoled enemies and budding rivals swallowed their wounded pride and geopolitical appetites and took advantage of the peace to focus inwards, industrialize, and eventually catch up to the U.K.'s economy. Britain, by providing expensive global public goods - security of sea lanes, off-shore balancing,10 a reserve currency, and financial capital - resolved the global collective-action dilemma and ushered in an era of dramatic economic globalization. Sound familiar? It should. As Chart 4 shows, we are at the conclusion of a similar period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. There are other forces at work, such as pernicious wage deflation that has soured the West's middle class on free trade and immigration. But the main threat to globalization is at heart geopolitical. The breakdown of twentieth-century institutions, norms, and rules will encourage regional powers to set up their own spheres of influence and to see the global economy as a zero-sum game instead of a cooperative one.11 Chart 4Multipolarity And De-Globalization Go Hand-In-Hand bca.gps_so_2016_12_14_c4 bca.gps_so_2016_12_14_c4 At the heart of this geopolitical process is the end of Sino-American symbiosis. We posited in February that Charts 5 and 6 are geopolitically unsustainable.12 China cannot keep capturing an ever-increasing global market share for exports while exporting deflation; particularly now that its exports are rising in complexity and encroaching on the markets of developed economies (Chart 7). China's economic policy might have been acceptable in an era of robust global growth and American geopolitical confidence, but we live in a world that is, for the time being, devoid of both. Chart 5China's Share Of Global##br## Exports Has Skyrocketed... bca.gps_so_2016_12_14_c5 bca.gps_so_2016_12_14_c5 Chart 6And Now China ##br##Is Exporting Deflation bca.gps_so_2016_12_14_c6 bca.gps_so_2016_12_14_c6 China and the U.S. are no longer in a symbiotic relationship. The close embrace between U.S. household leverage and Chinese export-led growth is over (Chart 8). Today the Chinese economy is domestically driven, with government stimulus and skyrocketing leverage playing a much more important role than external demand. Exports make up only 19% of China's GDP and 12% of U.S. GDP. The two leading economies are far less leveraged to globalization than the conventional wisdom would have it. Chart 7China's Steady Climb Up ##br##The Value Ladder Continues Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 8Sino-American ##br##Symbiosis Is Over bca.gps_so_2016_12_14_c8 bca.gps_so_2016_12_14_c8 Chinese policymakers have a choice. They can double down on globalization and use competition and creative destruction to drive up productivity growth, moving the economy up the value chain. Or they can use protectionism - particularly non-tariff barriers, as they have been doing - to defend their domestic market from competition.13 We expect that they will do the latter, especially in an environment where anti-globalization rhetoric is rising in the West and protectionism is already on the march (Chart 9). Chart 9Protectionism On The March Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The problem with this likely choice, however, is that it breaks up the post-1979 quid-pro-quo between Washington and Beijing. The "quid" was the Chinese entry into the international economic order (including the WTO in 2001), which the U.S. supported; the "quo" was that Beijing would open its economy as it became wealthy. Today, 45% of China's population is middle-class, which makes China potentially the world's second-largest market after the EU. If China decides not to share its middle class with the rest of the world, then the world will quickly move towards mercantilism - particularly with regard to Chinese imports. Mercantilism was a long-dominant economic theory, in Europe and elsewhere, that perceived global trade to be a zero-sum game and economic policy to be an extension of the geopolitical "Great Game" between major powers. As such, net export growth was the only way to prosperity and spheres of influence were jealously guarded via trade barriers and gunboat diplomacy. What should investors do if mercantilism is back? In a recent joint report with the BCA's Global Alpha Sector Strategy, we argued that investors should pursue three broad strategies: Buy small caps (or microcaps) at the expense of large caps (or mega caps) across equity markets as the former are almost universally domestically focused; Favor closed economies levered on domestic consumption, both within DM and EM universes; Stay long global defense stocks; mercantilism will lead to more geopolitical risk (Chart 10). Chart 10Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Defense Stocks Are A No-Brainer Investors should also expect a more inflationary environment over the next decade. De-globalization will mean marginally less trade, less migration, and less free movement of capital across borders. These are all inflationary. Bottom Line: Mercantilism is back. Sino-American tensions and peak multipolarity will impair coordination. It will harden the zero-sum game that erodes globalization and deepens geopolitical tensions between the world's two largest economies.14 One way to play this theme is to go long domestic sectors and domestically-oriented economies relative to export sectors and globally-exposed economies. The real risk of mercantilism is that it is bedfellows with nationalism and jingoism. We began this section with a quote from an 1896 pamphlet titled "Made in Germany." In it, British writer E.E. Williams argued that the U.K. should abandon free trade policies due to industrial competition from Germany. Twenty years later, 350,000 men died in the inferno of the Somme. From Legal To ... Charismatic Authority Legal authority, the bedrock of modern democracy, is a critical pillar of civilization that investors take for granted. The concept was defined in 1922 by German sociologist Max Weber. Weber's seminal essay, "The Three Types of Legitimate Rule," argues that legal-rational authority flows from the institutions and laws that define it, not the individuals holding the office.15 This form of authority is investor-friendly because it reduces uncertainty. Investors can predict the behavior of policymakers and business leaders by learning the laws that govern their behavior. Developed markets are almost universally made up of countries with such norms of "good governance." Investors can largely ignore day-to-day politics in these systems, other than the occasional policy shift or regulatory push that affects sector performance. Weber's original essay outlined three forms of authority, however. The other two were "traditional" and "charismatic."16 Today we are witnessing the revival of charismatic authority, which is derived from the extraordinary characteristics of an individual. From Russia and the U.S. to Turkey, Hungary, the Philippines, and soon perhaps Italy, politicians are winning elections on the back of their messianic qualities. The reason for the decline of legal-rational authority is threefold: Elites that manage governing institutions have been discredited by the 2008 Great Recession and subsequent low-growth recovery. Discontent with governing institutions is widespread in the developed world (Chart 11). Elite corruption is on the rise. Francis Fukuyama, perhaps America's greatest political theorist, argues that American political institutions have devolved into a "system of legalized gift exchange, in which politicians respond to organized interest groups that are collectively unrepresentative of the public as a whole."17 Political gridlock across developed and emerging markets has forced legal-rational policymakers to perform like charismatic ones. European policymakers have broken laws throughout the euro-area crisis, with the intention of keeping the currency union alive. President Obama has issued numerous executive orders due to congressional gridlock. While the numbers of executive orders have declined under Obama, their economic significance has increased (Chart 12). Each time these policymakers reached around established rules and institutions in the name of contingencies and crises, they opened the door wider for future charismatic leaders to eschew the institutions entirely. Chart 11As Institutional Trust Declines, ##br##Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders As Institutional Trust Declines, Voters Turn To Charismatic Leaders Chart 12Obama ##br##The Regulator Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Furthermore, a generational shift is underway. Millennials do not understand the value of legal-rational institutions and are beginning to doubt the benefits of democracy itself (Chart 13). The trend appears to be the most pronounced in the U.S. and U.K., perhaps because neither experienced the disastrous effects of populism and extremism of the 1930s. In fact, millennials in China appear to view democracy as more essential to the "good life" than their Anglo-Saxon peers. Chart 13Who Needs Democracy When You Have Tinder? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Charismatic leaders can certainly outperform expectations. Donald Trump may end up being FDR. The problem for investors is that it is much more difficult to predict the behavior of a charismatic authority than a legal-rational one.18 For example, President-elect Trump has said that he will intervene in the U.S. economy throughout his four-year term, as he did with Carrier in Indiana. Whether these deals are good or bad, in a normative sense, is irrelevant. The point is that bottom-up investment analysis becomes useless when analysts must consider Trump's tweets, as well as company fundamentals, in their earnings projections! We suspect that the revival of charismatic leadership - and the danger that it might succeed in upcoming European elections - at least partly explains the record high levels of global policy uncertainty (Chart 14). Markets do not seem to have priced in the danger fully yet. Global bond spreads are particularely muted despite the high levels of uncertainty. This is unsustainable. Chart 14Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Are Assets Fully Pricing In Global Uncertainty? Bottom Line: The twenty-first century is witnessing the return of charismatic authority and erosion of legal-rational authority. This should be synonymous with uncertainty and market volatility over the next decade. In 2017, expect a rise in EuroStoxx volatility. From Laissez-Faire To ... Dirigisme The two economic pillars of the late twentieth century have been globalization and laissez-faire capitalism, or neo-liberalism. The collapse of the Soviet Union ended the communist challenge, anointing the U.S.-led "Washington Consensus" as the global "law of the land." The tenets of this epoch are free trade, fiscal discipline, low tax burden, and withdrawal of the state from the free market. Not all countries approached the new "order of things" with equal zeal, but most of them at least rhetorically committed themselves to asymptotically approaching the American ideal. Chart 15Debt Replaced Wages##br## In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies Debt Replaced Wages In Laissez-Faire Economies The 2008 Great Recession put an end to the bull market in neo-liberal ideology. The main culprit has been the low-growth recovery, but that is not the full story. Tepid growth would have been digested without a political crisis had it not followed decades of stagnating wages. With no wage growth, households in the most laissez-faire economies of the West gorged themselves on debt (Chart 15) to keep up with rising cost of housing, education, healthcare, and childcare -- all staples of a middle-class lifestyle. As such, the low-growth context after 2008 has combined with a deflationary environment to produce the most pernicious of economic conditions: debt-deflation, which Irving Fisher warned of in 1933.19 It is unsurprising that globalization became the target of middle-class angst in this context. Globalization was one of the greatest supply-side shocks in recent history: it exerted a strong deflationary force on wages (Chart 16). While it certainly lifted hundreds of millions of people out of poverty in developing nations, globalization undermined those low-income and middle-class workers in the developed world whose jobs were most easily exported. World Bank economist Branko Milanovic's infamous "elephant trunk" shows the stagnation of real incomes since 1988 for the 75-95 percentile of the global income distribution - essentially the West's middle class (Chart 17).20 It is this section of the elephant trunk that increasingly supports populism and anti-globalization policies, while eschewing laissez faire liberalism. In our April report, "The End Of The Anglo-Saxon Economy," we posited that the pivot away from laissez-faire capitalism would be most pronounced in the economies of its greatest adherents, the U.S. and U.K. We warned that Brexit and the candidacy of Donald Trump should be taken seriously, while the populist movements in Europe would surprise to the downside. Why the gap between Europe and the U.S. and U.K.? Because Europe's cumbersome, expensive, inefficient, and onerous social-welfare state finally came through when it mattered: it mitigated the pernicious effects of globalization and redistributed enough of the gains to temper populist angst. Chart 16Globalization: A Deflationary Shock Globalization: A Deflationary Shock Globalization: A Deflationary Shock Chart 17Globalization: No Friend To DM Middle Class Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This view was prescient in 2016. The U.K. voted to leave the EU, Trump triumphed, while European populists stumbled in both the Spanish and Austrian elections. The Anglo-Saxon median voter has essentially moved to the left of the economic spectrum (Diagram 1).21 The Median Voter Theorem holds that policymakers will follow the shift to the left in order to capture as many voters as possible under the proverbial curve. In other words, Donald Trump and Bernie Sanders are not political price-makers but price-takers. Diagram 1The Median Voter Is Moving To The Left In The U.S. And U.K. Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now How does laissez-faire capitalism end? In socialism or communism? No, the institutions that underpin capitalism in the West - private property, rule of law, representative government, and enforcement of contracts - remain strong. Instead, we expect to see more dirigisme, a form of capitalism where the state adopts a "directing" rather than merely regulatory role. In the U.S., Donald Trump unabashedly campaigned on dirigisme. We do not expand on the investment implications of American dirigisme in this report (we encourage clients to read our post-election treatment of Trump's domestic politics).22 But investors can clearly see the writing on the wall: a late-cycle fiscal stimulus will be positive for economic growth in the short term, but most likely more positive for inflation in the long term. Donald Trump's policies therefore are a risk to bonds, positive for equities (in the near term), and potentially negative for both in the long term if stagflation results from late-cycle stimulus. What about Europe? Is it not already quite dirigiste? It is! But in Europe, we see a marginal change towards the right, not the left. In Spain, the supply-side reforms of Prime Minister Mariano Rajoy will remain in place, as he won a second term this year. In France, right-wing reformer - and self-professed "Thatcherite" - François Fillon is likely to emerge victorious in the April-May presidential election. And in Germany, the status-quo Grand Coalition will likely prevail. Only in Italy are there risks, but even there we expect financial markets to force the country - kicking and screaming - down the path of reforms. Bottom Line: In 2017, the market will be shocked to find itself face-to-face with a marginally more laissez-faire Europe and a marginally more dirigiste America and Britain. Investors should overweight European assets in a global portfolio given valuations, relative monetary policy (which will remain accommodative in Europe), a weak euro, and economic fundamentals (Chart 18), and upcoming political surprises. For clients with low tolerance of risk and volatility, a better entry point may exist following the French presidential elections in the spring. From Bias To ... Conspiracies As with the printing press, the radio, film, and television before it, the Internet has created a super-cyclical boom in the supply and dissemination of information. The result of the sudden surge is that quality and accountability are declining. The mainstream media has dubbed this the "fake news" phenomenon, no doubt to differentiate the conspiracy theories coursing through Facebook and Twitter from the "real news" of CNN and MSNBC. The reality is that mainstream media has fallen far short of its own vaunted journalistic standards (Chart 19). Chart 18Europe's Economy Is Holding Up Europe's Economy Is Holding Up Europe's Economy Is Holding Up Chart 19 "Mainstream Media" Is A Dirty Word For Many "Mainstream Media" Is A Dirty Word For Many We are not interested in this debate, nor are we buying the media narrative that "fake news" delivered Trump the presidency. Instead, we are focused on how geopolitical and political information is disseminated to voters, investors, and ultimately priced by the market. We fear that markets will struggle to price information correctly due to three factors: Low barriers to entry: The Internet makes publishing easy. Information entrepreneurs - i.e. hack writers - and non-traditional publications ("rags") are proliferating. The result is greater output but a decrease in quality control. For example, Facebook is now the second most trusted source of news for Americans (Chart 20). Cost-cutting: The boom in supply has squeezed the media industry's finances. Newspapers have died in droves; news websites and social-media giants have mushroomed (Chart 21). News companies are pulling back on things like investigative reporting, editorial oversight, and foreign correspondent desks. Foreign meddling: In this context, governments have gained a new advantage because they can bring superior financial resources and command-and-control to an industry that is chaotic and cash-strapped. Russian news outlets like RT and Sputnik have mastered this game - attracting "clicks" around the world from users who are not aware they are reading Russian propaganda. China has also raised its media profile through Western-accessible propaganda like the Global Times, but more importantly it has grown more aggressive at monitoring, censoring, and manipulating foreign and domestic media. Chart 20Facebook Is The New Cronkite? Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 21The Internet Has Killed Journalism Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The above points would be disruptive enough alone. But we know that technology is not the root cause of today's disruptions. Income inequality, the plight of the middle class, elite corruption, unchecked migration, and misguided foreign policy have combined to create a toxic mix of distrust and angst. In the West, the decline of the middle class has produced a lack of socio-political consensus that is fueling demand for media of a kind that traditional outlets can no longer satisfy. Media producers are scrambling to meet this demand while struggling with intense competition from all the new entrants and new platforms. What is missing is investment in downstream refining and processing to convert the oversupply of crude information into valuable product for voters and investors.23 Otherwise, the public loses access to "transparent" or baseline information. Obviously the baseline was never perfect. Both the Vietnam and Iraq wars began as gross impositions on the public's credulity: the Gulf of Tonkin Incident and Saddam Hussein's weapons of mass destruction. But there was a shared reference point across society. The difference today, as we see it, is that mass opinion will swing even more wildly during a crisis as a result of the poor quality of information that spreads online and mobilizes social networks more rapidly than ever before. We could have "flash mobs" in the voting booth - or on the steps of the Supreme Court - just like "flash crashes" in financial markets, i.e. mass movements borne of passing misconceptions rather than persistent misrule. Election results are more likely to strain the limits of the margin of error, while anti-establishment candidates are more likely to remain viable despite dubious platforms. What does this mean for investors? Fundamental analysis of a country's political and geopolitical risk is now an essential tool in the investor toolkit. If investors rely on the media, and the market prices what the media reports, then the same investors will continue to get blindsided by misleading probabilities, as with Brexit and Trump (Chart 22). While we did not predict these final outcomes, we consistently advised clients, for months in advance, that the market probabilities were too low and serious hedging was necessary. Those who heeded our advice cheered their returns, even as some lamented the electoral returns. Chart 22Get Used To Tail-Risk Events Get Used To Tail-Risk Events Get Used To Tail-Risk Events Bottom Line: Keep reading BCA's Geopolitical Strategy! Final Thoughts On The Next Decade The nineteenth century ended in the human carnage that was the Battle of the Somme. The First World War ushered in social, economic, political, geopolitical, demographic, and technological changes that drove the evolution of twentieth-century institutions, rules, and norms. It created the "order of things" that we all take for granted today. The coming decade will be the dawn of the new geopolitical century. We can begin to discern the ordering of this new epoch. It will see peak multipolarity lead to global conflict and disequilibrium, with globalization and laissez-faire economic consensus giving way to mercantilism and dirigisme. Investors will see the benevolent deflationary impulse of globalization evolve into state intervention in the domestic economy and the return of inflation. Globally oriented economies and sectors will underperform domestic ones. Developed markets will continue to outperform emerging markets, particularly as populism spreads to developing economies that fail to meet expectations of their rising middle classes. Over the next ten years, these changes will leave the U.S. as the most powerful country in the world. China and wider EM will struggle to adapt to a less globalized world, while Europe and Japan will focus inward. The U.S. is essentially a low-beta Great Power: its economy, markets, demographics, natural resources, and security are the least exposed to the vagaries of the rest of the world. As such, when the rest of the world descends into chaos, the U.S. will hide behind its Oceans, and Canada, and the deserts of Mexico, and flourish. Five Themes For 2017: Our decade themes inform our view of cyclical geopolitical events and crises, such as elections and geopolitical tensions. As such, they form our "net assessment" of the world and provide a prism through which we refract geopolitical events. Below we address five geopolitical themes that we expect to drive the news flow, and thus the markets, in 2017. Some themes are Red Herrings (overstated risks) and thus present investment opportunities, others are Black Swans (understated risks) and are therefore genuine risks. Europe In 2017: A Trophy Red Herring? Europe's electoral calendar is ominously packed (Table 1). Four of the euro area's five largest economies are likely to have elections in 2017. Another election could occur if Spain's shaky minority government collapses. Table 1 Europe In 2017 Will Be A Headline Risk Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now We expect market volatility to be elevated throughout the year due to the busy calendar. In this context, we advise readers to follow our colleague Dhaval Joshi at BCA's European Investment Strategy. Dhaval recommends that BCA clients combine every €1 of equity exposure with 40 cents of exposure to VIX term-structure, which means going long the nearest-month VIX futures and equally short the subsequent month's contract. The logic is that the term structure will invert sharply if risks spike.24 While we expect elevated uncertainty and lots of headline risk, we do not believe the elections in 2017 will transform Europe's future. As we have posited since 2011, global multipolarity increases the logic for European integration.25 Crises driven by Russian assertiveness, Islamic terrorism, and the migration wave are not dealt with more effectively or easily by nation states acting on their own. Thus far, it appears that Europeans agree with this assessment: polling suggests that few are genuinely antagonistic towards the euro (Chart 23) or the EU (Chart 24). In our July report called "After BREXIT, N-EXIT?" we posited that the euro area will likely persevere over at least the next five years.26 Chart 23Support For The Euro Remains Stable Support For The Euro Remains Stable Support For The Euro Remains Stable Chart 24Few Europeans Want Out Of The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Take the Spanish and Austrian elections in 2016. In Spain, Mariano Rajoy's right-wing People's Party managed to hold onto power despite four years of painful internal devaluations and supply-side reforms. In Austria, the establishment candidate for president, Alexander Van der Bellen, won the election despite Austria's elevated level of Euroskepticism (Chart 24), its central role in the migration crisis, and the almost comically unenthusiastic campaign of the out-of-touch Van der Bellen. In both cases, the centrist candidates survived because voters hesitated when confronted with an anti-establishment choice. Next year, we expect more of the same in three crucial elections: The Netherlands: The anti-establishment and Euroskeptic Party for Freedom (PVV) will likely perform better than it did in the last election, perhaps even doubling its 15% result in 2012. However, it has no chance of forming a government, given that all the other parties contesting the election are centrist and opposed to its Euroskeptic agenda (Chart 25). Furthermore, support for the euro remains at a very high level in the country (Chart 26). This is a reality that the PVV will have to confront if it wants to rule the Netherlands. Chart 25No Government For Dutch Euroskeptics Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 26The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair The Netherlands & Euro: Love Affair France: Our high conviction view is that Marine Le Pen, leader of the Euroskeptic National Front (FN), will be defeated in the second round of the presidential election.27 Despite three major terrorist attacks in the country, unchecked migration crisis, and tepid economic growth, Le Pen's popularity peaked in 2013 (Chart 27). She continues to poll poorly against her most likely opponents in the second round, François Fillon and Emmanuel Macron (Chart 28). Investors who doubt the polls should consider the FN's poor performance in the December 2015 regional elections, a critical case study for Le Pen's viability in 2017.28 Chart 27Le Pen's Polling: ##br##Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Le Pen's Polling: Head And Shoulder Formation? Chart 28Le Pen Will Not Be##br## Next French President Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Germany: Chancellor Angela Merkel's popularity is holding up (Chart 29), the migration crisis has abated (Chart 30), and there remains a lot of daylight between the German establishment and populist parties (Chart 31). The anti-establishment Alternative für Deutschland will enter parliament, but remain isolated. Chart 29Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Merkel's Approval Rating Has Stabilized Chart 30Migration Crisis Is Abating bca.gps_so_2016_12_14_c30 bca.gps_so_2016_12_14_c30 Chart 31There Is A Lot Of Daylight... bca.gps_so_2016_12_14_c31 bca.gps_so_2016_12_14_c31 The real risk in 2017 remains Italy. The country has failed to enact any structural reforms, being a laggard behind the reform poster-child Spain (Chart 32). Meanwhile, support for the euro remains in the high 50s, which is low compared to the euro-area average (Chart 33). Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory (Chart 34). However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Chamber of Deputies remains under review by the Constitutional Court until at least February. This will make all the difference between further gridlock and a viable government. Chart 32Italy Is Europe's bca.gps_so_2016_12_14_c32 bca.gps_so_2016_12_14_c32 Chart 33Italy Lags Peers On Euro Support bca.gps_so_2016_12_14_c33 bca.gps_so_2016_12_14_c33 Chart 34Italy's Next Election Is Too Close To Call bca.gps_so_2016_12_14_c34 bca.gps_so_2016_12_14_c34 Investors should consider three factors when thinking about Italy in 2017: The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.29 The market will punish Italy the moment it sniffs out even a whiff of a potential Itexit referendum. This will bring forward the future pain of redenomination, influencing voter choices. Benefits of the EU membership for Italy are considerable, especially as they allow the country to integrate its unproductive, poor, and expensive southern regions.30 Sans Europe, the Mezzogiorno (Southern Italy) is Rome's problem, and it is a big one. The larger question is whether the rest of Italy's euro-area peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes. First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, how unsustainable is the Italian status quo? OECD projections for Italy's debt-to-GDP ratio are not ominous. Chart 35 shows four scenarios, the most likely one charting Italy's debt-to-GDP rise from 133% today to about 150% by 2060. Italy's GDP growth would essentially approximate 0%, but its impressive budget discipline would ensure that its debt load would only rise marginally (Chart 36). Chart 35So What If Italy's Debt-To-GDP Ends Up At 170%? bca.gps_so_2016_12_14_c35 bca.gps_so_2016_12_14_c35 Chart 36Italy Has Learned To Live With Its Debt Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now This may seem like a dire prospect for Italy, but it ensures that the ECB has to maintain its accommodative stance in Europe even as the Fed continues its tightening cycle, a boon for euro-area equities as a whole. In other words, Italy's predicament would be unsustainable if the country were on its own. Its "sick man" status would be terminal if left to its own devices. But as a patient in the euro-area hospital, it can survive. And what happens to the euro area beyond our five-year forecasting horizon? We are not sure. Defeat of anti-establishment forces in 2017 will give centrist policymakers another electoral cycle to resolve the currency union's built-in flaws. If the Germans do not budge on greater fiscal integration over the next half-decade, then the future of the currency union will become murkier. Bottom Line: Remain long the nearest-month VIX futures and equally short the subsequent month's contract. We have held this position since September 14 and it has returned -0.84%. The advantage of this strategy is that it is a near-perfect hedge when risk assets sell off, but pays a low price for insurance. Investors with high risk tolerance who can stomach some volatility should take the plunge and overweight euro-area equities in a global equity portfolio. Solid global growth prospects, accommodative monetary policy, euro weakness, and valuations augur a solid year for euro-area equities. Politics will be a red herring as euro-area stocks climb the proverbial wall of worry in 2017. U.S.-Russia Détente: A Genuine Investment Opportunity Trump's election is good news for Russia. Over the past 16 years, Russia has methodically attempted to collect the pieces from the Soviet collapse. Putin sought to defend the Russian sphere of influence from outside powers (Ukraine and Belarus, the Caucasus, Central Asia). Putin also needed to rally popular support at various times by distracting the public. We view Ukraine and Syria through this prism. Lastly, Russia acted aggressively because it needed to reassure its allies that it would stand up for them.31 And yet the U.S. can live with a "strong" Russia. It can make a deal if the Trump administration recognizes some core interests (e.g. Crimea) and calls off the promotion of democracy in Russia's sphere, which Putin considers an attempt to undermine his rule. As we argued during the Ukraine invasion, it is the U.S., not Russia, which poses the greatest risk of destabilization.32 The U.S. lacks constraints in this theater. It can be aggressive towards Russia and face zero consequences: it has no economic relationship with Russia and does not stand directly in the way of any Russian reprisals, unlike Europe. That is why we think Trump and Putin will reset relations. Trump's team may be comfortable with Russia having a sphere of influence, unlike the Obama administration, which explicitly rejected this idea. The U.S. could even pledge not to expand NATO further, given that it has already expanded as far as it can feasibly and credibly go. Note, however, that a Russo-American truce may not last long. George W. Bush famously "looked into Putin's eyes and ... saw his soul," but relations soured nonetheless. Obama went further with his "Russian reset," removing European missile defense plans from Poland and the Czech Republic. These are avowed NATO allies, and this occurred merely one year after Russian troops marched on Georgia. And yet Moscow and Washington ended up rattling sabers and meddling in each other's internal affairs anyway. Chart 37Thaw In Russian-West##br## Cold War Is Bullish Europe bca.gps_so_2016_12_14_c37 bca.gps_so_2016_12_14_c37 Ultimately, U.S. resets fail because Russia is in structural decline and attempting to hold onto a very large sphere of influence whose citizens are not entirely willing participants.33 Because Moscow must often use blunt force to prevent the revolt of its vassal states (e.g. Georgia in 2008, Ukraine in 2014), it periodically revives tensions with the West. Unless Russia strengthens significantly in the next few years, which we do not expect, then the cycle of tensions will continue. On the horizon may be Ukraine-like incidents in neighboring Belarus and Kazakhstan, both key components of the Russian sphere of influence. Bottom Line: Russia will get a reprieve from U.S. pressure. While we expect Europe to extend sanctions through 2017, a rapprochement with Washington will ultimately thaw relations between Europe and Russia by the end of that year. Europe will benefit from resuming business as usual. It will face less of a risk of Russian provocations via the Middle East and cybersecurity. The ebbing of the Russian geopolitical risk premium will have a positive effect on Europe, given its close correlation with European risk assets since the crisis in Ukraine (Chart 37). Investors who want exposure to Russia may consider overweighing Russian equities to Malaysian. BCA's Emerging Market Strategy has initiated this position for a 55.6% gain since March 2016 and our EM strategists believe there is more room to run for this trade. We recommend that investors simply go long Russia relative to the broad basket of EM equities. The rally in oil prices, easing of the geopolitical risk premium, and hints of pro-market reforms from the Kremlin will buoy Russian equities further in 2017. Middle East: ISIS Defeat Is A Black Swan In February 2016, we made two bold predictions about the Middle East: Iran-Saudi tensions had peaked;34 The defeat of ISIS would entice Turkey to intervene militarily in both Iraq and Syria.35 The first prediction was based on a simple maxim: sustained geopolitical conflict requires resources and thus Saudi military expenditures are unsustainable when a barrel of oil costs less than $100. Saudi Arabia overtook Russia in 2015 as the globe's third-largest defense spender (Chart 38)! Chart 38Saudi Arabia: Lock And Load Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now The mini-détente between Iran and Saudi Arabia concluded in 2016 with the announced OPEC production cut and freeze. While we continue to see the OPEC deal as more of a recognition of the status quo than an actual cut (because OPEC production has most likely reached its limits), nevertheless it is significant as it will slightly hasten the pace of oil-market rebalancing. On the margin, the OPEC deal is therefore bullish for oil prices. Our second prediction, that ISIS is more of a risk to the region in defeat than in glory, was highly controversial. However, it has since become consensus, with several Western intelligence agencies essentially making the same claim. But while our peers in the intelligence community have focused on the risk posed by returning militants to Europe and elsewhere, our focus remains on the Middle East. In particular, we fear that Turkey will become embroiled in conflicts in Syria and Iraq, potentially in a proxy war with Iran and Russia. The reason for this concern is that the defeat of the Islamic State will create a vacuum in the Middle East that the Syrian and Iraqi Kurds are most likely to fill. This is unacceptable to Turkey, which has intervened militarily to counter Kurdish gains and may do so in the future. We are particularly concerned about three potential dynamics: Direct intervention in Syria and Iraq: The Turkish military entered Syria in August, launching operation "Euphrates Shield." Turkey also reinforced a small military base in Bashiqa, Iraq, only 15 kilometers north of Mosul. Both operations were ostensibly undertaken against the Islamic State, but the real intention is to limit the Syrian and Iraqi Kurds. As Map 1 illustrates, Kurds have expanded their territorial control in both countries. Map 1Kurdish Gains In Syria & Iraq Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Conflict with Russia and Iran: President Recep Erdogan has stated that Turkey's objective in Syria is to remove President Bashar al-Assad from power.36 Yet Russia and Iran are both involved militarily in the country - the latter with regular ground troops - to keep Assad in power. Russia and Turkey did manage to cool tensions recently. Yet the Turkish ground incursion into Syria increases the probability that tensions will re-emerge. Meanwhile, in Iraq, Erdogan has cast himself as a defender of Sunni Arabs and has suggested that Turkey still has a territorial claim to northern Iraq. This stance would put Ankara in direct confrontation with the Shia-dominated Iraqi government, allied with Iran. Turkey-NATO/EU tensions: Tensions have increased between Turkey and the EU over the migration deal they signed in March 2016. Turkey claims that the deal has stemmed the flow of migrants to Europe, which is dubious given that the flow abated well before the deal was struck. Since then, Turkey has threatened to open the spigot and let millions of Syrian refugees into Europe. This is likely a bluff as Turkey depends on European tourists, import demand, and FDI for hard currency (Chart 39). If Erdogan acted on his threat and unleashed Syrian refugees into Europe, the EU could abrogate the 1995 EU-Turkey customs union agreement and impose economic sanctions. The Turkish foray into the Middle East poses the chief risk of a "shooting war" that could impact global investors in 2017. While there are much greater geopolitical games afoot - such as increasing Sino-American tensions - this one is the most likely to produce military conflict between serious powers. It would be disastrous for Turkey. The broader point is that the redrawing of the Middle East map is not yet complete. As the Islamic State is defeated, the Sunni population of Iraq and Syria will remain at risk of Shia domination. As such, countries like Turkey and Saudi Arabia could be drawn into renewed proxy conflicts to prevent complete marginalization of the Sunni population. While tensions between Turkey, Russia, and Iran will not spill over into oil-producing regions of the Middle East, they may cloud Iraq's future. Since 2010, Iraq has increased oil production by 1.6 million barrels per day. This is about half of the U.S. shale production increase over the same time frame. As such, Iraq's production "surprise" has been a major contributor to the 2014-2015 oil-supply glut. However, Iraq needs a steady inflow of FDI in order to boost production further (Chart 40). Proxy warfare between Turkey, Russia, and Iran - all major conventional military powers - on its territory will go a long way to sour potential investors interested in Iraqi production. Chart 39Turkey Is Heavily Dependent On The EU Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 40Iraq Is The Big, And Cheap, Hope bca.gps_so_2016_12_14_c40 bca.gps_so_2016_12_14_c40 This is a real problem for global oil supply. The International Energy Agency sees Iraq as a critical source of future global oil production. Chart 41 shows that Iraq is expected to contribute the second-largest increase in oil production by 2020. And given Iraq's low breakeven production cost, it may be the last piece of real estate - along with Iran - where the world can get a brand-new barrel of oil for under $13. In addition to the risk of expanding Turkish involvement in the region, investors will also have to deal with the headline risk of a hawkish U.S. administration pursuing diplomatic brinkmanship against Iran. We do not expect the Trump administration to abrogate the Iran nuclear deal due to several constraints. First, American allies will not go along with new sanctions. Second, Trump's focus is squarely on China. Third, the U.S. does not have alternatives to diplomacy, since bombing Iran would be an exceedingly complex operation that would bog down American forces in the Middle East. When we put all the risks together, a geopolitical risk premium will likely seep into oil markets in 2017. BCA's Commodity & Energy Strategy argues that the physical oil market is already balanced (Chart 42) and that the OPEC deal will help draw down bloated inventories in 2017. This means that global oil spare capacity will be very low next year, with essentially no margin of safety in case of a major supply loss. Given the political risks of major oil producers like Nigeria and Venezuela, this is a precarious situation for the oil markets. Chart 41Iraq Really Matters For Global Oil Production Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 42Oil Supply Glut Is Gone In 2017 bca.gps_so_2016_12_14_c42 bca.gps_so_2016_12_14_c42 Bottom Line: Given our geopolitical view of risks in the Middle East, balanced oil markets, lack of global spare capacity, the OPEC production cut, and ongoing capex reductions, we recommend clients to follow BCA's Commodity & Energy Strategy view of expecting widening backwardation in the new year.37 U.S.-China: From Rivalry To Proxy Wars President-elect Trump has called into question the U.S.'s adherence to the "One China policy," which holds that "there is but one China and Taiwan is part of China" and that the U.S. recognizes only the People's Republic of China as the legitimate Chinese government. There is widespread alarm about Trump's willingness to use this policy, the very premise of U.S.-China relations since 1978, as a negotiating tool. And indeed, Sino-U.S. relations are very alarming, as we have warned our readers since 2012.38 Trump is a dramatic new agent reinforcing this trend. Trump's suggestion that the policy could be discarded - and his break with convention in speaking to the Taiwanese president - are very deliberate. Observe that in the same diplomatic document that establishes the One China policy, the United States and China also agreed that "neither should seek hegemony in the Asia-Pacific region or in any other region." Trump is initiating a change in U.S. policy by which the U.S. accuses China of seeking hegemony in Asia, a violation of the foundation of their relationship. The U.S. is not seeking unilaterally to cancel the One China policy, but asking China to give new and durable assurances that it does not seek hegemony and will play by international rules. Otherwise, the U.S. is saying, the entire relationship will have to be revisited and nothing (not even Taiwan) will be off limits. The assurances that China is expected to give relate not only to trade, but also, as Trump signaled, to the South China Sea and North Korea. Therefore we are entering a new era in U.S-China relations. China Is Toast Asia Pacific is a region of frozen conflicts. Russia and Japan never signed a peace treaty. Nor did China and Taiwan. Nor did the Koreas. Why have these conflicts lain dormant over the past seventy years? Need we ask? Japan, South Korea, Taiwan, and Hong Kong have seen their GDP per capita rise 14 times since 1950. China has seen its own rise 21 times (Chart 43). Since the wars in Vietnam over forty years ago, no manner of conflict, terrorism, or geopolitical crisis has fundamentally disrupted this manifestly beneficial status quo. As a result, Asia has been a region synonymous with economics - not geopolitics. It developed this reputation because its various large economies all followed Japan's path of dirigisme: export-oriented, state-backed, investment-led capitalism. This era of stability is over. The region has become the chief source of geopolitical risk and potential "Black Swan" events.39 The reason is deteriorating U.S.-China relations and the decline in China's integration with other economies. The Asian state-led economic model was underpinned by the Pax Americana. Two factors were foundational: America's commitment to free trade and its military supremacy. China was not technically an ally, like Japan and Korea, but after 1979 it sure looked like one in terms of trade surpluses and military spending (Chart 44).40 For the sake of containing the Soviet Union, the U.S. wrapped East Asia under its aegis. Chart 43The Twentieth Century Was Kind To East Asia Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Chart 44Asia Sells, America Rules bca.gps_so_2016_12_14_c44 bca.gps_so_2016_12_14_c44 It is well known, however, that Japan's economic model led it smack into a confrontation with the U.S. in the 1980s over its suppressed currency and giant trade surpluses. President Ronald Reagan's economic team forced Japan to reform, but the result was ultimately financial crisis as the artificial supports of its economic model fell away (Chart 45). Astute investors have always suspected that a similar fate awaited China. It is unsustainable for China to seize ever greater market share and drive down manufacturing prices without reforming its economy to match G7 standards, especially if it denies the U.S. access to its vast consumer market. Today there are signs that the time for confrontation is upon us: Since the Great Recession, U.S. household debt and Chinese exports have declined as a share of GDP, falling harder in the latter than the former, in a sign of shattered symbiosis (see Chart 8 above). Chinese holdings of U.S. Treasurys have begun to decline (Chart 46). China's exports to the U.S., both as a share of total exports and of GDP, have rolled over, and are at levels comparable to Japan's 1980s peaks (Chart 47). China is wading into high-tech and advanced industries, threatening the core advantages of the developed markets. The U.S. just elected a populist president whose platform included aggressive trade protectionism against China. Protectionist "Rust Belt" voters were pivotal to Trump's win and will remain so in future elections. China is apparently reneging on every major economic promise it has made in recent years: the RMB is depreciating, not appreciating, whatever the reason; China is closing, not opening, its capital account; it is reinforcing, not reforming, its state-owned companies; and it is shutting, not widening, access to its domestic market (Chart 48). Chart 45Japan's Crisis Followed Currency Spike bca.gps_so_2016_12_14_c45 bca.gps_so_2016_12_14_c45 Chart 46China Backing Away From U.S. Treasuries bca.gps_so_2016_12_14_c46 bca.gps_so_2016_12_14_c46 There is a critical difference between the "Japan bashing" of the 1980s-90s and the increasingly potent "China bashing" of today. Japan and the U.S. had established a strategic hierarchy in World War II. That is not the case for the U.S. and China in 2017. Unlike Japan, Korea, or any of the other Asian tigers, China cannot trust the United States to preserve its security. Far from it - China has no greater security threat than the United States. The American navy threatens Chinese access to critical commodities and export markets via the South China Sea. In a world that is evolving into a zero-sum game, these things suddenly matter. Chart 47The U.S. Will Get Tougher On China Trade bca.gps_so_2016_12_14_c47 bca.gps_so_2016_12_14_c47 Chart 48China Is De-Globalizing bca.gps_so_2016_12_14_c48 bca.gps_so_2016_12_14_c48 That means that when the Trump administration tries to "get tough" on longstanding American demands, these demands will not be taken as well-intentioned or trustworthy. We see Sino-American rivalry as the chief geopolitical risk to investors in 2017: Trump will initiate a more assertive U.S. policy toward China;41 It will begin with symbolic or minor punitive actions - a "shot across the bow" like charging China with currency manipulation or imposing duties on specific goods.42 It will be critical to see whether Trump acts arbitrarily through executive power, or systematically through procedures laid out by Congress. The two countries will proceed to a series of high-level, bilateral negotiations through which the Trump administration will aim to get a "better deal" from the Xi administration on trade, investment, and other issues. The key to the negotiations will be whether the Trump team settles for technical concessions or instead demands progress on long-delayed structural issues that are more difficult and risky for China to undertake. Too much pressure on the latter could trigger a confrontation and broader economic instability. Chart 49China's Demographic Dividend Is Gone bca.gps_so_2016_12_14_c49 bca.gps_so_2016_12_14_c49 The coming year may see U.S.-China relations start with a bang and end with a whimper, as Trump's initial combativeness gives way to talks. But make no mistake: Sino-U.S. rivalry and distrust will worsen over the long run. That is because China faces a confluence of negative trends: The U.S. is turning against it. Geopolitical problems with its periphery are worsening. It is at high risk of a financial crisis due to excessive leverage. The middle class is a growing political constraint on the regime. Demographics are now a long-term headwind (Chart 49). The Chinese regime will be especially sensitive to these trends because the Xi administration will want stability in the lead up to the CCP's National Party Congress in the fall, which promises to see at least some factional trouble.43 It no longer appears as if the rotation of party leaders will leave Xi in the minority on the Politburo Standing Committee for 2017-22, as it did in 2012.44 More likely, he will solidify power within the highest decision-making body. This removes an impediment to his policy agenda in 2017-22, though any reforms will still take a back seat to stability, since leadership changes and policy debates will absorb a great deal of policymakers' attention at all levels for most of the year.45 Xi will also put in place his successors for 2022, putting a cap on rumors that he intends to eschew informal term limits. Failing this, market uncertainty over China's future will explode upward. The midterm party congress will thus reaffirm the fact that China's ruling party and regime are relatively unified and centralized, and hence that China has relatively strong political capabilities for dealing with crises. Evidence does not support the popular belief that China massively stimulates the economy prior to five-year party congresses (Chart 50), but we would expect all means to be employed to prevent a major downturn. Chart 50Not Much Evidence Of Aggressive Stimulus Ahead Of Five-Year Party Congresses bca.gps_so_2016_12_14_c50 bca.gps_so_2016_12_14_c50 What this means is that the real risks of the U.S.-China relationship in 2017 will emanate from China's periphery. Asia's Frozen Conflicts Are Thawing Today the Trump administration seems willing to allow China to carve a sphere of influence - but it is entirely unclear whether and where existing boundaries would be redrawn. Here are the key regional dynamics:46 The Koreas: The U.S. and Japan are increasingly concerned about North Korea's missile advances but will find their attempts to deal with the problem blocked by China and likely by the new government in South Korea.47 U.S. threats of sanctioning China over North Korea will increase market uncertainty, as will South Korea's political turmoil and (likely) souring relations with the U.S. Taiwan: Taiwan's ruling party has very few domestic political constraints and therefore could make a mistake, especially when emboldened by an audacious U.S. leadership.48 The same combination could convince China that it has to abandon the post-2000 policy of playing "nice" with Taiwan.49 China will employ discrete sanctions against Taiwan. Hong Kong: Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.50 Japan: Japan will effectively receive a waiver from Trump's protectionism and will benefit from U.S. stimulus efforts; it will continue reflating at home in order to generate enough popular support to pass constitutional revisions in 2018; and it will not shy away from regional confrontations, since these will enhance the need for the hawkish defense component of the same revisions. Vietnam: The above issues may provide Vietnam with a chance to improve its strategic position at China's expense, whether by courting U.S. market access or improving its position in the South China Sea. But the absence of an alliance with the U.S. leaves it highly exposed to Chinese reprisals if it pushes too far. Russia: Russia will become more important to the region because its relations with the U.S. are improving and it may forge a peace deal with Japan, giving it more leverage in energy negotiations with China.51 This may also reinforce the view in Beijing that the U.S. is circling the wagons around China. What these dynamics have in common is the emergence of U.S.-China proxy conflicts. China has long suspected that the Obama administration's "Pivot to Asia" was a Cold War "containment" strategy. The fear is well-grounded but the reality takes time to materialize, which is what we will see playing out in the coming years. The reason we say "proxy wars" is because several American allies are conspicuously warming up to China: Thailand, the Philippines, and soon South Korea. They are not abandoning the U.S. but keeping their options open. The other ASEAN states also stand to benefit as the U.S. seeks economic substitutes for China while the latter courts their allegiance.52 The problem is that as U.S.-China tensions rise, these small states run greater risks in playing both sides. Bottom Line: The overarching investment implications of U.S.-China proxy wars all derive from de-globalization. China was by far the biggest winner of globalization and will suffer accordingly (Chart 51). But it will not be the biggest loser, since it is politically unified, its economy is domestically driven, and it has room to maneuver on policy. Hong Kong, Taiwan, South Korea, and Singapore are all chiefly at risk from de-globalization over the long run. Chart 51Globalization's Winners Will Be De-Globalization's Losers Strategic Outlook 2017: We Are All Geopolitical Strategists Now Strategic Outlook 2017: We Are All Geopolitical Strategists Now Japan is best situated to prosper in 2017. We have argued since well before the Bank of Japan's September monetary policy shift that unconventional reflation will continue, with geopolitics as the primary motivation for the country's "pedal to the metal" strategy.53 We will look to re-initiate our long Japanese equities position in early 2017. ASEAN countries offer an opportunity, though country-by-country fundamentals are essential. Brexit: The Three Kingdoms The striking thing about the Brexit vote's aftermath is that no recession followed the spike in uncertainty, no infighting debilitated the Tory party, and no reversal occurred in popular opinion. The authorities stimulated the economy, the people rallied around the flag (and ruling party), and the media's "Bregret" narrative flopped. That said, Brexit also hasn't happened yet.54 Formal negotiations with Europe begin in March, which means uncertainty will persist for much of the year as the U.K. and EU posture around their demands for a post-exit deal. However, improving growth prospects for Britain, Europe, and the U.S. all suggest that the negotiations are less likely to take place in an atmosphere of crisis. That does not mean that EU negotiators will be soft. With each successive electoral victory for the political establishment in 2017, the European negotiating position will harden. This will create a collision of Triumphant Tories and Triumphant Brussels. Still, the tide is not turning much further against the U.K. than was already the case, given how badly the U.K. needs a decent deal. Tightercontrol over the movement of people will be the core demand of Westminster, but it is not necessarily mutually exclusive with access to the common market. The major EU states have an incentive to compromise on immigration with the U.K. because they would benefit from tighter immigration controls that send highly qualified EU nationals away from the U.K. labor market and into their own. But the EU will exact a steep price for granting the U.K. the gist of what it wants on immigration and market access. This could be a hefty fee or - more troublingly for Britain - curbs on British financial-service access to euro markets. Though other EU states are not likely to exit, the European Council will not want to leave any doubt about the pain of doing so. The Tories may have to accept this outcome. Tory strength is now the Brexit voter base. That base is uncompromising on cutting immigration, and it is indifferent, or even hostile, to the City. So it stands to reason that Prime Minister Theresa May will sacrifice the U.K.'s financial sector in the coming negotiations. The bigger question is what happens to the U.K. economy in the medium and long term. First, it is unclear how the U.K. will revive productivity as lower labor-force growth and FDI, and higher inflation, take shape. Government "guidance" of the economy - dirigisme again - is clearly the Tory answer. But it remains to be seen how effectively it will be done. Second, what happens to the United Kingdom as a nation? Another Scottish independence referendum is likely after the contours of the exit deal take shape, especially as oil prices gin up Scottish courage to revisit the issue. The entire question of Scotland and Northern Ireland (both of which voted to stay in the EU) puts deeper constitutional and governmental restructuring on the horizon. Westminster is facing a situation where it drastically loses influence on the global stage as it not only exits the European "superstate" but also struggles to maintain a semblance of order among the "three kingdoms." Bottom Line: The two-year timeframe for exit negotiations ensures that posturing will ratchet up tensions and uncertainty throughout the year - invoking the abyss of a no-deal exit - but our optimistic outlook on the end-game (eventual "soft Brexit") suggests that investors should fade the various crisis points. That said, the pound is no longer a buy as it rises to around 1.30. Investment Views De-globalization, dirigisme, and the ascendancy of charismatic authority will all prove to be inflationary. On the margin, we expect less trade, less free movement of people, and more direct intervention in the economy. Given that these are all marginally more inflationary, it makes sense to expect the "End Of The 35-Year Bond Bull Market," as our colleague Peter Berezin argued in July.55 That said, Peter does not expect the bond bull market to end in a crash - and neither do we. There are many macroeconomic factors that will continue to suppress global yields: the savings glut, search for yield, and economic secular stagnation. In addition, we expect peak multipolarity in 2017 and thus a rise in geopolitical conflict. This geopolitical context will keep the U.S. Treasury market well bid. However, clients may want to begin switching their safe-haven exposure to gold. In a recent research report on safe havens, we showed that gold and Treasurys have changed places as safe havens in the past.56 Only after 2000 did Treasurys start providing a good hedge to equity corrections due to geopolitical and financial risks. The contrary is true for gold - it acted as one of the most secure investments during corrections until that time, but has since become correlated with S&P 500 total returns. As deflationary risks abate in the future, we suspect that gold will return to its safe-haven status. In addition to safe havens, U.S. and global defense stocks will be well bid due to global multipolarity. We recommend that clients go long S&P 500 aerospace and defense relative to global equities on a strategic basis. We are also sticking with our tactical trade of long U.S. defense / short U.S. aerospace. On the equity front, we have closed our post-election bullish trade of long S&P 500 / short gold position for an 11.53% gain in just 22 days of trading. We are also closing our long S&P 600 / short S&P 100 position - a play on de-globalization - for an 8.4% gain. Instead, we are initiating a strategic long U.S. small caps / short U.S. large caps, recommended jointly with our colleague Anastasios Avgeriou of the BCA Global Alpha Sector Strategy. We are keeping our EuroStoxx VIX term-structure hedge due to mounting political risk in Europe. However, we are looking for an opening into European stocks in early 2017. For now, we are maintaining our long USD/EUR - return 4.2% since July - and long USD/SEK - return 2.25% since November. The first is a strategic play on our view that the ECB has to remain accommodative due to political risks in the European periphery. The latter is a way to articulate de-globalization via currencies, given that Sweden is one of the most open economies in the world. We are converting it from a tactical to a strategic recommendation. Finally, we are keeping our RMB short in place - via 12-month NDF. We do not think that Beijing will "blink" and defend its currency more aggressively just because Donald Trump is in charge of America. China is a much more powerful country than in the past, and cannot allow RMB appreciation at America's bidding. Our trade has returned 7.14% since December 2015. With the dollar bull market expected to continue and RMB depreciating, the biggest loser will be emerging markets. We are therefore keeping our strategic long DM / short EM recommendation, which has returned 56.5% since November 2012. We are particularly fond of shorting Brazilian and Turkish equities and are keeping both trades in place. However, we are initiating a long Russian equities / short EM equities. As an oil producer, Russia will benefit from the OPEC deal and the ongoing risks to Iraqi stability. In addition, we expect that removing sanctions against Russia will be on table for 2017. Europe will likely extend the sanctions for another six months, but beyond that the unity of the European position will be in question. And the United States is looking at a different approach. We wish our clients all the best in health, family, and investing in 2017. Thank you for your confidence in BCA's Geopolitical Strategy. Marko Papic Senior Vice President Matt Gertken Associate Editor Jesse Anak Kurri Research Analyst 1 In Michel Foucault's famous The Order of Things (1966), he argues that each period of human history has its own "episteme," or set of ordering conditions that define that epoch's "truth" and discourse. The premise is comparable to Thomas Kuhn's notion of "paradigms," which we have referenced in previous Strategic Outlooks. 2 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2012," dated January 27, 2016, available at gps.bcaresearch.com. 3 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2013," dated January 16, 2013, available at gps.bcaresearch.com. 4 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, available at gps.bcaresearch.com and Global Investment Strategy Special Report, "Underestimating Sino-American Tensions," dated November 6, 2015, available at gis.bcaresearch.com. 5 Please see BCA Geopolitical Strategy Special Report, "The Apex Of Globalization - All Downhill From Here," dated November 12, 2014, available at gps.bcaresearch.com. 6 Please see BCA Geopolitical Strategy Special Report, "The End Of The Anglo-Saxon Economy?" dated April 13, 2016, and "Introducing: The Median Voter Theory," dated June 8, 2016, available at gps.bcaresearch.com. 7 Please see BCA Geopolitical Strategy Strategic Outlook, "Strategic Outlook 2014 - Stay The Course: EM Risk - DM Reward," dated January 23, 2014, and Special Report, "The Coming Bloodbath In Emerging Markets," dated August 12, 2015, available at gps.bcaresearch.com. 8 Please see BCA The Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 25, 2016, available at bca.bcaresearch.com. 9 Please see BCA Geopolitical Strategy Monthly Report, "Multipolarity And Investing," dated April 9, 2014, available at gps.bcaresearch.com. 10 A military-security strategy necessary for British self-defense that also preserved peace on the European continent by undermining potential aggressors. 11 Please see BCA Global Investment Strategy Special Report, "Trump And Trade," dated December 8, 2016, available at gis.bcaresearch.com. 12 Please see BCA Geopolitical Strategy Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 13 Please see BCA Geopolitical Strategy Special Report, "Taking Stock Of China's Reforms," dated May 13, 2015, available at gps.bcaresearch.com. 14 Please see BCA Geopolitical Strategy Monthly Report, "De-Globalization," dated November 9, 2016, available at gps.bcaresearch.com. 15 Please see Max Weber, "The Three Types Of Legitimate Rule," Berkeley Publications in Society and Institutions 4 (1): 1-11 (1958). Translated by Hans Gerth. Originally published in German in the journal Preussische Jahrbücher 182, 1-2 (1922). 16 We do not concern ourselves with traditional authority here, but the obvious examples are Persian Gulf monarchies. 17 Please see Francis Fukuyama, Political Order And Political Decay (New York: Farrar, Straus and Giroux, 2014). See also our review of this book, available at gps.bcaresearch.com. 18 Please see BCA Geopolitical Strategy Monthly Report, "Transformative Vs. Transactional Leadership," dated September 14, 2016, available at gps.bcaresearch.com. 19 Please see Irving Fisher, "The Debt-deflation Theory of Great Depressions," Econometrica 1(4) (1933): 337-357, available at fraser.stlouisfed.org. 20 Please see Milanovic, Branko, "Global Income Inequality by the Numbers: in History and Now," dated November 2012, Policy Research Working Paper 6250, World Bank, available at worldbank.org. 21 Please see BCA Geopolitical Strategy Monthly Report, "Introducing: The Median Voter Theory," June 8, 2016, available at gps.bcaresearch.com. 22 Please see BCA Geopolitical Strategy Special Report, "Constraints And Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 23 In some way, BCA's Geopolitical Strategy was designed precisely to fill this role. It is difficult to see what would be the point of this service if our clients could get unbiased, investment-relevant, prescient, high-quality geopolitical news and analysis from the press. 24 Please see BCA European Investment Strategy Weekly Report, "Roller Coaster," dated March 31, 2016, available at eis.bcaresearch.com. 25 Please see The Bank Credit Analyst, "Europe's Geopolitical Gambit: Relevance Through Integration," dated November 2011, available at bca.bcaresearch.com. 26 Please see BCA Geopolitical Strategy Special Report, "After BREXIT, N-EXIT?" dated July 13, 2016, available at gps.bcaresearch.com. 27 Please see BCA Geopolitical Strategy Client Note, "Will Marine Le Pen Win?" dated November 16, 2016, available at gps.bcaresearch.com. 28 Despite winning an extraordinary six of the 13 continental regions in France in the first round, FN ended up winning zero in the second round. This even though the election occurred after the November 13 terrorist attack that ought to have buoyed the anti-migration, law and order, anti-establishment FN. The regional election is an instructive case of how the French two-round electoral system enables the establishment to remain in power. 29 Please see BCA European Investment Strategy Weekly Report, "Italy: Asking The Wrong Question," dated December 1, 2016, available at eis.bcaresearch.com. 30 Please see BCA Geopolitical Strategy Special Report, "Europe's Divine Comedy: Italian Inferno," dated September 14, 2016, available at gps.bcaresearch.com. 31 Please see BCA Geopolitical Strategy Special Report, "Cold War Redux?" dated March 12, 2014, and Geopolitical Strategy Special Report, "Russia: To Buy Or Not To Buy?" dated March 20, 2015, available at gps.bcaresearch.com. 32 Please see BCA Geopolitical Strategy Special Report, "Russia-West Showdown: The West, Not Putin, Is The 'Wild Card,'" dated July 31, 2014, available at gps.bcaresearch.com. 33 Please see BCA's Emerging Markets Strategy Special Report, "Russia's Trilemma And The Coming Power Paralysis," dated February 21, 2012, available at ems.bcaresearch.com. 34 Please see BCA Geopolitical Strategy, "Middle East: Saudi-Iranian Tensions Have Peaked," in Monthly Report, "Mercantilism Is Back," dated February 10, 2016, available at gps.bcaresearch.com. 35 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, available at gps.bcaresearch.com. 36 President Erdogan, speaking at the first Inter-Parliamentary Jerusalem Platform Symposium in Istanbul in November 2016, said that Turkey "entered [Syria] to end the rule of the tyrant al-Assad who terrorizes with state terror... We do not have an eye on Syrian soil. The issue is to provide lands to their real owners. That is to say we are there for the establishment of justice." 37 Please see BCA Commodity & Energy Strategy Weekly Report, "2017 Commodity Outlook: Energy," dated December 8, 2016, available at ces.bcaresearch.com. 38 Please see BCA Geopolitical Strategy Special Report, "Power And Politics In East Asia: Cold War 2.0?" dated September 25, 2012, available at gps.bcaresearch.com. 39 Please see BCA Geopolitical Strategy Special Report, "Sino-American Conflict: More Likely Than You Think," dated October 4, 2013, and "Sino-American Conflict: More Likely Than You Think, Part II," dated November 6, 2015, available at gps.bcaresearch.com. 40 In recent years, however, China's "official" defense budget statistics have understated its real spending, possibly by as much as half. 41 Please see "U.S. Election Update: Trump, Presidential Powers, And Investment Implications" in BCA Geopolitical Strategy Monthly Report, "The Socialism Put," dated May 11, 2016, available at gps.bcaresearch.com. 42 Please see BCA Geopolitical Strategy Special Report, "Constraints & Preferences Of The Trump Presidency," dated November 30, 2016, available at gps.bcaresearch.com. 43 Please see BCA Geopolitical Strategy Special Report, "Five Myths About Chinese Politics," dated August 10, 2016, available at gps.bcaresearch.com. 44 Please see BCA Geopolitical Strategy Monthly Report, "China: Two Factions, One Party - Part II," dated September 2012, available at gps.bcaresearch.com. 45 The National Financial Work Conference will be one key event to watch for an updated reform agenda. 46 Please see "East Asia: Tensions Simmer ... Will They Boil?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 47 Please see "North Korea: A Red Herring No More?" in BCA Geopolitical Strategy Monthly Report, "Partem Mirabilis," dated April 13, 2016, available at gps.bcaresearch.com. 48 Please see BCA Geopolitical Strategy Special Report, "Scared Yet? Five Black Swans For 2016," dated February 10, 2016, and "Taiwan's Election: How Dire Will The Straits Get?" dated January 13, 2016, available at gps.bcaresearch.com. 49 The Trump administration has signaled a policy shift through Trump's phone conversation with Taiwanese President Tsai Ing-wen. The "One China policy" is the foundation of China-Taiwan relations, and U.S.-China relations depend on Washington's acceptance of it. The risk, then, is not so much an overt change to One China, a sure path to conflict, but the dynamic described above. 50 Please see BCA China Investment Strategy Weekly Report, "Hong Kong: From Politics To Political Economy," dated September 8, 2016, available at cis.bcaresearch.com. 51 Please see BCA Geopolitical Strategy Special Report, "Can Russia Import Productivity From China?" dated June 29, 2016, available at gps.bcaresearch.com. 52 Please see "Thailand: Upgrade Stocks To Overweight And Go Long THB Versus KRW" in BCA Emerging Markets Strategy Weekly Report, "The EM Rally: Running Out Of Steam?" dated October 19, 2016, and Geopolitical Strategy Special Report, "Philippine Elections: Taking The Shine Off Reform," dated May 11, 2016, available at gps.bcaresearch.com. 53 Please see BCA Geopolitical Strategy Special Report, "Japan: The Emperor's Act Of Grace," dated June 8, 2016, and "Unleash The Kraken: Debt Monetization And Politics," dated September 26, 2016, available at gps.bcaresearch.com. 54 Please see BCA Geopolitical Strategy Special Report, "BREXIT Update: Brexit Means Brexit, Until Brexit," dated September 16, 2016, available at gps.bcaresearch.com. 55 Please see BCA Global Investment Strategy Special Report, "End Of The 35-Year Bond Bull Market," dated July 5, 2016, available at gis.bcaresearch.com. 56 Please see Bank Credit Analyst Special Report, "Stairway To (Safe) Haven: Investing In Times Of Crisis," dated August 15, 2016, available at gps.bcaresearch.com. Geopolitical Calendar

Highlights The brief history of our model portfolios is a tale of two regions: our global portfolios are beating their benchmarks by an aggregate 350 basis points ("bps"), while our U.S. portfolios lag by 55 bps. Defensive sector tilts weighed on all four portfolios, but market-cap tilts gave the U.S. portfolios a big boost, and currency-hedged country and fixed-income positions turbocharged global portfolio performance. We expect to see bond yields, the dollar and DM equity prices higher at year-end 2017 and our portfolio positioning will continue to reflect these broad themes. True inflection points are few and far between, but the U.S. will at least experience a sugar rush, and we are adding some credit risk while walking back some of our defensive equity positioning to prepare for it. Table 1Summary Portfolio Performance December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Feature This report presents the first review of our model portfolios, which have now been live for seven weeks. Going forward, we will review them in our first publication of every month. The reviews will have two components: an ex-post examination of portfolio performance and an ex-ante discussion of our outlook. Both components are meant to foster transparency, with the ex-post component opening a window on our ongoing efforts to improve our process, and the ex-ante component shining a light on how our views are evolving in real time. Results To Date Our model portfolios have outperformed, on balance, over their first two months, but the aggregate results cover over a fault line between U.S. and global portfolio performance. The U.S. Long-Only portfolio is just even with its benchmark and the Long/Short lags by 55 bps, (Table 1). The disparity highlights the way dollar moves can create international opportunities. Being on the right side of the greenback helped us generate alpha despite dreadful sector positioning. Portfolio Performance Attribution We track portfolio attribution on up to six applicable dimensions. For all the portfolios, we consider Asset Allocation, Equity Sector Allocation and Fixed Income Category Allocation. If the Equity portion of the portfolios has any mid- or small-cap exposures, we track Market Cap Allocation; if it has multi-country exposures, we track Country Allocation; and if it has short positions, we track Long/Short Allocation based on the contribution from its long/short pairs. Since all of the portfolios were initially set to match our benchmark asset allocations (60% Equity/37.5% Fixed Income/2.5% Cash), we have no Asset Allocation attribution to report in this update (Table 2). Table 2Applicable Attribution Sources December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market U.S. Long-Only Our U.S. Long-Only portfolio (Table 3) outperformed its benchmark by 1 basis point through November 30.1 Market cap allocation paved the way to the outperformance, as small- and mid-cap stocks zoomed higher following the election (Table 4). Our fixed-income category allocations helped, as well, with the outperformance of our income hybrids bucket and our sizable underweight in lagging investment-grade corporates more than making up for our zero weight in outperforming high yield (Table 5, bottom panel). The gains were consumed by equity sector underperformance, which labored mightily under an inopportune defensive bias (Table 5, top panel). Table 3U.S. Long-Only Model Portfolio: Absolute Performance By Position December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 4U.S. Relative Performance Contribution From Market-Cap Positioning December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 5U.S. Relative Performance Contribution From Sector Positioning December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market U.S. Long/Short Our U.S. Long/Short portfolio (Table 6) underperformed its benchmark by 55 basis points through November 30.2 Larger defensive sector tilts weighed on the long/short portfolio relative to its long-only counterpart, compounded by short positions in cyclical sectors (Table 7, bottom panel). Our fixed-income pairs fared better: while the HYG short/LQD long detracted from performance, the IEF short/TIP long was able to offset it (Table 7, top panel). The former, an anti-credit risk (and duration-extending) play, was poorly positioned on both counts, but the latter was well positioned to reap the benefit of the pickup in inflation expectations. Table 6U.S. Long/Short Model Portfolio: Absolute Performance By Position December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 7U.S. Relative Performance Contribution From Long/Short Pairs December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Global Long-Only Our Global Long-Only portfolio (Table 8) outperformed its benchmark by 188 basis points through November 30.3 Successful country positioning contributed to the sizable outperformance, as the (currency-hedged) Japan overweight was a rousing success (Table 9). Fixed-income category allocations were also big winners, driven by the currency-hedged non-U.S. aggregate exposure (BNDX) and the U.S. aggregate (AGG) and corporate holdings (LQD), which more than offset the drag from the unhedged international sovereign exposure (BWX) (Table 10, bottom panel). Only equity sector allocations weighed on the portfolio, as both Staples and Health Care were drubbed by the benchmark index (Table 10, top panel). Table 8Global Long-Only Model Portfolio: Absolute Performance By Position December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 9Global Relative Performance Contribution From Country Positioning December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 10Global Relative Performance Contribution From Sector Positioning December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Global Long/Short Our Global Long/Short portfolio (Table 11) outperformed its benchmark by 166 basis points through November 30.4 Just like its U.S. counterpart, the global Long/Short portfolio was weighed down by its wrong-footed long defensives/short cyclicals pairs (Table 12). Country long/short pairs paid off nicely, however, especially in November, as emerging markets with sizable current account deficits, like Turkey and Brazil, underperformed their less dollar-vulnerable peers. Our fixed-income long/short pairs also outperformed, albeit by a smaller margin. Table 11Global Long/Short Model Portfolio: Absolute Performance By Position December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 12Global Relative Performance Contribution From Long/Short Pairs December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market How Our Views Fared Rates, Inflation And Credit Markets rewarded two of the four components of our fixed-income view. U.S. inflation expectations surged (Chart 1) and developed-world sovereigns proved to be an especially poor value, as the aggregate G7 economies' 10-year bond yield spiked faster than at any point since the taper tantrum in 2013 (Chart 2). These views, expressed as portfolio tilts - underweight fixed income, own TIPS and hold duration at or below benchmark duration - worked well when translated to portfolio positions, as noted above. Chart 1Inflation Expectations Spiked... bca.bcasr_sr_2016_12_08_c1 bca.bcasr_sr_2016_12_08_c1 Chart 2...And So Did Nominal Yields bca.bcasr_sr_2016_12_08_c2 bca.bcasr_sr_2016_12_08_c2 The bear-flattening call turned out to be a dud, as the Treasury yield curve steepened despite the looming Fed tightening cycle. Overwhelmed by our anti-duration call, though, it had no meaningful portfolio impact. Our credit-bearish call was a central fixed-income pillar in all four of our portfolios, and it did constrain performance as high yield outperformed at home and abroad. Yields may well be due to pull back following their November surge, but we see them ending 2017 higher, making credit's positive carry an attractive buffer against rising rates. Economic Growth And Corporate Earnings Our concerns that the equity rally has become uncomfortably stretched, and that U.S. corporate margins face downward pressure, did not amount to anything over the last two months. Since we maintained benchmark equity weightings across all of our portfolios, however, our too-early views did not affect performance. We expressed our defensives-over-cyclicals view in every portfolio's sector allocations to the detriment of performance across the board. Thanks to currency-hedged Japanese equities' surge, the global portfolios benefitted slightly from our view that European and Japanese multinationals would find the going easier than their U.S. counterparts, and we remain optimistic about the potential for a relative European profit inflection. New And Revised Views Rates, Inflation And Credit There are still too many unknowns about the details of policy proposals to assess whether or not the U.S. is on the cusp of sustained growth acceleration, but the incoming administration, supported by a compliant Congress, can unquestionably bestow a sugar rush. The credit upshot is that it will be harder to default if both growth and inflation get a fillip in 2017. The curve is likely to steepen on the grounds that our bond strategists expect the Fed to allow inflation expectations to gather momentum before it signals an increased pace of hikes and a higher terminal rate. The bond vigilantes could add to the upward pressure on long rates if they ever stir from their long hibernation. It would be entirely reasonable for yields to retrace at least a portion of their sudden and sizable move, and our U.S. Bond Strategy service has moved to benchmark duration to position for near-term consolidation. It still sees long rates higher a year from now, though, and we are not going to wait to add some carry to the portfolio. We are replacing our U.S. REIT exposure with business development company exposure via the BIZD ETF, which will add some beta along with credit exposure. We are going to add bank loans in the form of the BKLN ETF, providing some rate protection (bank loans carry floating rates) and allowing us to dip our toe into the most senior tranche of the high-yield space. BKLN will push our Treasuries exposure to below benchmark,5 but we will maintain Treasury duration near benchmark in line with our bond strategists' tactical guidance. We will look to exit our TLT position on a 10-year rally back to the 2-2.2% range. Chart 3Pigs Get Slaughtered bca.bcasr_sr_2016_12_08_c3 bca.bcasr_sr_2016_12_08_c3 Cyclicals Versus Defensives The uncertainty around the impact of the incoming administration's proposed policies keeps us from fully reversing course on our cyclicals/defensives positioning. But our conviction about higher rates increases our remorse at overstaying our welcome in Staples and Telcos (Chart 3). As an analogue to positioning for near-term economic acceleration by taking on some credit risk, we're shifting capital away from rate-driven Staples and Telecom to Discretionaries and Energy. Our exit from Swiss equities in the global portfolios furthers our move to more neutral intra-equity settings. We are adding Energy exposure to all of the portfolios to reflect our strategists' bullish take on crude oil. The recently agreed OPEC-Russia production cuts will fuel inventory drawdowns that will keep crude prices from falling below $50. Our Energy Sector Strategy service argues that U.S. shale producers will reap the greatest benefits, as $50+ crude will allow them to accelerate oilfield reinvestment and grow production in 2017. We are therefore adding FRAK, an ETF dominated by U.S. shale oil and natural gas producers, to our U.S. portfolios.6 Other Portfolio Changes Aside from dialing back our defensive equity positioning and embracing some credit risk, our biggest change has been to pull in our horns on the sector tilts across all of our portfolios. We are chastened by being off-sides with our sector calls and are pulling back until we have a better sense of direction. We are waiting in all portfolios for an opportune time to shorten duration. We expect to maintain our sizable income hybrids sleeve as the nascent bond bear market grinds along. Table 13 shows our revised U.S. Long-Only portfolio. As mentioned above, it no longer shuns cyclical sector or credit exposures and will continue to evolve with the anticipated direction of the economy. We have chosen not to rebalance our mid- and small-cap exposures and we would be happy to increase them if they retrace some of their relative gains in the near term. The U.S. Long/Short portfolio (Table 14) is effectively an amplified version of the Long-Only portfolio but its sector tilts are being trimmed considerably as well. Table 13Revised U.S. Long-Only Model Portfolio December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Table 14Revised U.S. Long/Short Model Portfolio December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market The changes to our Global Long-Only portfolio mute its defensive bias and attempt to simplify it by removing standalone currency-hedging positions (Table 15). We substitute HEWU, the currency-hedged version of EWU, for our existing EWU/FXB pair, giving up some liquidity to save on ETF and borrow fees. We clean up the other currency short by exiting our Swiss equity position, which is no longer needed now that we are dialing back the portfolio's defensive cast. We exit BWX and reallocate its proceeds to BNDX and AGG to simplify the portfolio and remove incremental sovereign and currency exposure. We replace LQD with JNK to introduce a modest high-yield exposure to the portfolio. Table 15Revised Global Long-Only Model Portfolio December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Like its U.S. counterpart, our Global Long/Short portfolio is significantly dialing back its sector tilts (Table 16). The Staples, Telco and Utilities overweights are being eliminated, along with the Financials short. The Health Care overweight and the corresponding Industrials and Tech shorts have been reduced. As in the Long-Only portfolio, we are exiting Switzerland and redeploying the proceeds in Energy, Discretionaries and a slightly reduced U.S. underweight. We are replacing the incremental exposure to U.S. Investment Grade (LQD) with High Yield (JNK), reflecting our U.S. rates and credit view. With the addition of JNK, we are taking the opportunity to do a little housecleaning by replacing the U.S. leg of our EM junk spread-widening pair, formerly HYG, with JNK, which better aligns with our portfolio benchmark and is 10 bps cheaper per annum. Table 16Revised Global Long/Short Model Portfolio December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market December Model Portfolios Review: The Power Of Currency Hedging In A Dollar Bull Market Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 Through December 5th, the U.S. Long-Only portfolio is in line with its benchmark. 2 Through December 5th, the U.S. Long/Short portfolio has underperformed by 65 basis points. 3 Through December 5th, the Global Long-Only portfolio has outperformed by 184 basis points. 4 Through December 5th, the Global Long/Short portfolio has outperformed by 160 basis points. 5 In our October 12th Special Report introducing the model portfolios, we referred to outdated Aggregate/High Yield proportions in our U.S. and global fixed income benchmarks. Based on the outstanding value of the bonds in the indexes, the correct U.S. breakdown is 90/10 AGG/HY and the correct global breakdown is 93/7 AGG/HY, not 95/5 as originally stated. Our performance attribution calculations reflect the correct benchmarks. 6 For more information on the shale producers and the effects of the OPEC cuts, please see the following Energy Sector Strategy reports, available at nrg.bcaresearch.com: Constructive On U.S. Shale Producers And Select Service Companies, published July 6, 2016; The OPEC Debate, published November 23, 2016; and Recommendation Additions & Changes Following OPEC's Cut, published December 7, 2016.

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of November 30, 2016. The model further augmented the overweight to the U.S. despite the fact that the U.S. had already been the largest overweight, at the expenses of the Euro Area. Japan's underweight is reduced again, albeit slightly. The model continues to dislike Canada and Australia even though the two countries have outperformed year to date. U.K. remains the largest underweight (Table 1). Table 1Model Allocation Vs. Benchmark Weights GAA Model Updates GAA Model Updates As shown in Table 2 and Chart 1, Chart 2 and Chart 3, the large overweight of the U.S. versus the non-U.S. (Level 1 model) worked well in November with 49 bps of outperformance versus the MSCI World benchmark, the level 2 (allocation within the 11 non-U.S. countries), however, underperformed significantly, resulting the overall model to underperform by 16 bps. Please see also on the website http://gaa.bcaresearch.com/trades/allocation_performance. Table 2Performance (Total Returns In USD) GAA Model Updates GAA Model Updates Chart 1GAA DM Model Vs. MSCI World bca.gaa_sa_2016_12_01_c1 bca.gaa_sa_2016_12_01_c1 Chart 2GAA U.S. Vs. Non U.S. Model (Level1) bca.gaa_sa_2016_12_01_c2 bca.gaa_sa_2016_12_01_c2 Chart 3GAA Non U.S. Model (Level 2) bca.gaa_sa_2016_12_01_c3 bca.gaa_sa_2016_12_01_c3 For more details on the models, please see the January 29th, 2016 Special Report "Global Equity Allocation: Introducing the Developed Markets Country Allocation Model." http://gaa.bcaresearch.com/articles/view_report/18850. GAA Equity Sector Selection Model The GAA Equity Sector Selection Model (Chart 4) is updated as of November 30, 2016. Table 3Allocations GAA Model Updates GAA Model Updates Table 4Performance Since Going Live GAA Model Updates GAA Model Updates Chart 4Overall Model Performance bca.gaa_sa_2016_12_01_c4 bca.gaa_sa_2016_12_01_c4 The momentum component has shifted Consumer Discretionary from underweight to overweight. For mode details on the model, please see the Special Report "Introducing The GAA Equity Sector Selection Model," July 27, 2016 available at https://gaa.bcaresearch.com. Xiaoli Tang, Associate Vice President xiaoli@bcaresearch.com Patrick Trinh, Senior Analyst patrick@bcaresearch.com Aditya Kurian, Research Analyst adityak@bcaresearch.com

The Tactical Asset Allocation model can provide investment recommendations which diverge from those outlined in our regular weekly publications. The model has a much shorter investment horizon - namely, one month - and thus attempts to capture very tactical opportunities. Meanwhile, our regular recommendations have a longer expected life, anywhere from 3-months to a year (or longer). This difference explains why the recommendations between the two publications can deviate from each other from time to time. Highlights In November, the model underperformed global equities and the S&P in USD and in local-currency terms. For December, the model reduced its allocation to cash and stocks and boosted its weighting in bonds (Chart 1). Within the equity portfolio, most of the decrease in allocation came at the expense of EM, Sweden, Netherlands, U.S., and New Zealand. The model increased its weighting in Swedish, French, U.K., and Canadian bonds. The risk index for stocks deteriorated in November, while the bond risk index improved significantly. Chart 1Model Weights bca.gis_taami_2016_11_25_c1 bca.gis_taami_2016_11_25_c1 Feature Performance In November, the recommended balanced portfolio lost 1.5% in local-currency terms and was down 3.4% in U.S. dollar terms (Chart 2). This compares with a gain of 1.3% for the global equity benchmark, and a 3.7% gain for the S&P 500 index. Given that the underlying model is structured in local-currency terms, we generally recommend that investors hedge their positions, though we do provide recommendations from time to time. The sharp bond selloff and weakness in EM equity markets both took a toll on the model's performance in November. Weights The model cut its allocation to stocks from 66% to 53%, and increased its bond weighting from 26% to 47%. The allocation to cash was brought down to zero from 8%, while commodities remain excluded from the portfolio (Table 1). The model trimmed its allocation to Latin American equities by 4 points, Sweden by 3 points, and the Netherlands by 3 points. Also, weightings were reduced in U.S., New Zealand, Spanish, and Emerging Asian stocks. In the fixed-income space, the allocation to Swedish paper was boosted by 12 points, France by 7 points, Canada by 5 points, the U.K. by 3 points, and Italy by 1 point. Allocation to New Zealand bonds was decreased by 6 points and U.S. Treasurys by 1 point. Chart 2Portfolio Total Returns bca.gis_taami_2016_11_25_c2 bca.gis_taami_2016_11_25_c2 Table 1Model Weights (As Of November 24, 2016) Tactical Asset Allocation And Market Indicators Tactical Asset Allocation And Market Indicators Currency Allocation Local currency-based indicators drive the construction of our model. As such, the performance of the model's portfolio should be compared with the local-currency global equity benchmark. The decision to hedge currency exposure should be made at the client's discretion, though from time to time, we do provide our recommendations. The dollar appreciated significantly in November following the U.S. presidential election. Our Dollar Capitulation Index spiked and is currently at levels that suggest the rally in the broad trade-weighted dollar could pause (Chart 3). Chart 3U.S. Trade-Weighted Dollar* And Capitulation bca.gis_taami_2016_11_25_c3 bca.gis_taami_2016_11_25_c3 Capital Market Indicators The momentum indicator for commodities has moved further into overbought territory, pushing up the overall risk index. This asset class remains excluded from the portfolio (Chart 4). The deterioration in the liquidity and momentum indicators has lifted the risk index for global equities to the highest level in over 2 years. Our model cut its weighting in equities for the fourth month in a row (Chart 5). Chart 4Commodity Index And Risk bca.gis_taami_2016_11_25_c4 bca.gis_taami_2016_11_25_c4 Chart 5Global Stock Market And Risk Global Stock Market And Risk Global Stock Market And Risk The risk index for U.S. stocks increased sharply in November. With stocks reaching new highs, the model trimmed its allocation to this bourse. The markets took note of the growth-positive aspects of Trump's policies, but seem complacent about the stronger dollar, higher interest rates, and the potential for trade protectionist policies (Chart 6). The risk index for euro area equities has ticked up slightly in November. However, unlike its U.S. peers, it remains in the low-risk zone. Above-trend growth could provide support for euro area equities. (Chart 7). Chart 6U.S. Stock Market And Risk bca.gis_taami_2016_11_25_c6 bca.gis_taami_2016_11_25_c6 Chart 7Euro Area Stock Market And Risk Euro Area Stock Market And Risk Euro Area Stock Market And Risk The risk index for Dutch equities ticked up slightly and the model has downgraded this asset. That said, the weighting in Dutch equities remains the highest among its euro area counterparts (Chart 8). Improvements in the value and momentum measures for Latin American stocks have been largely offset by a deteriorating liquidity reading. As a result, the risk index did not decline much after the selloff. The model decreased its allocation to this asset (Chart 9). Chart 8Dutch Stock Market And Risk bca.gis_taami_2016_11_25_c8 bca.gis_taami_2016_11_25_c8 Chart 9Latin American Stock Market And Risk bca.gis_taami_2016_11_25_c9 bca.gis_taami_2016_11_25_c9 Over the course of only a few months, the risk index for bonds has swung from an extremely high risk level to the low-risk zone. Momentum has been the primary driving force behind this move and currently suggests that yields could pull back in the near term (Chart 10). The risk index for U.S. Treasurys declined significantly in November. While the model used the latest selloff to boost its allocation to bonds, it preferred to add allocation to bond markets outside of Treasurys. (Chart 11). Chart 10Global Bond Yields And Risk bca.gis_taami_2016_11_25_c10 bca.gis_taami_2016_11_25_c10 Chart 11U.S. Bond Yields And Risk bca.gis_taami_2016_11_25_c11 bca.gis_taami_2016_11_25_c11 After the rise in yields, Canadian bonds are massively oversold based on our momentum measure. The extremely low-risk reading has prompted the model to allocate to this asset (Chart 12). German bonds are oversold, but the reading on the cyclical measure has become considerably more bund-unfriendly. The model opted not to include bunds in the overall boost to its bond allocation. (Chart 13). Chart 12Canadian Bond Yields And Risk bca.gis_taami_2016_11_25_c12 bca.gis_taami_2016_11_25_c12 Chart 13German Bond Yields And Risk bca.gis_taami_2016_11_25_c13 bca.gis_taami_2016_11_25_c13 The risk reading in French bonds is more favorable than for bunds. Apart from oversold momentum, the value reading has also improved. The model increased its allocation to French bonds (Chart 14). The cyclical component of the risk index for Swedish bonds keeps moving in a bond-bearish direction. But that is completely overshadowed by extremely oversold conditions. In fact, the overall risk index for Swedish bonds is the lowest within our bond universe. Much of the increase in overall bond allocation ended up in Swedish paper (Chart 15). Chart 14French Bond Yields And Risk bca.gis_taami_2016_11_25_c14 bca.gis_taami_2016_11_25_c14 Chart 15Swedish Bond Yields And Risk bca.gis_taami_2016_11_25_c15 bca.gis_taami_2016_11_25_c15 Following sharp gains, the 13-week momentum measure for the U.S. dollar has reached levels at which some consolidation may take place. But the recovery in the 40-week rate of change measure indicates that it would probably be a pause in the dollar bull market rather than a trend change. With the December rate hike baked in, the Fed's communication about the policy next year holds the key to the path of the dollar - in addition to the fiscal policy of the next administration (Chart 16). The Japanese yen has been a major victim of the dollar rally. The 13-week momentum measure is approaching levels that halted the yen weakening trend in 2013 and 2015. However, this time around, it is not coupled with the same signal from the 40-week rate of change measure. The BoJ is sticking to its easy monetary policy, and some additional support on the fiscal front could drag the yen lower, notwithstanding a possible hiatus in the short term. Short term the yen could benefit from an EM pullback (Chart 17). After the latest bout of depreciation, the euro seems poised for another attempt to break below 1.05. The 13-week and 40-week momentum measures do not preclude this from happening. However, it would probably take the ECB to reaffirm its dovish message to push EUR/USD technical indicators into more oversold territory (Chart 18). Chart 16U.S. Trade-Weighted Dollar* bca.gis_taami_2016_11_25_c16 bca.gis_taami_2016_11_25_c16 Chart 17Yen bca.gis_taami_2016_11_25_c17 bca.gis_taami_2016_11_25_c17 Chart 18Euro bca.gis_taami_2016_11_25_c18 bca.gis_taami_2016_11_25_c18 Miroslav Aradski, Senior Analyst miroslava@bcaresearch.com

Highlights Huge short-term moves have occurred in several markets in the wake of the U.S. election. From a tactical perspective, we believe the moves have gone too far, too fast. Beyond the tactical, the key question is whether or not the U.S. economy is at an inflection point. Will the incoming administration's policies boost activity enough to allow the U.S. to break free of the mushy growth that has characterized the post-crisis era? Key swing factors include the details of tax reform and spending proposals, revised regulatory measures and trade and immigration policy and their effects on consumption and capex. It is too early to tell if the U.S. is on the cusp of a durable inflection, but we list a range of indicators for investors to monitor as events unfold. Feature The hallmarks of president-elect Donald Trump's campaign promises - deregulation, de-globalization and aggressively reflationary fiscal policy - mark a sharp break with the post-crisis status quo and markets have responded in kind. Across asset classes and regions, prices have gone vertical (Chart 1). The policy proposals, and the market responses to them, have left investors facing two big questions: Have the markets gone too far in discounting the potential policy changes? Does the election herald an inflection point for the U.S. economy? The first question is tactical, the second is cyclical. Regarding the former, we are with the too-far, too-fast camp. Given the swiftness and the magnitude of the moves, it seems as if markets have brushed off any consideration of the uncertainties surrounding the details of the incoming administration's proposals and the compromises that will be required to implement them. Not since TARP has so much been assumed by so many on so few details. A reliable technical rule suggests that the biggest moves are unsustainable. Relative to their 40-week moving averages, USD/MXN, small-cap versus large-cap U.S. stocks, U.S. banks and 10-year Treasury yields are all two to two-and-a-half standard deviations from their post-crisis means (Chart 2). Our geopolitical strategists are more confident than the broad consensus that the new administration will get its policies through Congress, but even those who agree are advised to wait for a better entry point. Asset prices often retrace swiftly once they've been stretched two standard deviations from their 200-day moving average. Chart 1Awfully Far, Awfully Fast bca.bcasr_sr_2016_11_23_c1 bca.bcasr_sr_2016_11_23_c1 Chart 2Stretched To Extremes bca.bcasr_sr_2016_11_23_c2 bca.bcasr_sr_2016_11_23_c2 The GDP Equation The cyclical timeframe is BCA's sweet spot, however, and our main concern is whether or not the U.S. economy is poised to break out of the 2-2.25% growth range it's settled into (Table 1). GDP growth is no more than the sum of labor force growth and productivity growth, so any successful attempt to lift the trend rate of GDP will have to lift the trend rate of one or both of its components. These sorts of gains are not easily won. Labor force growth, for example, is mainly tied to the glacial pace of shifts in population growth, with shorter-cycle changes in labor force participation exerting a modest impact around the edges. The new administration's pledges to tighten America's borders and more stringently enforce existing immigration laws would curtail population growth if they were brought to fruition. The U.S. relies on new immigrants, especially those from Latin America, to maintain steady-state population growth1. While accelerating economic growth could bring some discouraged workers back into the labor force, the decline in participation is a secular phenomenon (Chart 3). The labor force is unlikely to grow enough to move the needle, and potential deportations and voluntary departures tilt the balance to the downside. Table 1The Mushy Post-Crisis Path Is The U.S. At An Inflection Point? Is The U.S. At An Inflection Point? Chart 3A Secular Decline bca.bcasr_sr_2016_11_23_c3 bca.bcasr_sr_2016_11_23_c3 Capital expenditures are the best predictor of productivity growth, as efficiency gains occur when workers are supported by new tools, facilities and software. Investment per worker consistently leads productivity growth by about a year in the U.S. (Chart 4, top panel) and is a leading productivity indicator around the world (Chart 4, bottom panel). Capex has disappointed across the developed world following the crisis, and all three elements of U.S. non-residential investment have recently fallen well short of past expansions (Chart 5). Chart 4Capex Leads Productivity bca.bcasr_sr_2016_11_23_c4 bca.bcasr_sr_2016_11_23_c4 Chart 5Falling Short bca.bcasr_sr_2016_11_23_c5 bca.bcasr_sr_2016_11_23_c5 Immediate expensing (as opposed to capitalization and depreciation) will increase the after-tax net present values of all projects, encouraging investment. Even so, attempts to give investment a cyclical jolt will run up against the powerful secular drags of declining trend growth, the capital-lite economy and expanding income inequality. The link between trend growth and investment is readily apparent; demand for industrial, office, retail, and residential construction is directly related to the pace of aggregate income growth. Capital-lite may be a new term, but it describes an entrenched phenomenon. Capital-intensive manufacturing's share of employment has been falling since the fifties (Chart 6). On-shoring could partially roll back this trend, boosting capex as manufacturing facilities are built or refurbished. Dollar strength and stricter immigration enforcement will increase the cost of on-shoring, however. Chart 6A Long Decline In Capital-Intensive Activity Is The U.S. At An Inflection Point? Is The U.S. At An Inflection Point? Expanding inequality weighs on trend growth because it concentrates income in the hands of those least likely to spend it. Reducing the top marginal income tax rate and eliminating the estate tax could squeeze aggregate demand if Congress demands cuts in the social safety net to help pay for it. On the other hand, increased employment opportunities for the low-skilled could help boost demand. Populist policies would generally be expected to narrow inequality, but it remains to be seen if the populist campaign will translate to a populist presidency. Bottom Line: Shifting trend GDP growth higher is a tall order, and stimulus efforts are unlikely to reverse secular drags. The Trouble With The Long Run We acknowledge the truth of Keynes' beef with overly long-run analyses. Even investors with the longest timeframes need to pay attention to the intermediate term. The most relevant question for the broad sweep of institutional investors is what might the incoming administration achieve over the next couple of years? To answer that question, it helps to go back to the GDP equation framework and consider the complete self-reinforcing productivity chain: productivity gains from capex, capex from consumption, consumption from employment, income and spending/saving preferences. All Roads Lead To The Consumer Do corporations build capacity ahead of a ramp-up in demand, or do they wait for demand to emerge before they expand their ability to meet it? With all due respect to Monsieur Say2, the evidence suggests that consumption leads capex (Chart 7). This leaves open the possibility that a robust labor market generating real income gains, alongside a revival of C-suite animal spirits, could generate a self-reinforcing lift in activity over the next few years. A sizable fiscal impulse could energize both channels. All of the components of GDP have undershot past cycle averages at different points of this expansion, but government spending has consistently lagged since the stimulus act petered out at the end of 2010 (Chart 8). Viewed in terms of the year-over-year change in government outlays, the shortfall is especially sharp, as much as four or five percentage points below the typical pattern (Chart 9). Unfortunately, the optimal time for fiscal thrust has passed. As our U.S. Investment Strategy service has shown3, fiscal stimulus is more effective in recessions than in expansions. The mix of stimulus measures matters, too, and the CBO has estimated that tax cuts for high-income households - the central element of the incoming administration's fiscal package - have no more than a tepid impact. Chart 7First Consumption, Then Capex bca.bcasr_sr_2016_11_23_c7 bca.bcasr_sr_2016_11_23_c7 Chart 8A Lack Of Fiscal Spending... bca.bcasr_sr_2016_11_23_c8 bca.bcasr_sr_2016_11_23_c8 Chart 9...Has Held This Expansion Back bca.bcasr_sr_2016_11_23_c9 bca.bcasr_sr_2016_11_23_c9 The state of the labor market is more encouraging for consumption. Wages have begun to rise as the pool of available workers has shrunk and solid real income gains may well be in store. Both the Atlanta Fed's Wage Tracker (Chart 10, top panel) and average hourly earnings (Chart 10, bottom panel) have inflected higher over the last two years. Richer compensation is not good for corporate margins, but an optimistic scenario would allow increased revenues to make up much of the difference. Chart 10Wage Growth Is Surging bca.bcasr_sr_2016_11_23_c10 bca.bcasr_sr_2016_11_23_c10 Chart 11The Savings Rate Has Stabilized... bca.bcasr_sr_2016_11_23_c11 bca.bcasr_sr_2016_11_23_c11 Just because households are earning doesn't mean they're consuming. The propensity to save or dis-save, via taking on debt, can exert a strong influence. With no pressing need to pay down debt, the savings rate appears to have stabilized around 6% (Chart 11), while the household debt-to-GDP ratio has ticked higher for three straight quarters after falling 20 points from its 2008 peak (Chart 12, top panel). The Debt Supercycle may have run its course, but with the debt-service burden lighter than it's been at any point since Ronald Reagan took office (Chart 12, bottom panel), households once again have unused borrowing capacity. Chart 12...And The Household Debt Burden Is Much Lighter bca.bcasr_sr_2016_11_23_c12 bca.bcasr_sr_2016_11_23_c12 Bottom Line: With employment and wage growth already moving in the right direction, and households regaining the ability to add some debt, a pickup in consumption could amplify the effects of fiscal stimulus and give rise to two years of notably stronger growth. Potential Pitfalls Reflation efforts seven years into an expansion have more complicated consequences than reflation efforts undertaken near a cycle trough. They are much more likely to lead to overheating and monetary policy makers may be obliged to counteract them. With government debt-to-GDP at an already elevated level (Chart 13), the bond vigilantes may force yields sharply higher, subverting stimulus efforts and twisting reflation into something more like stagflation. Crowding out is a plausible threat. Chart 13Limited Capacity For Stimulus bca.bcasr_sr_2016_11_23_c13 bca.bcasr_sr_2016_11_23_c13 Infrastructure spending is difficult to get just right. There is not necessarily a correlation between a given project's shovel-readiness and its relative net present value. It is unclear just how many skilled workers are available to wield the shovels and operate the machinery to execute projects. Infrastructure is a comparatively small element of the proposed fiscal plan, but it is not likely to come on full blast in 2017. Mainstream economists unanimously agree that protectionist policies and immigration restrictions dampen growth. The U.S. economy is comparatively closed, but its multinational corporations are vulnerable to the imposition of new trade barriers. Limited access to foreign end-markets and disruptions to low-cost global supply chains would quickly show up in S&P 500 earnings. Continued dollar strength would be a headwind for many of the largest S&P 500 constituents as well. Our Reflation Checklist The incoming administration's discussions of its policy plans have so far been confined to generalities, making it difficult to assess their impact. Even if investors had a clearer outline of policy plans, there are too many moving parts to allow for much forecasting precision. Heeding our Geopolitical Strategy team's view, we are taking compliant Republican legislators as a given and assuming that the administration's signature objectives will not encounter much resistance. But even with legislative majorities, incoming administrations have short honeymoons, and the way the White House prioritizes its initiatives will be important. Investors will have to keep tabs on a wide range of factors to weigh reflation prospects. We are in the midst of building a checklist to track those factors, but are going to wait to finalize it with quantitative parameters until markets settle down to consolidate some of their initial moves. We expect to cull the final factors from the following preliminary list of questions. Fed Policy 1. Will the Fed feel confident enough to hike rates in December? 2. Will the Fed signal an increase in its expected pace of hikes, or an increase in the terminal rate, in its Summaries of Economic Projections? Market Signals 3. Will OIS rate-hike expectations continue to chase the FOMC dots higher? 4. How tight can monetary conditions get? 5. Where will dollar appreciation stop? 6. Are long rates pricing in higher real yields? 7. Are S&P 500 multiples expanding, contracting or holding steady? 8. Are credit spreads taking their cue from better growth prospects, or increased uncertainty? Economic Signals 9. How is the labor force participation rate responding to stronger growth and higher wages? 10. Is there upward pressure on wages? 11. Is the savings rate poised to break out in either direction? 12. Are households taking on more debt? 13. Are corporations using lower taxes to fund capex? 14. Are trade restrictions shaping up as cosmetic or substantive? 15. Is enforcement squeezing immigration and/or sparking reverse migration? Investment Implications The election results, and their promise of reflationary policy, were not friendly for our defensives-over-cyclicals tilt, or our income hybrids bucket. There is no guarantee, however, that policies will be enacted in their anticipated form. Even if they are, we view several moves as overdone. We will therefore wait two more weeks, until our scheduled model portfolio review on December 7, to make changes. We are contemplating pulling in our defensive horns by reducing our Consumer Staples positions. Our Staples overweights are our least favorite defensive positions given that they are an express play on a continued valuation overshoot. We are most likely to direct a reduced Staples allocation to Discretionaries. We are also considering increasing our exposure to spread product, most likely at the expense of the income hybrids bucket and/or Treasuries. Stronger growth, even if only on the order of 50 or 100 basis points, will make it easier to service debt, as will increased inflation, and the carry in spread product will help protect a fixed income portfolio better than Treasuries in a rising-rate environment. Doug Peta, Vice President Global ETF Strategy dougp@bcaresearch.com 1 It takes a birthrate of 2.1 to keep the population at a steady state. Without immigration, the U.S. would look much more like its developed-world peers with mid-1-handle birthrates, as incumbent families tend to have fewer children than newly arrived families. 2 Say's Law, named for an early nineteenth-century French economist, posits that supply creates its own demand. 3 Please see the November 7, 2016 U.S. Investment Strategy Weekly Report, "Policy, Polls, Probability," available at usis.bcaresearch.com.

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

Highlights Most narratives surrounding G7 bond yields, the U.S. dollar, Chinese credit/fiscal impulses, and the RMB exchange rate - which justified the EM rally from February's lows - have been overturned. To be consistent, this warrants a relapse in EM risk assets. In China, recent property market and marginal credit policy tightening will weigh on growth. Feature The more recent strength in Chinese and emerging markets' (EM) manufacturing PMI indexes as well as the bounce in industrial metals prices have gone against our negative view on EM/China growth and related markets. While it is hard to predict market patterns over the next several weeks, we maintain that the EM rally is on borrowed time, and that the risk-reward profile for EM risk assets (stocks, credit markets and currencies) remains very unfavorable. Tracking Correlations And Indicators The overwhelming majority of indicators and variables that supported the rally in EM since February have reversed in recent months. Specifically: China's credit and fiscal spending impulses have rolled over (Charts I-1 and Chart I-2, on page 1). This will likely lead to a rollover in mainland industrial activity early next year (Chart 1, top panel). Similarly, this bodes ill for much-followed Chinese ex-factory producer prices - i.e., producer price deflation will probably recommence early next year (Chart I-1, bottom panel). Chart I-1China: Industrial Sectors To Retreat? bca.ems_wr_2016_11_09_s1_c1 bca.ems_wr_2016_11_09_s1_c1 Chart I-2China: Credit And Fiscal Impulses China: Credit And Fiscal Impulses China: Credit And Fiscal Impulses In a nutshell, the strong credit and fiscal impulses of late 2015 and early 2016 explain the stabilization and mild improvement in the Chinese economy during the past few months. However, these same impulses project renewed weakness/rollover in the economy in early 2017. If financial markets are forward looking, they should begin pricing-in deteriorating growth momentum sooner than later - especially as Chinese policymakers are announcing marginal tightening policies (see below for more details). One of the narratives that triggered the EM and global equity rally in February was speculation that there was a "Shanghai accord" between global central banks. According to this narrative, the People's Bank of China (PBoC) promised not to devalue the RMB in exchange for the Federal Reserve not hiking rates. Since then, the RMB has continued to depreciate, both versus the greenback and the CFETS1 basket. Yet EM and global stocks have completely disregarded the RMB depreciation (Chart I-3). We do not have good explanation as to why. Indeed, the RMB has weakened meaningfully, despite the PBoC's massive currency defense: the latter's foreign exchange reserves have shrunk further since then (Chart I-4), as capital flight has exceeded the enormous current account surplus by a large margin. Chart I-3Investors Are ##br##Complacent About RMB bca.ems_wr_2016_11_09_s1_c3 bca.ems_wr_2016_11_09_s1_c3 Chart I-4China: Foreign Exchange ##br##Reserves Still Shrinking bca.ems_wr_2016_11_09_s1_c4 bca.ems_wr_2016_11_09_s1_c4 Chart I-5PBoC Liquidity Injections ##br##Have Been Enormous bca.ems_wr_2016_11_09_s1_c5 bca.ems_wr_2016_11_09_s1_c5 The PBoC's selling of U.S. dollars to prop up the yuan has drained domestic currency liquidity and one would expect interbank rates to rise. However, the PBoC has been re-injecting RMBs into the system to keep interest rates low (Chart I-5). Such RMB liquidity proliferation makes further declines in the currency's value all the more likely. We expect the RMB to continue depreciating. Yet global financial markets have become extremely complacent about the potential for additional RMB depreciation. After having been bullish on U.S./G7 bonds for the past several years, in our July 13 Weekly Report,2 we highlighted that U.S./G7 bond yields would rise and closed our strategic short EM equities/long 30-year U.S. Treasurys position. Even though U.S./G7 bond yields have risen since July, EM equities have not declined. Given that falling G7 bond yields were used as justification for the EM rally, the opposite should also hold true. We expect U.S. bond yields to rise further. Our EM Corporate Health Monitor - constructed using bottom-up financial variables of companies with outstanding U.S. dollar corporate bonds - points to a reversal in the EM corporate credit market rally (Chart I-6). Furthermore, EM sovereign and corporate credit spreads have tightened considerably and are now very overbought and expensive. As we argued in our Special Report titled EM Corporate Health Is Flashing Red3 that introduced the EM Corporate Financial Health (CFH) Monitor, EM corporate credit spreads are as expensive as they were before they began widening in 2013 and 2014 (Chart I-7). Chart I-6EM Corporate Bond Rally To Reverse? EM Corporate Bond Rally To Reverse? EM Corporate Bond Rally To Reverse? Chart I-7EM Corporate Spreads Are Too Tight EM Corporate Spreads Are Too Tight EM Corporate Spreads Are Too Tight Finally, the U.S. dollar sold off early this year, but it has held firm in recent months. Nevertheless, EM risk assets have not retreated, despite the greenback's strength (Chart I-8). Few would argue that sharp U.S. dollar appreciation is negative for EM risk assets, but there is a debate among investors and analysts about whether EM risk assets can rally amidst a gradual appreciation in the U.S. dollar. Turning to the empirical evidence, Chart I-9 reveals that in the past 30 years any U.S. dollar appreciation - whether gradual or not - even versus DM currencies has coincided with weakness in EM share prices. Chart I-8EM Investors Have ##br##Ignored U.S. Dollar Strength bca.ems_wr_2016_11_09_s1_c8 bca.ems_wr_2016_11_09_s1_c8 Chart I-9EM Equities And ##br##U.S. Dollar: A 30 Year History EM Equities And U.S. Dollar: A 30 Year History EM Equities And U.S. Dollar: A 30 Year History Bottom Line: The majority of narratives that justified the EM rally from February's lows have been overturned. To be consistent, this warrants a relapse in EM risk assets. China's Credit And Property Tightening In recent weeks, there have been numerous policy tightening efforts in China. In particular: At the annual World Bank/IMF meetings in Washington last month, PBoC Governor Zhou Xiaochuan stated that once markets stabilized there would no longer be additional large increases in bank credit. His exact words were: "With the gradual recovery of the global economy, China will control its credit growth".4 As U.S. and European PMIs have firmed up and U.S. employment and wage growth is robust, Chinese policymakers will be emboldened to moderate unsustainable credit growth and not to repeat the massive fiscal push of early this year. In a bid to curb excessive bank credit growth and discourage "window dressing" accounting, the PBoC announced on October 255 that going forward it will include off-balance-sheet wealth management products (WMPs) in the calculation of banks' quarterly Marco Prudential Assessment ratios, starting from the third quarter. The clampdown on WMP accounting will reduce banks' capital adequacy ratios (CARs). One key reason that banks had aggressively boosted the size of their off-balance-sheet WMP assets was that they were not required to have capital charges against them, helping banks extend more credit while complying with CARs. In short, Chinese banks' CARs are inflated. This policy measure along with provisioning and writing-off non-performing loans, if reinforced, could meaningfully reduce the CARs of all Chinese banks, especially small- and medium-sized ones, as well as force them to reduce the pace of credit expansion. Given that the majority of medium and small banks have been more aggressive than the country's five biggest banks in expanding credit in recent years, this may have a damping effect on credit growth in 2017. In fact, the 110 medium and small banks retain 60% of on- and off-balance-sheet credit claims on companies, while the five largest banks hold 40% (Table I-1). Hence, credit trends in small and medium banks are at least as important as those among large banks. Table I-1China: Five Largest Banks Hold Only 40% Of Credit Assets EM: Defying Gravity? EM: Defying Gravity? Finally, a number of cities have announced various tightening measures on property markets of late, including the re-launch of house purchasing restrictions and increases in minimum down payments. Similar restrictions on home purchases served as an efficient tool for curbing property purchases in 2013-14, and there is no reason why it will be different this time around. This is especially true given the market is more expensive than it was back in 2013. In addition, the government has curbed financing for property developers. The biggest economic risk remains construction activity. Even though housing sales and prices have skyrocketed by 20-40% in the past 12 months (Chart I-10, top and middle panels), residential floor space started has been very timid - it has in fact failed to recover (Chart I-10, bottom panel). As residential property sales contract again due to new purchasing restrictions, property developers will certainly curtail new investment, and housing construction activity will shrink anew. The same is true for commercial properties (Chart I-11). Chart I-10China's Residential Market: ##br##Demand, Prices And Starts China's Residential Market: Demand, Prices And Starts China's Residential Market: Demand, Prices And Starts Chart I-11China's Non-Residential ##br##Market: Demand And Starts China's Non-Residential Market: Demand And Starts China's Non-Residential Market: Demand And Starts An interesting question is why property starts have been so weak, as indicated in the bottom panels of Chart I-10 and Chart I-11 - particularly when both floor space sold (units) and property prices have surged exponentially in the past 12 months. Our view is that there is a large hidden inventory overhang in the Chinese property market. For example, government data on residential floor space started, completed and under construction attest that there is still a large gap between floor space started versus completed (Chart I-12). From these data/charts and the enormous leverage carried by property developers, we infer the latter have been accumulating / carrying on their balance sheets vast amounts of inventory in excess of what market-based sources suggest, and what is widely followed by analysts. It is very hard to make sense of the Chinese property inventory data, but we suspect these market-based data sources may track only inventories that have been completed and released to the market - and do not account for inventories classified as "under construction". For residential housing, according to government data the "under construction floor space" is 5 billion square meters (Chart I-13, top panel), which is equal to 3.5-4 years of sales at the fervent pace of the past 12 months (Chart I-13, bottom panel). Another way to assess this is as follows: Assuming an average construction cycle of three years, there will be supply of new housing in amounts of 16.7 units in each of the next three years. This compares with sales of 13.3 million units in the past 12 months that occurred amid a buying frenzy and booming mortgage lending. Faced with a potential drop in sales due to the recent purchasing restrictions, elevated inventories, enormous leverage (Chart I-14), and tighter financing, property developers will most likely curtail new starts. In turn, a reduction in property starts means less construction activity next year, and weak demand for commodities. Consistent with the rollover in the fiscal spending impulse, infrastructure spending will likely also lose its potency in early 2017. Chart I-12China's Residential ##br##Market: Hidden Inventories bca.ems_wr_2016_11_09_s1_c12 bca.ems_wr_2016_11_09_s1_c12 Chart I-13Chinese Real Estate: Massive ##br##Volumes Under Construction Chinese Real Estate: Massive Volumes Under Construction Chinese Real Estate: Massive Volumes Under Construction Chart I-14Leverage Of Chinese ##br##Listed Property Developers bca.ems_wr_2016_11_09_s1_c14 bca.ems_wr_2016_11_09_s1_c14 Bottom Line: Recent property market and marginal credit policy tightening will weigh on construction activity and depress Chinese demand for commodities and industrial goods next year. Confirmation Bias, Or Bias Based On Fundamentals? Why did we not follow the indicators discussed above from February through June, when the EM rally emerged and these indicators bottomed? Do we have a confirmation bias? We did not recommend playing the EM rebound early this year because we did not believe the rally would last this long or go this far. If we had had conviction about the duration and magnitude of the rally, we would have changed our strategy - tactically upgrading EM risk assets despite our negative structural and cyclical views. Simply put, we were wrong on strategy. In our April 13, 2016 Weekly Report,6 we argued that based on China's injection of massive amounts of fiscal and credit stimulus, growth would marginally improve in the months ahead. Yet, we stopped short of recommending chasing the EM rally given the menace of numerous cyclical and structural negatives surrounding the EM/China growth outlook. As to the reasons why we put more emphasis on some indicators and less on others at various times, we have the following points: We are biased in so far as our assessment and analysis of EM/China is based on fundamentals. In this sense, we are biased towards centering our investment strategy on fundamentals. Specifically, given our view/analysis that EM/China have credit bubbles/excesses, rapidly falling or weak productivity growth and record-low return on capital (Chart I-15), we cannot help but to have a fundamentally bearish bias on EM. This, in turn, means that we view any rally in EM risk assets or uptick in EM/China economic indicators with suspicion and likely as unsustainable. The opposite also holds true. All in all, if we are wrong on our fundamental view and analysis, we will be wrong on financial markets. When investors expect a bear market, they are better off selling rallies and not buying dips. When an asset class is in a multiyear bull market, it pays off to buy dips rather not sell rallies. Unless one can time market swings well, it is hard to make money on the long sides of bear markets. Similarly, it is difficult to profit from short positions in bull markets. In brief, countertrend moves are about timing. Timing does not depend on fundamentals. It is often a coin toss. Typically we do not recommend clients invest based on a coin toss. For example, it is impossible to rationalize why the EM rally did not begin following the August 2015 selloff, but instead started in February 2016. In late August 2015, with carnage in EM risk assets pervasive, it was clear that Chinese policymakers would stimulate and in fact the massive fiscal stimulus was initiated in August/September 2015 not in 2016. Similarly, China's manufacturing PMI bottomed in September 2015, not in 2016 (Chart I-16). Chart I-15EM Non-Financial Return ##br##On Equity Is At All Time Low EM Non-Financial Return On Equity Is At All Time Low EM Non-Financial Return On Equity Is At All Time Low Chart I-16China's Manufacturing PMI ##br##Bottomed In October 2015 China's Manufacturing PMI Bottomed In October 2015 China's Manufacturing PMI Bottomed In October 2015 In September 2015, EM and global equities rebounded, but chasing momentum at that time did not pay off as risk assets cratered in the following months. This is all to say that timing markets is often a random walk. We do attempt to time market moves that go along with our fundamental bias, but prefer not to time market moves that go against the primary trend. We assume any countertrend move is typically short-lived and unsustainable. That said, we also realize these moves can be very painful for investors if they last long enough, like this EM rally. Finally, we often get questions on fund flows. We do not make investment recommendations based on fund flows - even though we recognize they are very important in driving markets. The reason is that there is no comprehensive data on global fund flows that one can analyze and make reasonably educated bets. The often-cited EPRF dataset only tracks inflows and outflows of mutual funds and ETFs. It does not account for flows and positioning of various asset managers, sovereign funds, pension funds, insurance companies, hedge funds and private wealth managers, among many others. What's more, the EPRF dataset only covers the funds located in advanced countries and offshore jurisdictions, but not emerging countries where investment pools have become large and important. In brief, the available investment flow and portfolio positioning data are not comprehensive at all, and they cannot be relied upon too much to make investment recommendations. In this vein, a question arises: Why can't flows into EM sustain the current rally for a while even though it is not based on fundamentals? In this context, let's consider the case of the rally in euro area share prices when markets sensed the arrival of the European Central Bank's quantitative easing efforts at the beginning of 2015. There was a fervent rush to buy/overweight euro area stocks heading into the QE announcement by the ECB. European bourses surged. Nevertheless, euro area equity prices have been sliding and massively underperforming the global equity benchmark since March 2015 (Chart I-17). The reason the ECB's QE has not helped euro area stocks is because their fundamentals were bad - profits have been shrinking despite the ECB's QE. We suspect EM stocks and currencies will have a similar destiny: EM profits will disappoint considerably, and the current rally will prove unsustainable. Notably, net EPS revisions have so far failed to move into the positive territory (Chart I-18). Chart I-17Euro Area Stocks And EPS: ##br##Why The QE Rally Proved To Be Bogus Euro Area Stocks And EPS: Why The QE Rally Proved To Be Bogus Euro Area Stocks And EPS: Why The QE Rally Proved To Be Bogus Chart I-18EM Stocks And EPS: ##br##Earning Revisions Are Still Contracting bca.ems_wr_2016_11_09_s1_c18 bca.ems_wr_2016_11_09_s1_c18 Arthur Budaghyan, Senior Vice President Emerging Markets Strategy & Frontier Markets Strategy arthurb@bcaresearch.com 1 China Foreign Exchange Trading System. 2 Please refer to the Emerging Markets Strategy Weekly Report, titled "Risks To Our Negative EM View," dated July 13, 2016; a link is available on page 15. 3 Please refer to the Emerging Markets Strategy Special Report, titled "EM Corporate Health Is Flashing Red," dated September 14, 2016; a link is available on page 15. 4 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3155686/index.html 5 Please see http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3183204/index.html 6 Please refer to the Emerging Markets Strategy Weekly Report titled, "Revisiting China's Fiscal And Credit Impulses," dated April 13, 2016; a link is available on page 15. Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights There is an eternal duality between bulls and bears on the Chinese economy. We prefer to stay away from the debate, and simply monitor the situation while adjusting our portfolio recommendations as the situation evolves. From the perspective of BCA Global Fixed Income Strategy (GFIS), and in the short term, five key questions on China influence our duration stance and our core bond portfolio allocation recommendations. To answer these questions, we are following specific indicators, laid out in this Special Report. Together, those form the "GFIS China Checklist". Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. China's cyclical growth impulses are positive, suggesting a tailwind for the global economy, and upward pressure on inflation and bond yields in the near-term. At the moment, the "China Factor" reinforces our below-benchmark portfolio duration stance and our bias towards underweighting bond markets that are most exposed to Chinese demand and higher commodity prices (i.e. Australian government debt), while also favoring inflation-linked bonds over nominals across the developed world. Table 1The GFIS China Checklist How To Assess The "China Factor" For Global Bonds How To Assess The "China Factor" For Global Bonds Feature Chart 1Getting China Right Is Crucial Getting China Right Is Crucial Getting China Right Is Crucial At the macro level, several factors have a disproportionate impact on the direction of global bond yields. The evolution of monetary policies in the developed economies, globalization, new technologies, demographic changes and productivity trends are among the themes that top our list. A positive or negative shift in these factors could significantly alter the path of global growth and inflation and, by the same token, bond yields. In this Special Report, we will address the "China factor". Through its massive aggregate demand, this huge country can tip the global macro landscape into equilibrium or disequilibrium (Chart 1).1 As such, closely monitoring its developments is crucial for investors to correctly position for/against the cyclical drivers of bond markets. Unfortunately, understanding China's dynamics and seeing through the opacity of its policy-setting process is extremely challenging. Experts on the matter often disagree (even here at BCA!) on the complex issues, and sometimes even the most basic assumptions, underlying a view on China. In this Special Report, our goal is not to try to untangle the ultimate truth about China. Instead, we will cut through the fog and offer a simple framework to monitor its economy and associated risks. From an investment perspective, getting China right comes down to answering five keys questions: Is China's macro stability starting to deteriorate? Are China's growth impulses positive? Is Chinese economic momentum accelerating? Are China's business fundamentals evolving positively? Is the outlook for Chinese household consumption improving? To answer those, we follow simple indicators, laid out in this Report. Together, they form the BCA Global Fixed Income Strategy (GFIS) "China Checklist" (Table 1). The Eternal Duality In Chinese philosophy, the Yin - the dark swirl - represents shadows, the moon and the trough of a wave. In the investment world, members of the Yin camp view China's great accomplishments of the last 30 years with a doubtful eye. In its economic miracle, they see fragility and unsustainability. Those doubters are quick to raise the multiple structural problems such as regional disparities, income inequality, pollution, workers' dissatisfaction, and the unfair hukou2 system, among others. China' high debt levels and widespread, institutionalized misallocation of capital usually anchor their gloomy view. On the other end of the spectrum, the Yang - the light swirl - represents the sun and growth. For members of the Yang camp, China's policymakers have a grand master plan that will lead China to dominate economically and geopolitically for decades to come. Discarding the potential credit addiction problem, they believe that China should continue to invest at a record pace, arguing that investments will eventually lead to faster productivity, which will lift potential growth and overall prosperity. They posit that leveraging is simply a natural process for a fast-growing country with massive excess savings. To their despondency, China bears fail to recognize the merits of the country's un-paralleled meritocratic political system and the communal dynamic that makes it unique. Where does GFIS stand in this debate? Both camps have legitimate arguments and could be right in the end. The key thing about the Yin/Yang symbol is that both the black and white contain a little bit of each other. In the end, this duality might just be a healthy dynamic where one cannot exist without its opposite. For us, it leaves an important dilemma. On one hand, betting on a Chinese hard landing that never materializes could turn out to be a widow-maker trade.3 On the other hand, ignoring China's structural issues and assuming that everything will be all right is a strategy that can be prone to devastating disappointments. Instead of trying to predict the end game, we will focus our efforts on assessing how the economic momentum and the risks are evolving at each particular moment. This will inform our overall views on global growth and inflation and, in the end, the direction of bond yields and credit spreads. Bottom Line: There is eternal debate between the Yin and Yang camp in regards to China's future. We prefer to stay away from the debate, and will monitor the situation through specific indicators and adjust our investment recommendations accordingly. Is China's Macro Stability Starting To Deteriorate? Maybe Nobody knows for sure when or if China will go through an acute period of turbulence related to stresses in its financial system. Nonetheless, to properly calibrate our duration call and the pro-cyclical bets in our recommended fixed income portfolio, we need to assess if the stress points are flashing red, and to what degree. Below, we propose a set of indicators that could eventually signal a bubbling credit-related event (Chart 2 & Chart 3). Chart 2Is China's Macro Stability Deteriorating? Part I bca.gfis_sr_2016_11_08_c2 bca.gfis_sr_2016_11_08_c2 Chart 3Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II Is China's Macro Stability Deteriorating? Part II In aggregate, they warn that China has been experiencing some instability lately. This should be taken seriously and temper any China optimism. The Renminbi If China goes through a period of instability, its currency, the Renminbi (RMB), would deteriorate as money tries to escape through any cracks in the financial system or real economy. The RMB has had several episodes of rapid depreciation (by China's standards) over the past 18 months which could be a bad omen. That said, since China's policymakers still largely have the capacity to control the evolution of its currency, the RMB could end up reflecting a serious capital outflow problem only far after the fact. Nonetheless, it is still something to follow closely. Hibor/Shibor rates When a financial system goes through episodes of turbulence, lenders tend to freeze operations until the cause is clear. Banks stop lending to each other and overnight interest rates tend to spike. It is possible that the RMB-based Hong Kong Interbank Offered rate (Hibor) or the Shanghai Interbank Offered Rate (Shibor) can offer such a signal. Since mid-2015, the Hibor has experienced three such episodes. In each case, they proved to be temporary - rates came down shortly after each spike - but we still view this with a wary eye. Since China has a closed capital account and maintains a stable currency through several interlinked instruments, it is possible that the overnight lending market might not be as relevant a signal as it would be for countries with open capital accounts. Our colleagues at the BCA China Investment Strategy have recently been sanguine about the significance of those spikes.4 Regardless, we will keep this indicator on our list of possible China stress points. Equity prices of global banks with heavy links to China & Emerging Markets Capital market data are often the first to hint that financial stress is rising. In China's case, the stock prices of major global banks that are highly exposed to China and, more broadly, emerging markets might play that role. Two such banks are Standard Chartered and HSBC. If China's internal dynamic eventually becomes shaky, the relative equity performance of those banks could quickly erode.5 For now, this does not seem to be the case, as their stocks are performing well; the stress appears to be contained. Capital outflows If China's economy is about to crumble under a pile of debt, money will leak through the cracks. Part of the money flowing out will eventually trickle through to safe assets in the rest of the world, like U.S. Treasuries and non-Chinese property markets. Since mid-2014, China capital flight has been large and clearly represents a potential source of worry. Official Holdings of U.S. Treasuries If the Chinese economy were to deteriorate meaningfully, or if there were potential undercapitalization issues stemming from any buildup of bad loans within the Chinese banking system, the authorities might be driven to sell some of China's enormous stock of U.S. Treasuries and "invest" the money domestically. Lately, China has been a net seller of U.S. Treasuries, which could be a potential sign of trouble but could also simply be the result of China having less of a need to accumulate U.S. dollar assets to fight inherent appreciation pressures on the RMB. Policy Uncertainty Capital flight out of China could be related to many factors. Pessimism towards the future or lack of domestic investment opportunities could force savings outward. Another possibility is increasing policy uncertainty and/or brewing political instability among China's leadership. Lately, China's Policy Uncertainty Index has skyrocketed.6 Before pushing the panic button, however, one has to consider mitigating factors. It is possible, considering the after-effects of the shocking U.K. Brexit referendum and the increased odds of a Donald Trump U.S. Presidency, that this jump in the China uncertainty index has been more externally than domestically driven. Bottom Line: Several of our financial stress indicators reveal the possibility that China's macro stability could be starting to fray a bit at the edges. These trends could become worrisome if they linger or re-appear. Are China's Growth Impulses Positive? Yes Economic momentum can develop as a result of several growth impulses. Below, we propose five of them (Chart 4 & Chart 5). Currently, they are trending favorably, for the most part, and suggest that China is in the expansionary phase of its economic cycle. If sustained, this tendency should have a considerable impact on global growth, inflation and bond yields. Chart 4Are The Growth Impulses Positive? Part I bca.gfis_sr_2016_11_08_c4 bca.gfis_sr_2016_11_08_c4 Chart 5Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II Are The Growth Impulses Positive? Part II The monetary conditions index Both the movement in policy interest rates and the currency can influence a country's monetary conditions, which in turn impact the backdrop for growth. Since the beginning of 2015, China's policy interest rate and the reserve requirement ratio for banks have been cut several times. The Renminbi has also depreciated during the same period. Combined, these factors have eased monetary conditions, which has been a positive development for the Chinese economy. Money supply growth In most countries, a more rapidly growing money supply usually leads to greater credit expansion, which eventually leads to faster economic growth. Again, since the beginning of 2015, Chinese money supply growth has shot up markedly. This should sustain credit/growth expansion in the coming months. Corporate bond yields An abundance of money can be of little help to an economy if corporations cannot finance themselves at a reasonable yield. Historically, the average Chinese corporate bond yield has been a leading indicator of industrial output growth. As the corporate yield decreases, financing becomes more attractive and a credit boom could follow, resulting in increased economic activity. Since 2015, Chinese corporate bond yields have literally collapsed, seemingly following the trend in non-Chinese corporate bond yields. If history is any guide, this should be setting the stage for accelerating output growth. One caveat: China's private sector debt servicing ratio might have reached too high a level, such that it has reduced the ability for companies to benefit from lower corporate bond yields moving forward. This could explain why industrial output growth has not gained ground as corporate bond yields have fallen. The credit impulse Credit origination has been a vital part of China's economic success since 2000 and even more so since the 2008 global financial crisis. Our Emerging Markets Strategy team has created the credit impulse indicator - which is the second derivative of credit growth - to assess the condition of the credit impulse.7 This simple indicator has proven to be one of our more reliable leading indicators of economic growth (for China and for many other countries) Of late, this indicator has moved into positive territory. Possibly, easy monetary conditions, stronger money supply growth and lower corporate bond yields have helped push the impulse upward. We interpret that as a very powerful signal for future Chinese growth. Again, a cautionary note is warranted. For a while now, Chinese credit growth has been faster than nominal GDP growth, potentially representing an unsustainable dynamic. Hence, it is likely that the latest surge proves to be only temporary, as credit growth slows to a more desirable pace.8 So, we won't get too excited just yet. Fiscal thrust Outside the credit channel, the Chinese government embodies another major contributor to the growth impulse. Considering its relatively low debt levels, the government has the means to sustain the economy via increased fiscal expenditures, especially via infrastructure investments. Lately, to alleviate the pain from the reforms and restructuring of certain parts of the economy,9 the government has engineered a decent fiscal thrust. Many infrastructure projects have been laid out, growing at a rate up of 15% in the last four years. As long as China continues along a long-term restructuring path, reducing that rapid pace of government spending will prove to be difficult. Bottom Line: Chinese growth impulses are currently positive. Is Chinese Economic Momentum Accelerating? Yes An open liquidity tap and a positive fiscal thrust should lead to increased Chinese demand. Below, we provide six indicators showing that this occurred lately (Chart 6 and Chart 7). The synchronicity of their upward acceleration reinforces our optimism about the Chinese cyclical outlook. Chart 6Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Is Chinese Economic Momentum Accelerating? Part I Chart 7Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Is Chinese Economic Momentum Accelerating? Part II Keqiang index Since Chinese economic growth data could be described as "man-made" and potentially unreliable, an index of Premier Li Keqiang's favorite economic indicators has been used, since it was leaked to the press several years ago, to appraise the true state of the economy. Cargo volumes, electricity consumption and loans disbursed by banks comprise this indicator. In the last twelve months, the Keqiang index has hooked decisively higher. The index has a flaw - the declining role of banks loans in overall new credit - but it is still useful, and it corroborates the positive signal sent by the growth impulses mentioned previously in this report. Excavator sales Traditionally, the construction sector has been at the core of China's growth miracle. To gauge the evolution of this sector, the growth rate of excavator sales has been very reliable. After being negative since mid-2011, it has surged in 2016. With a lift off of such magnitude, one could doubt the validity of this data. However, it has followed a similar spurt seen in money supply and a burst in the "projects started" capital spending growth rate. Residential floor space sold The state of the construction sector can also be assessed through the time series of residential floor space sold, which tends to lead new housing starts by several months. Again, since the beginning of the year, this indicator has been trending higher, echoing the message sent by excavator sales growth. Import volume growth No other time series better expresses the state of China's demand than its import volume growth. If the global growth and inflation outlook were to get a boost, Chinese imports would need to gain positive momentum. Lately, they have accelerated; this constitutes a very positive sign. CRB Raw Industrials prices Since China is by far the biggest consumer of commodities globally (see Chart 1, on page 2), China's demand indicators should be correlated with global commodity prices. In theory, both should move in a similar fashion to validate one another. This year, the CRB Raw Industrials price index has indeed stabilized and confirmed the positive growth dynamic observed through other indicators. The Chinese yield curve The yield curve has traditionally been recognized as an excellent leading indicator for most economies. It usually signals slowing growth when it flattens and steepens when growth gains momentum. China's yield curve has been especially well correlated with the Chinese PMI data, for example. Lately, China's yield curve has flattened a bit, which is not a good sign. However, until it inverts, like in 2011, 2013 and 2015, we will treat its message as neutral. Bottom Line: Chinese economic momentum is accelerating. A flattening yield curve tempers our optimism to some degree, however. Chart 8Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Are The Business Fundamentals Evolving Positively? Yes If Chinese economic momentum truly accelerates, domestic businesses should reap the benefits and their internal dynamics should improve. As per the business indicators presented below, this is currently the case (Chart 8). Final goods producer prices Producer pricing power is crucial and it has been lacking over the last few years on a global scale. Without pricing power, capital investment and employment growth tend to stay depressed, and vice versa. Since 2012, China's final goods producer prices have been contracting. This started before the beginning of the commodities collapse in 2014 and has been hugely deflationary for the rest of the world. But this might be a story of the past; final goods producer prices have turned positive lately. This could prove a major development, if it lasts. The risk here is that the U.S. dollar appreciates - due to a Fed hike and/or a more hawkish tone going forward - pushing global commodity prices lower, which has historically depressed global producer prices. However, if the Fed treads carefully after the December rate hike that we expect, waiting for the rest of the global economy to catch up to a U.S. acceleration, the dollar could end up trending sideways. Commodity prices could then continue on the current upward trend, preventing producer price growth from relapsing back into negative territory. Cash flow ratio Leveraging during the 2009-2011 period has left many Chinese firms highly indebted, especially in the industrials, materials and real estate sectors. As debts increased, debt servicing cash flows substantially shrank during the 2011-2014 period. Fortunately, since mid-2015, this situation has reversed, with the cash flow/total liabilities ratio having increased steadily. Net earnings revisions In the end, strong profits are necessary for a healthy economy. This has been lacking globally, but even more so in China; most China MSCI equity index sectors suffer from contracting earnings per share, except consumer staples. Nonetheless, the jump higher in net earnings revisions seen this year is encouraging. Bottom Line: China's business fundamentals are evolving positively. Chart 9 Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is Chinese Consumption Outlook Improving? Is the Outlook For Chinese Household Consumption Improving? Yes Ultimately, improved business conditions should lead to better job creation, strong workers' income and more robust final consumer spending. Lately, the virtuous cycles in credit, demand and the business sector have indeed trickled down to the consumers. Employment and consumption are synchronously accelerating (Chart 9). PMI Employment Index Despite the questionable quality of China's employment data - making it difficult to assess the true picture of the labor market - the employment sub-index of the overall China Purchasing Managers Index (PMI) gives a relatively reasonable reading. Since 2012, it has been trending downward. However, the fact that the latest data point rose sharply above the 12-month moving average is a good sign, perhaps indicating the cyclical downtrend in Chinese employment growth truly bottomed in 2015. Auto sales If employment growth and wages are indeed in a cyclical upturn, Chinese retail consumption growth should be thriving. This has been the case in 2016, with auto sales growth shooting up sharply. Bottom Line: The outlook for Chinese household consumption is improving. Investment Implications Chart 10Investment Implications Investment Implications Investment Implications In the analysis above, we concluded that: The possibility of eroding Chinese macro stability cannot be discarded, as financial stress points are rising. This needs close monitoring. Chinese growth impulses are, for the most part, positive. Chinese economic momentum is accelerating, but a flattening yield curve tempers our optimism. China's business fundamentals are evolving positively. The outlook for Chinese household consumption is improving. In sum, despite the reigning policy uncertainty and persistent capital outflows, the current short-term dynamics are surprisingly positive. Accordingly, and taking the overall "China factor" in isolation, the following fixed income investment recommendations should be implemented (Chart 10): Maintain a below-benchmark duration bias. There is a meaningful positive contribution to global growth and inflation from China. If the Chinese economy gathers more steam, global bond yields and inflation will also move higher. Maintain low exposure to bond markets most negatively exposed to faster Chinese growth & rising commodity prices. Our positive cyclical view on China has an impact on our core recommended bond portfolio allocation. We have been underweight Australian government bonds versus global hedged benchmarks since the summer, and China's improving demand constitutes a definite plus to this view, as it is Australia's largest export destination. We have also maintained a bias to favor inflation-linked bonds versus nominals in the major developed markets. A faster pace of Chinese goods inflation should translate into an acceleration in global traded goods prices (and inflation rates) in the coming months, to the benefit of the relative performance of linkers. Maintain a neutral stance on Emerging Market hard currency bonds. Due to a very unappealing structural backdrop, we have a negative longer-term bias towards Emerging Markets sovereign and corporate bonds. However, in July, we turned neutral, from underweight, due to the improving global cyclical outlook, especially based on what was happening in China. This move has paid off so far and the position should be maintained, even if there is some upward pressure on the U.S. dollar from a Fed rate hike next month.10 Overweight Australian Semis. Since March 2016, we have had a positive bias towards Australian Semi-government debt.11 Semis outperform Australia federal government debt during global expansionary phases, and China will continue to support the current cyclical growth upturn. Finally, the biggest risk to our view is that China's structural fragilities won't allow the current cyclical recovery to be sustained beyond the next year. Our GFIS China Checklist will help us to detect any downturn if and when it becomes apparent. Jean-Laurent Gagnon, Editor/Strategist jeang@bcaresearch.com 1 Furceri, Jalles, and Zdzienicka (2016) perform time-varying coefficient analysis using local projection methods on a sample of 148 countries over 1990-2014, and show that spillovers from a 1 percentage point shock to China's final demand growth now have a cumulative impact on global GDP of about 0.25 percent, after one year. Source: http://www.imf.org/external/pubs/ft/weo/2016/02/pdf/c4.pdf 2 The hukou system was originally introduced to register China's households as part of an effort to gather population statistics. It has morphed into a government tool to control rural-urban migration flows that has made it more difficult for migrant workers to access health care or education services in China's cities. For more information, please see: http://thediplomat.com/2016/02 chinas-plan-for-orderly-hukou-reform/ 3 Here we have a thought for all those who have bet on the demise of the Japanese bond market over the years without glory. 4 For details on this issue, please see BCA China Investment Strategy Weekly Report, "HIBOR, Liquidity And Chinese Stocks", dated September 22, 2016, available at cis.bcaresearch.com 5 For details on this issue, please see http://www.imf.org/~/media/files/publications/spillovernotes/spillovernote5 6 This is part of a global suite of indicators produced by researchers Baker, Bloom and Davis, designed to measure economic policy uncertainty for the major economies. For more information, please go to www.policyuncertainty.com. 7 Please see BCA Emerging Markets Strategy Special Report, "Gauging EM/China Credit Impulses", dated August 31, 2016, available at ems.bcaresearch.com 8 For more perspective on this idea, please see BCA Emerging Market Strategy Special Report "Misconceptions About China's Credit Excesses", dated October 26, 2016, available at ems.bcaresearch.com 9 Massively decreased output and increased employee layoffs in the steel industry, for example. 10 Please see BCA Global Fixed Income Strategy Special Report, "Emerging Markets Hard Currency Debt: Time For More Optimism?", dated July 12, 2016, available at gfis.bcaresearch.com 11 Please see BCA Global Fixed Income Strategy Special Report, "Australian Credit: Time To Test The Waters", dated March 29, 2016, available at gfis.bcaresearch.com